The emergence of a futures and options market has created a new ecosystem for bitcoin markets. Author: CME Group Publish date: May 22, 2020 10:50 AM EDT
Once every four years something happens to bitcoin that slashes the supply growth rate in half. Bitcoin halving, as it’s called, took place for the third time on May 12.
In the past, this event has coincided with a strong run-up in the bitcoin price and has lead to pre- and post-halving volatility, with price implications extending into 2020 and beyond. The 2020 halving event has several additional factors than previous such events, including the availability of CME Bitcoin futures and options, which investors and miners can use to hedge or express views on the bitcoin price.
This changes the narrative around the halving for three key reasons: It enables price risks to be hedged, demand risk for bitcoin can be managed and speculators can look to the indicators of options pricing.
M iner Incentives
New units of bitcoin are created through mining. Mining is the process of confirming transactions, combining them into blocks and adding them to the blockchain. As a reward, and to keep miners incentivized, every time a block is completed, the miner responsible for creating that block receives a reward in the form of new bitcoin. Miners compete with each other to earn newly issued tokens known as the block reward .
The bitcoin protocol was programmed with several rules: a cap on the total supply of bitcoin of 21 million and a planned reduction in the block rewards miners receive. Currently a new block of bitcoin transactions is solved by miners and added to the blockchain approximately every 10 minutes.
Halvings happen once every four years -- or more precisely, at every 210,000 blocks of transactions. The latest one happened at block 630,000. With this program of diminishing returns, miners reap fewer bitcoins with each halving. Initially, in 2009, winning miners were rewarded with 50 bitcoin per block.
That halved in November 2012 to 25, and again in July 2016 to 12.5 bitcoin per block. The third halving saw the network incentives or block rewards fall to 6.25 bitcoin. In notional terms, given the bitcoin price of approximately $8,750 as of May 1, 2020, miners receive ~$110,000 for their 12.5 BTC. After the next halving, assuming the same price level, they will instead earn ~$55,000, giving them less of an incentive to mine blocks.
What Can We Expect for the Price of Bitcoin?
In normal markets, lower supply with steady demand usually leads to higher prices. With bitcoin supply reduced, halving has the potential to push the price up, theoretically to double the pre-halving level. This hasn’t happened in the past due to the pre-emptive run-up to the halving event; however, it has usually preceded some of bitcoin’s largest runs . In previous years, the price of bitcoin started rallying 12 months ahead of the reward halving and continued for some time after.
A year before the first halving, bitcoin was trading around $2.50. By the time of the halving event, it had hit $12.60. Over the course of the following year, the price rose to $1,007 before falling away. A similar pattern played out in July 2016 when bitcoin was gaining greater mainstream recognition and coincided with the first boom in initial coin offerings.
One year prior to the event, bitcoin was trading at $270. Twelve months after, it was at $2,500.
Will 2020 Be Different?
So far, bitcoin’s third halving looks different than prior events and there doesn’t appear to have been such a sustained price run-up. Given the reward change has been known since bitcoin’s inception in 2009, and having already seen two such events, investors may have incorporated the supply adjustment into their models before the fact and taken positions accordingly.
The impact of Covid-19 has resulted in lower volumes as some participants focused on larger adjacent non-crypto markets and some mining operations being impacted by these difficult market conditions. Previously, miners typically sold their bitcoin for fiat currency as they earned it to pay for operational costs.
Mining is now dominated by professional mining companies seeking a profit. With lower rewards they may decide to hold onto their bitcoin until a new price forms that compensates them for their expenses. The halving could force a shakeup of the mining landscape.
The Evolution of a Derivatives Market
For the first time there is a robust derivatives market for bitcoin in both futures and options. In previous halvings, market participants could only express their views on bitcoin through the spot market.
This time around, firms looking to hedge or speculate have the ability to trade a derivative rather than the underlying and so they can express both positive and negative views on bitcoin’s price action. At the time of the last halving in 2016, miners could either hold on to their block rewards or they could sell them in the spot market to pay for o...