Will Bitcoin Halving affect mining profitability? Here is what you should know.

What is Bitcoin Halving?

A halving is an event in which the protocol is programmed to automatically update, reducing the block reward for mining and halving the new bitcoin generation rate.

When Bitcoin was first conceived in 2009, its founder, who acted under the pseudonym Satoshi Nakamoto, faced the challenge of finding an equitable way to create and distribute newly manufactured Bitcoin. The mechanism he devised is commonly known as Bitcoin manufacturing —simulating the process of mining precious metals such as silver and gold.

To fully understand the concept of halving, it is necessary to briefly understand the principle of the mining mechanism and the principle of Bitcoin creation and flow in the Bitcoin ecosystem.

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What is Bitcoin Mining?

As many of you know, instead of relying on a single central authority to validate and execute transactions, Bitcoin allows a special type of network participant called miners to share this task in a decentralized way.

Bitcoin miners are network participants running specialized computational hardware, competing to solve mathematical problems based on a one-way cryptographic hash function. Solving these problems requires an enormous amount of computational power and electrical energy to find a suitable nonce. Strictly speaking, a nonce is just a random number that meets the protocol’s difficulty target. However, for the purpose and intent of mining, a nonce serves as a “proof of work” or piece of data, which is difficult to generate (expensive and time consuming) but easy for others to verify and ensure that special requirements are met.

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POW and POS – What are the differences?

Is Proof of Work (PoW ) different from Proof of Stake (PoS)? Let’s find out more: Pow vs. PoS

Excluding over-technical explanations, the purpose of this mining mechanism is to create an incentive structure so that the network is decentralized and robust enough to reach consensus across the network for the true state of the ledger. Through mining, the Bitcoin network can achieve two things at the same time: First, it introduces new Bitcoin into the Bitcoin financial supply. Second, P2P transactions are verified and concluded in a decentralized manner.

There are, of course, more complex game theories lurking in it, but suffice it to say that the core incentive structure for mining is based on the old “carrot and stick” model. Miners who honestly validate transactions according to protocol rules are rewarded with freshly manufactured bitcoins, and dishonest miners who attempt to cheat the system get nothing, wasting time and paying huge electricity bills.

What is a Bitcoin block?

A block is a file containing some, but not all, of the most recent Bitcoin transactions that have not yet entered the previous block. Bitcoin block sizes can be up to 2 megabytes, each containing approximately 2,000 transactions.

When someone transacts Bitcoin, the transaction is immediately made public on the Bitcoin network, propagating it until other nodes in the network validate the transaction and eventually reach everyone in the system.

From the point of view of a single node, when a new transaction is received and verified, it is stored in the Mempool, a storage space for unconfirmed transactions. Here, unconfirmed transactions wait quietly in the mempool until the mining node picks them up. About 2,000 are gathered in a single file called a block and then start calculating to find the answer to the aforementioned mathematical problem.

As soon as a miner finds a nonce that meets the protocol’s difficulty target, that block is immediately announced within the Bitcoin network, along with a proof of work pointing to the correct nonce. After that, when other miners in the network receive the block containing the proof-of-work, they independently backtest the proof to verify its validity. If all goes well, they accept the new block as valid and include it in their copy of the ledger. This confirms all transactions contained in that block. As soon as one miner finds a proof-of-work for a given block, all other miners in the network immediately stop trying to find a block of the same height and start computing the next block in the chain.

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What is Bitcoin Block Reward?

If you’re wondering why miners should put all this effort into securing the Bitcoin network and helping verify and execute peer-to-peer transactions, everything will be clear here.

It is important to understand the mining process. This is because new bitcoins are created through mining and circulated within the network. Literally, when a new per-block transaction is added to the ledger, it contains a special type of transaction called a Coinbase transaction.

Coinbase transactions are handled by the “winner” miner, or the miner who can first find the proof-of-work and inform the entire network that the block is valid. Coinbase transactions are special because they create new bitcoins that can be paid out as mining rewards to the winners.

Newly manufactured Bitcoins created from Coinbase transactions are called block rewards, and their exact quantity is recorded and defined in the Bitcoin protocol. Initially, when Bitcoin was first launched, the block reward was set at 50 BTC per block. However, Bitcoin’s creator, Satoshi Nakamoto, designed the protocol to automatically update every 210,000 blocks, halving the block reward.

To summarize so that there is no need to calculate, a new block in the Bitcoin ecosystem is mined about every 10 minutes, which is 144 in a day, and about 210,000 in 4 years.

So every four years, the Bitcoin supply halves, which is what we call the “Bitcoin Halving”.

To date (as of January 2021), there have been three Bitcoin halvings – the first halving was on November 28, 2012, at which time the block reward was reduced from 50 bits per block (BTC) to 25 bits per block. The second halving is July 9, 2019, and the reward has been reduced from 25 bits to 12.5 bits. The 3rd halving is May 11, 2020, and the block reward has now been reduced to 6.25 bits per block.

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What Happens When Bitcoin Block Rewards Are Very Small?

Another key characteristic of Bitcoin is that unlike fiat money, where the supply rate follows inflation and the supply is theoretically infinite, the supply of Bitcoin is finite, and the inflation rate is constant and predictable.

In practical terms, this means that after exactly 64 halvings, the block reward will converge to zero, bringing the total amount of Bitcoin to 20,999,998 forever. If everything goes as planned – and Bitcoin always goes as planned – the last Bitcoin will be manufactured sometime in the year 2140. When that time comes, the rewards given to miners will no longer be in the form of newly manufactured bitcoins, but will instead be rewarded entirely in the form of transaction fees.

So to answer the question right away: even if the block subsidy becomes too small, miners can still be incentivized to manufacture Bitcoin. This is because Bitcoin users can continue to make money by charging transaction fees.

Why is the Bitcoin halving important?

Satoshi Nakamoto did not disclose why he specifically chose this method for adding new bitcoins to circulation. But now it’s time to prove that the halving played a key role in Bitcoin’s tremendous success as the first digital currency on the Internet.

Had it not been for the halving and if the block subsidy had been maintained at 50 bits per block (BTC), the supplyable Bitcoin would have already been manufactured by the time Bitcoin began to enter the mainstream market in 2016. If that were the case, the vast majority of Bitcoin in circulation would have been in the hands of a small number of early entrants, and Bitcoin would not have had a broad public appeal.

On the other hand, if the supply rate had been programmed to be set lower than that, the circulation of new bitcoins was probably too slow to gain traction with early entrants. Either way, it is a proven fact that the current distribution model is just perfect. This is because it quickly circulated a significant portion of Bitcoin’s total supply and provided incentives for both miners and users to join. However, it did deal with the undesirable effects of inflation by limiting the total supply of Bitcoin to 21 million and slowly decreasing the supply rate over time.

In summary, the halving allowed Bitcoin to not only quickly gain popularity, but also sustain its profits over the long term.

How Will the Halving Affect Bitcoin Miners?

While some believe that the halving will ultimately drive a significant number of miners out of the ecosystem and will be catastrophic for Bitcoin security in the long run, no evidence has yet been found that it is heading in that direction.

Contrary to the majority opinion, halving block subsidies does not necessarily translate to halving mining revenue. The Bitcoin protocol is dynamically readjusted to mining difficulty. This, accompanied by outrageous prices in the market, resulted in the introduction of some sophisticated game theory into the system.

Literally, when the cost of mining outweighs the rewards – usually occurring shortly after the halving event and only lasting for a short period – the most inefficient miners force their jobs to quit and stop mining. This makes Bitcoin less secure. Because in theory it would be proportionally easier to launch a 51% attack on your network. However, when inefficient miners are blocked, the protocol automatically re- targets the difficulty, making bitcoin mining easier. So, it can be interpreted that the remaining more efficient miners’ profits will be greater.

Following the same logic, now with a higher profit margin, efficient miners continue to mine, while at the same time creating a greater incentive for new miners to join the network and take their share. When that happens, the difficulty is adjusted again, this time making Bitcoin mining more difficult, and the profit margin is again reduced. When the profit margin becomes tight, the least efficient miners are kicked out of the market again, closing the loop and going right back to the beginning.

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How will the halving affect the price of Bitcoin?

Before moving on, let’s quickly recap the key points and consider the indirect effect of halving on the price of Bitcoin as it has a more direct effect on the behavior of miners.

As previously explained, block subsidies are cut in half, causing a huge initial shock to miners and forced shrinkage within the industry. The most inefficient miners leave the network, and the more efficient miners get a larger share. In this way, efficient miners who have survived the halving storm will have a higher profit margin than before, and will be able to hold more of the bitcoins they earn and then sell them at a higher price. This pruning can effectively reduce the selling pressure caused by miners and indirectly benefit the Bitcoin price.

Not only this, the halving will have a more obvious and direct impact on the Bitcoin price. After all, since Bitcoin is a free financial asset, its price is determined only through the supply and demand of the market. As taught in Introduction to Economics, if the supply of an asset decreases and the demand equals or increases, the price of the asset also increases. This is exactly what happened in the months following each Bitcoin halving.

When a Bitcoin halving occurs, the supply of freshly manufactured Bitcoin is reduced by 50%, resulting in the price of Bitcoin rising while the demand remains the same. Not only that, the halving event sparks mainstream media attention, fueling the flames by creating FOMO and boosting the short-term demand for Bitcoin.

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