Why Market Prices Do Not Double With a Block Reward Halving

[Note: This was originally published on October 15, 2014 at Melotic.com]

For a little background to this post, see my previous post on block reward halving and the scrypt alliance.

One of the common misconceptions within the virtual currency space stated by many advocates is that when a proof-of-work blockchain has a block halving, for some reason the market price is supposed to immediately double. Yet in practice, it rarely, if ever does on that date.

There are a couple reasons for why this is the case.

To be clear, when a block reward halving takes place, it is the future money supply – monetary stock creation rate – that divides in half. The current existing monetary supply does not divide by 50% (see Jonathan Levin’s explanation for defining bitcoin as narrow money stock).

Again, it is not as if the entire monetary stock divides in half overnight, it is just the block reward that does. If half of the money supply was destroyed or permanently lost, then ceteris paribus, it could have a non-negligible impact. For example, in late February and early March of this year, news related to Mt. Gox’s collapse suggested that up to 850,000 bitcoins may not exist.

That is to say that one potential outcome of Mt. Gox’s bankruptcy is that they were fraudulent operating, perhaps by running in an undeclared fractional reserve-like manner and some, many or all those coins simply did not exist. Consequently, market prices actually jumped for several days on this news, with speculators considering the possibility that the total money supply in circulation was smaller than what the market had previously factored in.

This is important, because if the demand of an asset remains the same while the supply is reduced, then ceteris paribus, the price of the asset could rise. The price may only change dramatically if previously unknown information becomes available but the halving does not fall into that category as it is known well in advance.

And as I briefly explored in my last post, perhaps altcoins and altchains are a type of substitute good. If this is the case, if the elasticity of demand for a good (a coin) changes due to the availability of a substitute good, then during this timeframe consumers (or speculators) may switch to other chains (technically this is called price elasticity of demand, or PED). There are several other determinants which readers may also be interested in.

If true, then perhaps during a block halving, what we may be observing is shifts of the demand curve as speculators move towards more profitable chains (since supply is fixed). And in the case of mining, the activity of mining itself is essentially taking out a “long” position on the coin itself. Or in other words, one distinct class of speculators in bitcoin, litecoin and dogecoin are the “long” positions of miners (e.g., to recoup the sunk costs and operating expenses, mining is essentially a market signal for “bullish” sentiment). Miners are a type of speculator and consequently this in turn intersects with the hash rate protection challenge discussed in an earlier post.

Theory and practice

In practice, no virtual asset – including bitcoin – has continually seen price doublings immediately after a block reward halving. In point of fact, in November 2012, bitcoin’s price did not double immediately after the halving (see Chapter 15 for more details).

This again is a challenge and an existential problem for all coins, including bitcoin. As Ray Dillinger aptly noted earlier in May regarding the survivability of altcoins:

It doesn’t halve its remaining coin supply more often than it can double its value. That’s kind of hard to predict, but at this point I think the double-value time for cryptourrency is up to about a year, maybe two. It’ll get longer until it catches up to double-value period for the rest of the economy, which is 7 to 15 years depending on the industry. This is important because whenever the block reward goes down, the hash rate goes down in the same proportion; and when the hash rate gets too low, the blockchain becomes vulnerable to an attack which can destroy its value completely. Expect any coin that mines out its coin supply too fast, to collapse. I think even Bitcoin is going to be too fast in the long run; there’ll come a point when its double-value time is slower than its block-reward halving time and alts will start sucking up the hashing power making bitcoin vulnerable to attacks.

Will bitcoin’s price double again two years from now during its next block reward halving? It is unknowable what the price will be in the interim but historically it seems unlikely this would happen on that specific date.

What is another consequence of having a fixed, inelastic supply?

Again, when supply is fixed and its creation rate known, the only way to reflect changes in demand is through price. In bitcoin’s case, Robert Sams explained several months ago on a panel that this is a problem:

I think the issue [of] should you have more elastic supply or not…really comes down to the fact that if you have a fixed supply of something, the only way that changes in demand can be expressed is through the change in price. And people have expectations of increased demand so that means those expectations, expectations of future demand get translated into present day prices. And the inelastic supply creates volatility in the exchange rate which kind of undermines the long term objective of something like cryptocurrency ever becoming a unit of account. And forever it will be a medium of exchange that’s parasitic on the unit of account function of national currencies. So I do think the issue does need to be addressed.

This topic is continuously debated and is an issue highlighted by Yanis Varoufakis, a political economist at the University of Texas and the University of Athens. According to Jeffrey Robinson’s new book, Varoufakis says that speculative demand for bitcoin far outstrips transactional demand:

Bitcoin transactions don’t go beyond the first transaction. The people who have accepted bitcoins don’t use them to buy something else. It gets back to the circular flow of income. When Starbucks not only accepts bitcoins but pays their workers in bitcoins and pays their suppliers in bitcoins, when you go back four of five stages of productions using bitcoin, then bitcoin will have made it. But that isn’t happening now and I don’t think that will happen. [Because it isn’t happening now and because so many more people are speculating on bitcoin rather than transacting with it], volatility will remain huge and will deter those who might have wanted to enter the bitcoin economy as users, as opposed to speculators. Thus, just as bad money drives out good money, Gresham’s famous law, speculative demand for bitcoins drives out transactional demand for it.

While Varoufakis is discussing the circular flow of income, the last sentence in particular is germane to this conversation.

As described above, block rewards are fixed and known in advance. What is unknown in advance however is both the demand (from speculators) and in particular miners (the labor force).  If these assets have a fixed supply rate, the only way to reflect changes in demand is through price signals.

Correspondingly, speculative demand is at odds with transactional demand. Expectations of future demand (or lack thereof) in turn creates shocks and volatility which in turn disincentivizes transactional demand on all chains. There are proposed solutions to this, but those are for later posts and will likely require a new ledger altogether.

For additional perspective I contacted Jonathan Levin, co-founder of Coinometrics, and according to him:

In economics we have a concept called rational expectations where agents use all the available information to decide their actions in equilibrium. In this framework the halving in the block rewards would have been anticipated and factored into the price. You are right to emphasize that when doing a demand and supply analysis, it is not the coins produced on a daily basis that matter but rather the entire stock of bitcoins in circulation. In that way the price of bitcoin should not double for a halve in the hashrate, in fact the effect should be negligible. This is considering just transactional demand and total supply. With goods/commodities this is likely to hold true but in currencies or cryptocurrencies this may be different. There are issues of security and speculation.

Now if we consider that the market price is actually the price that the users wish to sustain in order to have sufficient network security (tenuous). Then we may make an argument that the price of bitcoin should double. People who are speculating that this will have real effect may be buying up coins which moves the price closer to that equilibrium.

In my mind, economics would predict the hashrate to halve as the reward halves. Essentially the argument would go if the price has not doubled the hashrate must fall.

While variables such as compliance/regulatory changes and the transition along the hashrate S-curve (CPU -> GPU -> FPGA -> ASIC) create wrinkles in this dynamic, thus far the empirical data matches the theory. And collectively this is why prices do not double on halving day.

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