29 Apr 2020

Bitcoin Halving and Market Maturity

There are many different forces at play, so no one knows how this will play out. That said, there are certain things we do know.
Source: BitIRA
Demand is key
First of all, the bitcoin price is always determined by the net demand for holding bitcoin. With a given amount of bitcoin available at any point in time, its value must adjust until investors realize their desired allocations, denominated in e.g. USD.
  • To make a simplified example: If there was only one bitcoin and two investors wanted to hold 1000 USD worth of bitcoin each, that would only be possible with bitcoin valued at 2000 USD a coin.
The current inflation rate is around 3.6% and will drop to 1.8% in May. This means that without a change in demand, the halving should only trigger a 1.8% price increase over the first year after the halving, relative to what would be the case without the halving. Without a change in demand, the market cap should stay fixed. With 3.6% yearly inflation in the stock of bitcoin, the price must drop 3.6% for the market cap to stay the same. With 1.8% inflation, the drop would only need to be 1.8%.
Hodlers are fully invested
In other words, it looks like the supply side effect is irrelevant. But that is not 100% true. The reason is that a lot of bitcoin hodlers are fully invested. They will keep holding if the price goes up, but they do not have more USD to buy BTC for. The price is therefore to some degree determined by the marginal buyer and the marginal seller and not the hodlers alone.
  • To make a simplified example: Imagine that all existing coins are held by strong hands not selling. Miners have to sell to cover costs, but no one has to buy. A halving in the supply of new bitcoin would, for a given rate of inflow of new USD, lead to a doubling of price. Once the price has doubled, half the number of coins will be enough to absorb the incoming USD.
But, looking at the past and popular predictions like the Stock to Flow model, optimists are expecting a 10x+ price increase? This will only happen if there is a massive increase in demand. And that is actually not too unlikely.
The scarcity of bitcoin
The halving could tilt the balance between the marginal buyers and sellers, setting off a bull market with a feedback loop where more people want to buy when the price rise. More importantly perhaps, the current halving draws attention to the absolute scarcity of bitcoin at a time when governments and central banks all over the world are doing what they can to stimulate the economy through lowering interest rates, quantitative easing, helicopter money and more.More and more people are learning about the halving and the scarcity of bitcoin and finding it appealing. That way the halving works as a Schelling point, accelerating the already strong momentum for bitcoin.It is therefore not unlikely that we can see a pre halving pump, followed by a correction, before the underlying growth trend in adoption and awareness drives bitcoin towards new highs.
What about market maturity?
The main thing is that the market is deeper now than in the past, making the rate of change slower. We have seen this through the historical bitcoin booms, where the time it took to 10x has gone from one month in 2013 to almost a year in 2017.
What about futures and options?
When CME and CBOE launched futures at the peak of the previous bitcoin bubble, they effectively removed the “no short constraint”, so that the value of bitcoin had to match the net portfolio demand rather than the gross. Open interest for short and longs must always balance. When there is more demand for long exposure, the premium to spot is pushed up, creating an “arbitrage opportunity” where you can buy spot and short the futures contract. In this way, the futures market still balance and the net increase in desired long exposure is shifted to the “physical” bitcoin market. These new futures contracts have also made it possible for institutional investors to build up long exposure, and drive the price, without having to buy and hold the “physical” bitcoin. More futures and options have entered the market since, making exposure easier for institutional and professional traders. While CBOE have closed their bitcoin futures offering, new actors like Bakkt has entered. Hedging and risk optimization have also become easier and the market is more liquid in normal times, but with amplified volatility when large shocks hit due to the increased leverage.
What will happen on the halving day?
This is a known event, and judging by the options market, a non-event. If anything, traders seem to be more interested in hedging downside risk with put options than speculate on a large upside with OTM (Out of the money) call options. Apart from providing some clarity around the market expectations (rather than just the Twitter sentiment) and giving traders the possibility to tailor their risk-reward profile, these derivatives do not fundamentally affect the underlining (lack of?) price effects of the halving.
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