Why bitcoin is heading back up (and down) again

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Early in 2018, I put forward a roadmap in finweek of how I expected bitcoin to move going forward.

The thesis was that bitcoin’s price should follow a similar pattern to what it has before – on the back of blockchain mining reward halving cycles (more detail on this further on in this article) – fueled of course by good old-fashioned supply and demand, with a dash of media frenzy for good luck.

I expected bitcoin would correct by around 80% from the level of $20 000 it reached in 2017, to trade at around $4 000 during 2018. That part of my projection played out perfectly.

But my roadmap suggested that the price of bitcoin would ‘double and halve’ in 2019 – to trade from around $4 000 to around $8 000 (which it sort of has).

But it’s also breached the $8 000 mark by a rather large margin. It has more than tripled so far this year. Whether or not it will halve again from here or come all the way back down to the $4 000 mark, remains to be seen.

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My original roadmap

In my original roadmap, I expected bitcoin to be somewhat range-bound for the rest of 2019 and the first half of 2020, albeit a massive range that sees repeated 100% rallies followed by 50% corrections. After this range-bound period, the mining reward is halved in May 2020. The expectation is for it to then trend back up to the $20 000 mark by mid-2021.

Of course, when it breaches the $20 000-mark the complete madness of people en masse takes over again and we have lift off for the next parabolic move towards, well, the moon.

This four-year cycle repeats until all the bitcoin are mined in 2140 – yes, over a century from now. Each cycle, though, should be a little less violent in terms of percentage move as the price of bitcoin fluctuates a few standard deviations around a logarithmic curve until it eventually stabilises.

Why the fluctuations?

Let’s start with the ‘halving’ in price. Bitcoin is essentially a software protocol, much (but nothing at all) like the http protocol that allows us to navigate the internet.

Basically, it’s just software that has very specific rules. The power of bitcoin is that this protocol cannot be changed unless every node in the entire network agrees to change it.

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The nodes are the computers that process and group transactions and place them in the blockchain. The blockchain is a permanent public record of every transaction that has ever taken place, for and with, every single bitcoin in existence.

Anyone can join the bitcoin network and mine, or process, transactions on behalf of users. They can do so in public to avoid fraud or mistakes.

The likelihood that every miner will agree to change a ruleset that is designed to protect them, and every other bitcoin user, is extremely low. Millions of people would need to agree to change the rules around how their money works (never mind the amount of people that will likely be using it in a hundred years from now).

Back to the protocol. One of the rules in this protocol is that nodes, or miners, that process transactions are rewarded in bitcoin (by the creation of new bitcoin) for processing transactions… until all the bitcoin are mined. (A comprehensive set of rules covers what will happen at that stage.)

This creation of bitcoin by ‘mining’ (covered in more detail in my 2018 article) happens every ten minutes. The limit on the total amount of bitcoin to ever be created is 21m.

Another rule is that once half of all the bitcoins that will ever be created is in existence, the reward for miners to process transactions is halved. When half of the remaining half is mined, the reward halves again. And so on and so on… until all the bitcoins are mined.

Originally, 50 bitcoins were mined/created every 10 minutes, then 25 bitcoin and currently 12.5. Next up is 6.25. The protocol governs this mining reward to halve every 210 000 blocks in the blockchain, which should be approximately every four years. This process is reported on by the protocol and is pretty easy to track.

A couple of things happen when the reward halves. One is obviously that the supply and demand dynamic shifts when input remains the same, but output halves (supply side shock).

Another is that, because there is a limited number of bitcoins (that will become more and more difficult to create), a deflationary monetary system is created. Simply put, the value of money (in this case bitcoin) increases due to scarcity and the price of goods and services decreases at the same rate at which money becomes more valuable.

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Of course, we don’t know if this system will work.

The entire monetary system is currently built on the concept of fractional reserve banking, whereby prices go up because money loses value.

Remember that bitcoin came about after the 2008/09 financial crisis, and the whole point of it is to turn the current global economic system completely on its head. There can only ever be so much of it, and it will forever become more difficult to come by and therefore, in theory, its value should only ever increase.

It won’t go up in a straight line, as we have already seen, but, if this hundred-plus year experiment works, it will lead to the greatest transfer of wealth in human history. Early adopters will become titans and those who refuse to adapt will be left by the wayside. But I digress. The point here is that there is an element of deflation built into the very core concept of how bitcoin works.

Thus far, each time the mining reward has halved it has left a vacuum in supply that can only be filled by higher prices. The electricity input cost as well as the cost of the computer hardware has to be recovered from earning and selling bitcoin. This only works if price rises to a level where miners can operate profitably.

So, what happens if miners decide to pack up and leave when the mining reward is halved, and their profitability is at stake?

Again, the protocol has a solution for this by adjusting the difficulty of mining. In other words, reducing (or increasing) the computing power required to mine a block and earn a reward as nodes (or miners) enter and leave the network.

So, when non-profitable miners leave the network, the easier conditions will attract new miners who can mine more efficiently (cheaper) with newer technology. This process of inefficient miners leaving and more efficient miners joining is what, in theory, should drive the current ‘half and double’ phase that we are in, as the market price adjusts to miners entering and exiting the market.

Once the reward is halved from the current 12.5 to 6.25, there should be a sudden supply side shock (as there was last time) and a rather fast move back toward the previous all-time high (as there was last time). This is simply because those who are ‘creating’ bitcoin will demand higher prices to cover their input costs, much like any factory that has to spend the same to produce half.

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Then, of course, we depend on the madness of people… asset bubbles driven by euphoria and greed. We’ve seen it over and over again in history. If this theory is correct, we’ll likely see it a few more times before bitcoin reaches anywhere near ‘fair value’.

In December 2018, I made the call that bitcoin will see $1m by 2040… my question is, what will it be worth in 2140? Will we even be measuring it in dollars anymore?

Back to the roadmap. We’ve seen bitcoin bounce back around 61.8% of the way to the previous high, so traders who are familiar with Fibonacci will understand the significance here.

The way I see it, is that we have likely seen the high of the year and the greedy will be trapped by chasing higher prices, which, of course, will cause some panic and lead to a sell off into the second half of the year. That’s when the smart money will start buying. Below $7 000 to $4 000 would be a great price to accumulate with the view to sell in December 2021.

Patterns often repeat themselves after all.

graph, bitcoin, petri

This article originally appeared in the 25 July edition of finweek. Buy and download the magazine here or subscribe to our newsletter here.

Petri Redelinghuys is a trader and founder of Herenya Capital Advisors.

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