This lecture aims to provide answers some questions about the Bitcoin halving, one of the most well-known and expected events in the cryptocurrency world. It’s also an event that can be associated with the notion of “planned” market shock. The halving event produces effects on essentially two levels in the Bitcoin ecosystem: on its price, as following past halvings there has always been a sharp rise; and on mining, i.e., a decrease in profitability and an increase in competition.
INTRODUCTION: THE MARKET SHOCK
A market shock is an phenomenon of significant impact and variable unpredictability that produces a significant change in financial asset prices and/or real asset prices, dramatically altering the starting market conditions.
Market shocks can be categorized according to their nature:
- Macroeconomic phenomena: sudden changes in a central bank’s monetary policy, such as an unexpected change to interest rates;
- Geopolitical events: wars, international political tensions, terrorist attacks, and so on;
- Natural disasters: earthquakes, hurricanes, floods and other events that can disrupt economic activity suddenly and sometimes for a long time;
- Supply or demand shocks: sudden change in preferences by consumers;
- Financial crises: bank failures, credit crises, and the like.
In general, market shocks can also be subdivided by their predictability:
- 100% predictable, such as the halving of Bitcoin, which we will discuss later;
- Poorly predictable but knowable, such as the flooding of a river, for which prevention can be done;
- Completely unpredictable, i.e., true black swans, such as the Covid-19 pandemic.
TRADITIONAL FINANCIAL MARKETS
The short-term effects of a market shock in stock markets usually give rise to high volatility, which consists of sharp and unpredictable fluctuations in the prices of financial assets. At the same time, in most cases a drastic reduction in liquidity occurs, as market participants, regardless of their level of professionalism, tend to sell assets in their portfolios and wait for the waters to calm down.
In some cases, market shocks can have long-lasting and profound negative effects not only in the financial markets but also in the real economy, unless the institutions and authorities in charge take the necessary measures to limit the damage and hopefully also to restore the starting conditions. Usually, if consequences turn out to be very severe, then the central bank lowers interest rates and carries out direct market interventions to restore confidence in the system. In fact, many companies and governments depend on the stock and bond markets for financing.
A prime example of a market shock consists of the official declaration of the bankruptcy of the investment bank Lehman Brothers on September 15, 2008, which caught much of the financial world off guard and set off a chain reaction with devastating effects. From the perspective of prices in the U.S. stock market, the SP500 stock index, which had been in a bearish trend for a few months, suddenly accelerated the speed of its downtrend, thus transforming a simple correction of a bullish trend to a full-blown, seemingly endless plunge.
Only the intervention of the U.S. central bank, the Federal Reserve Bank, which lowered the interest rate from July 2007 to January 2009 from a level of 5.5% to 0%, succeeded in calming the financial markets and recovering the confidence economic-financial system; it must be kept in mind that the stock market bottomed in the very first quarter of 2009, while the real economy took many more months to get back on track.
Turning to more recent examples, in March 2023 the U.S. banking sector experienced a series of failures (Silicon Valley Bank and Signature Bank in March and First Republic Bank in April) that forced the Fed to inject liquidity into the markets (specifically through the Bank Term Funding Program or BTFP established on March 12, 2023) in order to circumscribe the damage and avoid a market crash. The prices of riskier asset classes, such as equities and cryptocurrencies, were initially plunging as market participants feared the contagion effect. Following the intervention of Jerome Powell, chairman of the Federal Reserve, both asset classes rebounded strongly, as the U.S. central bank had once again either solved or postponed a problem due to a market shock.
Market shocks are potentially extremely dangerous because they can generate chain reactions (the contagion effect mentioned earlier) in other parts of the same sector or in sectors other than the one they started with. On the subject of international monetary shocks, Japan’s central bank raised its interest rate for the first time in 17 years, going from -0.1% to 0.1% at its March 19, 2024 meeting and from 0.1% to 0.25% at its July 31, 2024 meeting.
At the same time, the U.S. central bank was about to cut the interest rate: the combination of these opposite monetary policies produced a twofold effect on the dollar (USD) yen (JPY) currency pair, that is, the former lost strength and the latter gained strength simultaneously.
At the financial level, the currency exchange rate differential turned out to be so wide that the market was heavily impacted: from Thursday, July 11, to Monday, August 5, 2024, the dollar recorded -12.5% in 17 trading sessions, an extremely unusual movement for forex (the reversal of many carry trade positions in the USDJPY pair occurred, a topic that will be covered in another lecture), and in the same time frame the SP500 stock index recorded -10%, another unusually rapid and violent movement.
CRYPTO SECTOR
Of course, market shocks are phenomena that happen in the cryptocurrency sector as well and one could argue that they occur with greater frequency than in other more regulated and supervised environments.
For decades in mainstream finance, central banks have carried out various types of intervention (verbal, operational, concentrated, and sterilized), including bailouts, which consist of rescuing market players in big trouble in concert with other political and financial institutions. Bailouts cannot take place in the crypto sector. In fact, there is no entity that can prevent ex ante or correct ex post the damage caused by one or more market shocks: as in the jungle, everyone has to think about their own survival.
This is actually a great advantage for cryptocurrencies, as the so-called creative destruction is almost never hindered: essentially, new technologies, products or business models supplant existing ones, leading to a reallocation of resources, the closure of obsolete businesses and the creation of new markets and jobs. Of course, creative destruction causes temporary disruptions that are physiologically normal during transitions, and trying to stop this process would be like trying to stop time. An example known to everybody is the adoption of the Internet at the beginning of this century: some said that no one would use it and that in a couple of years it would be gone. Returning to market shocks, the level of formality and depth of topics discussed by participants in the cryptocurrency industry is frequently poor, and a prime example of this materializes with each halving of Bitcoin.
The absence of a entity that can carry out a bailout creates, besides from the creative destruction, a very strong disincentive to moral hazard. Moral hazard occurs when a party has an incentive to take excessive risks because it does not suffer in the present or won’t suffer in the future the negative consequences of its actions. In the economic-financial sphere, this often happens when the costs of a failure or loss are passed on to a third party; a classic example is insurance: when taking out the policy, the insured may be less careful to prevent loss, knowing that in the event of a claim, the insurance company will be the one to pay for it.
The long-term benefits of the almost complete absence of moral hazard are incalculable: anyone who commits crimes, such as Ponzi schemes and scams of various kinds, will be found out either by the authorities in charge or by the market itself sooner or later; the implosion of the Terra ecosystem (LUNA) and the failure of FTX, both events that happened in 2022 and which we will analyze in detail in another lecture, are two examples. Bitcoin and altcoin prices took a very hard hit in what was later called annus horribilis (BTCUSD recorded nearly -80 percent). However, in the years that followed, prices began to rise again, and legitimate market players benefited from the fact that they had rid themselves of some unwieldy malevolent actors.
There are some market shocks that, in the short term, cause severe consequences for most of those involved, but in the long run improve conditions in the affected sector, even without the intervention of outside actors.
HALVING OF BITCOIN
The halving is a very relevant event as it changes the supply of new bitcoin coins and positively affects its price in the long run. According to one of the basic laws of economics, the price is determined by how supply and demand relate in the spot market (this is a type of financial market in which assets are traded with immediate payment and delivery, as in a store). Basically, if there is an increase in demand for an asset and the amount of supply remains the same, then the price of the asset increases; if demand remains stable and supply increases, then the price of the asset decreases.
Every four years, Bitcoin’s coin production is automatically halved by the blockchain algorithm. To return to the market shock breakdowns described in the introduction, we are in the case where the change in supply occurs under 100% predictability. Basically, Bitcoin halving is called by industry “experts” by the following expression: a “supply shock“; it is a highly expected event, as it historically heralds a very substantial (in some cases exponential) rise in the price of Bitcoin.
In reality, the Bitcoin halving produces no effect in the supply-demand relationship between market participants and coins in circulation. Technically, it is an “issuance shock,” such that the circulating supply does not undergo any kind of change due to halving, while the supply of new coins, i.e., newly mined and placed on the market, is halved. Moreover, the stock of bitcoin is itself eternal, since it will be possible to hold, trade, and spend bitcoin as long as the blockchain remains active; although a small portion of existing bitcoin is lost each year, surely a supply shock from asset spoilage cannot occur, as in the case of wheat or other commodities.
Of the better-known commodities, the only commodity comparable to Bitcoin in such terms is gold, a precious metal, which is almost totally immune to deterioration. Hypothetically speaking, for a serious supply shock on Bitcoin to materialize, some of the largest holders of bitcoin would have to lose access to their wallets forever; in the case of gold, countless tons of gold would have to be thrown into the depths of the oceans.
CONCLUSIONS
In conclusion, although it is called a “supply shock,” the actual effect of halving is more accurately manifested as an “issuance shock,” since it does not change the circulating supply but reduces the issuance of new coins. This cyclical event, which repeats every four years, has been shown to positively affect Bitcoin’s price over the long term, largely confirming the link between scarcity and increase in value. Unlike other assets, however, Bitcoin’s total supply remains stable, reinforcing its status as a deflationary asset, comparable to gold in its ability to maintain value over time.
The halving, while planned and predictable, does not trigger the reactions typical of traditional shocks, but it does activate a precise mechanism: the reduction of new bitcoin creation. Combined with often increasing demand, this phenomenon puts upward pressure on prices, fueling expectations of future profits. However, it is essential not to confuse halving with a true “supply shock,” typical of assets such as commodities. In fact, halving does not immediately and drastically reduce the total supply in circulation.
This analysis highlights the complexity and multifactorial nature of market shocks, which can be both positive and negative, in cryptocurrencies as well as in traditional markets.