7 min readScarcity is one of the key features of bitcoin. By limiting the total circulation to 21 million, Satoshi Nakamoto - the pseudonymous founder - ensured it wouldn’t be subject to the same inflationary monetary policies implemented by central banks.
Satoshi designed the protocol to control circulation by programmatically cutting in half the number of new coins issued roughly every four years. This event has become known as 'the halving', and it's important to many in the crypto community because of its historic effect on bitcoin's price.
This article explores the role of miners in the ecosystem before explaining how the halving works and how the market has reacted in the past.
Understanding Bitcoin and its Current Dynamic
Following various attempts to launch a cryptocurrency dating back to the late 1980s, bitcoin was the first to gain traction. The concept emerged in a whitepaper published by Satoshi in October 2008, which outlined his vision for a peer-to-peer payments system that removed the need for an intermediary like a bank. Satoshi processed the first block of transactions- the genesis block- over seven days in January 2009. He famously acknowledged the ongoing financial crisis by adding this message to the block:
“The Times 03/Jan/2009 Chancellor on brink of second bailout for banks”
The first transaction took place later that month between Satoshi and Hal Finney, a software developer and early contributor to the bitcoin network.
Despite its original design as a medium of exchange, bitcoin has achieved significant adoption as an asset class. According to research by CoinShares, digital asset investment products have attracted $613 million in the year to date. Inflows in the last week of October alone hit $326 million, the highest since July 2022, as expectations rose that the Securities and Exchange Commission (SEC) is on the verge of approving a spot bitcoin exchange-traded fund (ETF) in the US.
The valuable diversification bitcoin offers a portfolio is one of the main drivers of demand. Separate research by CoinShares shows that a portfolio with a small bitcoin allocation outperforms both a standard portfolio (60% shares and 40% bonds) and an equivalent gold holding in terms of returns, volatility and diversification.
Learn more about bitcoin’s role in a portfolio.
Bitcoin Mining Explained
Bitcoin uses a ‘proof of work’ consensus mechanism to validate transactions. Participants - called miners - solve onerous mathematical problems for the right to process the next block of transactions. In return, they earn rewards - newly minted bitcoin and transaction fees - as an incentive.
Mining plays an important role in securing the blockchain as it lowers the risk of what’s known as a 51% attack. To reverse a transaction, an entity would need to control 51% of the network’s computing power, which would be prohibitively expensive. For instance, a 51% attack on the bitcoin protocol would cost nearly $1,768,620 million per hour on the 7th December.
Mining difficulty- the degree of effort it takes for a miner to solve the mathematical problems mentioned above - changes roughly every two weeks. The target time to mine a new block is 10 minutes, so the difficulty increases if the process speeds up or vice versa. The difficulty has risen steadily since the start of 2023, which means that miners have increased the resources they direct to the bitcoin network or that new miners have joined (potentially in anticipation of the next halving).
What is The Halving?
Twenty one million was apparently an arbitrary figure, but Satoshi had a clear reason for setting a maximum circulation for bitcoin. While central banks can issue unlimited quantities of fiat currencies, bitcoin is more like gold as both have a limited supply. This scarcity makes bitcoin anti-inflationary, a priority for Satoshi when designing the protocol (as revealed by his message on the genesis block). To date, there are 19,563,387 million bitcoins in circulation, representing 93,1% of the overall supply.
To maintain bitcoin’s scarcity, Satoshi introduced a mechanism to periodically reduce block rewards, an event the crypto community refers to as the halving. Every 210,000 blocks- which equates to roughly four years- the protocol cuts rewards in half. When bitcoin launched, miners earned 50 coins for each block of transactions they processed. Three halvings later, the reward has dropped to 6.25. The next halving is due in 2024, with the final one expected to take place once bitcoin reaches its maximum circulation in 2140.
As intended, the halving has lowered bitcoin’s inflation rate. According to Cointelegraph, inflation dropped from 50% to 12% in 2012 and then to between 4% and 5% in 2016. It fell by 50% following the 2020 halving and has generally remained in a range from 1.6% to 1.8% since. After the next event, the rate will fall below 1%.
The halving has also historically supported bitcoin’s price. Given it slows down the circulation of new coins, the law of supply and demand suggests that the price should rise following each event when demand stays the same. This effect has played out in the halvings to date. Bitcoin rose from $12 before the 2012 event to nearly $127 five months later. Despite falling to $650 ahead of the next halving in 2016, it rose to more than $758 within five months and finished the year just under $1,000. It jumped again after the latest event in 2020, when bitcoin rose from $8,821 to nearly $10,943 in the space of five months.
Looking further ahead, the limited supply of bitcoin should continue to support its price, especially as demand continues to rise. After all, adoption sits at around 3% according to CoinShares research, and demand should surge if the SEC approves BlackRock’s ETF. Scarcity should also reinforce bitcoin’s status as a store of value by helping it serve as a hedge against monetary inflation.
Conclusion
Mining plays an important role in bitcoin’s proof of work consensus mechanism because it validates transactions and helps secure the network. In return for providing this service, miners earn block rewards in the form of newly minted bitcoin and transaction fees.
One of bitcoin’s key features is scarcity. Satoshi capped the circulation at 21 million, while the protocol also controls the issuance of new coins through halving, where block rewards are cut in half roughly every four years. Scarcity makes bitcoin anti-inflationary, unlike fiat currencies.
Due to the law of supply and demand, halving events are typically bullish for bitcoin. In the longer term, each halving should reinforce bitcoin’s status as a store of value as it provides a hedge against inflation.
Learn how to add bitcoin exposure to your portfolio by investing in CoinShares’ exchange-traded products (ETPs).