The Bitcoin Halving Explained
By: Joseph Harris
Tags: Technology, Cryptocurrency, Explained, Cryptoasset, Bitcoin

You may be aware that Bitcoin is, in just a few days, set to pass a major milestone and undergo an important change in an event called the Halving — or Halvening, depending on who you ask.

But, what exactly is the Halving, why does it happen, and why should you care?

The short answer is that the Halving is a scheduled 50% reduction in the number of new bitcoin created in each block. Halvings are a core aspect of Bitcoin’s design, they take place roughly every 4 years, and, in about 120 years time, so many Halvings will have taken place that the number of bitcoin created in each block will fall below the smallest unit of the currency. At that point, no new bitcoin will be created at all, permanently capping Bitcoin’s overall supply just a sliver below 21 million coins.

That’s a very quick and shallow summary of the Halving, and maybe it’s enough for you. But, if you want to learn more and really understand the Halving, then we first need to take a bit of a step back and learn a bit more about why Bitcoin exists and how it works.

Some Background

Bitcoin seems to have been created, at least in part, as a response and objection to the monetary policies of Central Banks, who try to manipulate the rate of money creation to grow economies and maintain high employment. The thing is, that kind of manipulation is both very difficult to do well and arguably has a number of negative side effects, leading some people to conclude that it’s not worth the risk. Instead, they say, it’d be better to return to something like the gold standard, where money was scarce and un-manipulable, where human fallibility couldn’t unintentionally destroy economies and ruin lives, and where no individual or institution could claim or abuse the colossal power that comes with controlling money.

While many of the people falling into that school of thought simply spent decades complaining about what they believe to be an unfair and broken system, a mysterious figure going by the name Satoshi Nakamoto was hard at work creating a potential avenue for change: a gold-like digital currency that could form the backbone of an entirely new financial system. His money would have no central issuer and a fixed, almost-impossible-to-change total supply of 21 million coins that would be minted according to a predetermined 130-year schedule. He called this currency Bitcoin, and in January 2009 he released it to the world.

Satoshi’s new currency didn’t just remove the central issuer of money, it eliminated the need for trusted central parties altogether. In Bitcoin, banks aren’t required to safely store funds and payment processing companies aren’t needed to validate and carry out transactions. But, someone has to do these things. So, if there are no companies like PayPal or Visa to process transactions, then who’s doing it?

The answer is a collection of thousands of uncoordinated, independent entities distributed all over the world, all listening out for new Bitcoin transactions, validating them, and adding them to a list of ‘official’ transactions.

You can think of these entities as a bit like participants in a colossal group project, all trying to log into and update a spreadsheet in Google Docs. As you can imagine, with no way to communicate with one another and work in unison, things would devolve into chaos pretty quickly and the system would break down.

What’s needed is some kind of coordination mechanism, and it must fulfil two important criteria:

It must not accidentally reintroduce central parties It must be able to continuously function despite any number of unknown individuals joining or leaving the group without a moment’s notice.

The mechanism that Bitcoin uses is essentially a math-based guessing game, where participants continuously plug different numbers into an equation until they, or someone else, stumbles upon a combination of inputs that produces an answer below some target value. Whoever is first to find this solution wins the right to be a temporary leader and add a ‘block’ of validated transactions to Bitcoin’s transaction history.

In our Google Docs example, this would be like every participant pulling raffle tickets out of a hat until someone managed to find a ticket with a number less than ’10’ on it, and, at that point, they’d be free to make their desired adjustments to the sheet. As soon as they were done, everyone would refill their hats with tickets and start the process over again.

In this scenario, it’s fairly intuitive to say that an individual’s chance of winning a round is based on two factors: luck, and the speed at which they can pull a ticket from the hat and check what’s written on it — somebody processing 60 tickets a minute is much more likely to find a winning ticket than someone who can only check 10 tickets a minute, but there’s also a chance that the slower person happens to choose the right ticket in one of their first tries.

Knowing that, we can say that this mechanism fulfils the first of our requirements, as the only way for someone to dominate the process and become a new central player would be to process tickets faster than everyone else combined and therefore find solutions more often than everyone else combined — and that’s an unlikely enough scenario to discount it.

But, we may have an issue fulfilling the second requirement: as more and more people join the game, the rounds are going to continually decrease in length. Eventually, if enough people join, it becomes more and more likely that many people will simultaneously draw a winning ticket on their first try, and then we’ll have some big coordination problems again.

Bitcoin solves this problem by automatically adjusting the game every couple of weeks to make it easier or harder to win by moving the equation’s target either up or down, using the average time taken to complete the game since the previous adjustment to determine the size and direction of the change. These events are called ‘difficulty adjustments’, and they’ve so far done a pretty good job of maintaining a 10-minute gap between new blocks throughout Bitcoin’s life.

To compensate for increasing hardware speed and varying interest in running nodes over time, the proof-of-work difficulty is determined by a moving average targeting an average number of blocks per hour. If they’re generated too fast, the difficulty increases — Satoshi Nakamoto

Difficulty adjustments are an absolutely crucial — and fairly underrated — element of Bitcoin’s design, and they are what has allowed Bitcoin to properly function as new participants have joined the network and, perhaps more importantly, as computers have improved.

As mentioned earlier, the speed with which someone can trial different solutions to Bitcoin’s mathematical game is a major factor in their chance of winning it, and over time this has driven participants to use faster, better, and more specialised machines to boost their chance of success. The problem is, these specialised computers are rather expensive to purchase and they consume vast quantities of electricity as they run, making it participation costly.

These expenses present a significant barrier to entry for validating Bitcoin transactions — significant enough to dissuade even the most enthusiastic Bitcoin supporter from getting involved. What’s needed is an incentive, a financial reward that can cover the running costs and even give participants a bit of profit.

Satoshi realised that this issue was actually the solution to the seemingly separate problem of fairly distributing new bitcoin without any kind of central bank.

Instead of just awarding the winner of the guessing game the right to add a new block of transaction’s to Bitcoin’s history, they’d also be entitled to create some number of new bitcoin that could then be sold to cover the cost of taking part in the game. This prize is called a ‘block reward’.

This adds an incentive for nodes to support the network, and provides a way to initially distribute coins into circulation, since there is no central authority to issue them — Satoshi Nakamoto

The introduction of the block reward alters the competition and makes it analogous to gold mining, where companies spend colossal amounts of time, effort, and money digging up and processing earth in the hope of uncovering a scarce commodity that can then be sold to cover costs and hopefully generate a profit. Because of this, Bitcoin’s payment processors have become known as ‘miners’.

The steady addition of a constant of amount of new coins is analogous to gold miners expending resources to add gold to circulation. In our case, it is CPU time and electricity that is expended — Satoshi Nakamoto

But now there’s a new problem: how can Bitcoin’s all-important 21 million coin cap be reconciled with this need to economically incentivise miners?

The solution comes in two parts. First, transaction fees are introduced to enhance the incentive to mine. These fees are paid by the creator of a transaction, who sends slightly more bitcoin than they want the recipient to actually receive and allow the miners to claim the difference. (A useful byproduct of this is a kind of transaction prioritisation, as anyone wanting a particularly rapid transaction can pay extra to ensure miners take note of it and include it in their next block.)

Once a predetermined number of coins have entered circulation, the incentive can transition entirely to transaction fees and be completely inflation free — Satoshi Nakamoto

The second part of the solution is to gradually transition to a fee-only incentive model by slowly reducing the number of new bitcoin that can be minted in each block. And this is where the Halving comes in.

What Is The Halving?

The block reward reduction could have been handled in any number of ways — with perhaps the most obvious being a constant, gradual decline in block reward over time — but, for whatever reason, Bitcoin was designed to have block rewards slashed at regular intervals.

More specifically, the number of bitcoin that can be created in each block halves every 210,000 blocks, and the transition from one rate of issuance to the next is called ‘The Halving’.

For the first 210,000 blocks of Bitcoin’s life, miners could claim 50 bitcoin as their block reward, but eventually, after a total of 33 Halvings, this number will fall to less than 1 Satoshi, the smallest unit of a bitcoin (0.00000001 BTC). At that point, unable to be represented in the system, block rewards will cease entirely, permanently capping Bitcoin’s supply at 21 million coins (or, more accurately 20,999,999.9796 bitcoin).

Because the mathematical puzzle completed by miners is designed to take about 10 minutes to finish at all times, it’s possible to estimate the date that this final Halving will take place — with the answer being some time around 2140.

Similar estimates can be made for every other Halving leading up to that, and the long and short of it is that Halvings take place every four years.

Bitcoin has already undergone two Halvings, and the third is rapidly approaching.

The first took place November 28th 2012, cutting the initial issuance rate of 50 bitcoin per block to 25. That was reduced to the current issuance rate of 12.5 bitcoin per block on July 9th 2016, and it will fall to just 6.25 bitcoin per block on May 12th this year.

The Third Halving

This next Halving could be considered symbolically significant for a couple of reasons — and both relate to solidifying Bitcoin’s position as a gold-like store of value.

First, following the Halving, Bitcoin’s supply will only increase (or inflate) by around 1.8% per year. This is lower than the target rate of inflation in most developed countries and firmly within the ballpark of gold, which increases by about 1.3% each year according to figures on Gold.org, potentially enhancing Bitcoin’s credibility as a hedge against inflation.

Second, the Halving is now taking place against a backdrop that juxtaposes it perfectly, with Central Banks all over the world printing money faster than ever before in a desperate attempt to prop up locked-down economies. If there was ever a moment to showcase the difference between these two systems and the schools of thought going into them, this is certainly it.

Of course, the Central Bank money printing is very likely a necessity at this time, and in many ways it shows the benefits of having centrally controlled money, but it also draws attention to the dangers and raises major questions about the long term impact of this behaviour, about our ability to later wean economies off of frequent, massive stimulus packages, and — especially in countries like the US where vast quantities of money seem to have been created, but very little delivered to the people who truly need it — about how freshly created money is and should be allocated.

For people with these kinds of concerns, the idea of an asset that runs without interruption or intervention, that remains blissfully unaware of any external chaos, and that exclusively follows a transparent algorithm describing a progressively tightening monetary policy may well start to make sense.

Bitcoin Halving is “quantitative-hardening”. Fiat undergoing lots of politically driven quantitative easing. Bitcoin supply algorithm starts quantitative hardening next month, all while the world loses its fiat mind and plummets into quantitative easing infinity — Adam Back

What Is The Impact of Halvings?

Aside from acting as a regular reminder of Bitcoin’s scarcity, does the Halving really do anything? Does it have any impact on Bitcoin or the ecosystem that’s been developed around it?

Often, you’ll hear two major narratives about the impact of the Halving.

The first is about miners, who operate in an incredibly competitive environment with often razor-thin profit margins, leaving them rather exposed to any loss of income. It’s fairly obvious that, without a significant increase in transaction fees or Bitcoins price, miner income will halve after a Halving, and that could be catastrophic for many miner’s businesses, forcing many of them (certainly those paying a lot for electricity) to turn off their machines — at least until circumstances change to make mining profitable again.

The second major narrative is about Bitcoin’s price, arguing that it should increase in the wake of a Halving. The idea here is that miners act as a constant source of sell pressure, and that pressure is reduced by the Halving as there’s simply fewer bitcoin available for them to sell. At the same time, there’s no reason for demand to change or decrease significantly around a Halving, so the decrease in supply meets a constant level of demand and prices are driven higher.

There’s also a slightly less popular variation of this second narrative that says Bitcoin’s price will decrease immediately after a Halving as some miners completely shut up shop and sell off everything they still own. Only after all these failing miners have capitulated will prices rebound and benefit from the reduced sell-pressure.

Personally, I think these ideas sound nice on paper and that there may be some element of truth in each of them, but I’m sceptical about their ability to hold up amid the complexities of the real world and remain true for each and every Halving.

Sure, some miners that are less professionally run or operate at high costs will likely become unprofitable and throw in the towel, but many of them will have been preparing for the Halving for months, they’ll have set up the latest and cheapest-to-run equipment, stockpiled cash to survive a period of unprofitability, and made use of various derivative products to minimise any losses they might suffer. These miners won’t need to turn off their machines because they’ll have anticipated a period of losses and other challenges they’ll face in the coming months, and they’ll have mitigated these things as much as possible so they can continue operations and accumulate as much bitcoin as possible.

I’ll admit, though, that my thoughts have changed a bit with regards to the Halving’s impact on price. Not long ago I would have said that, given miners contribute relatively little to Bitcoin’s overall trade volume, and that they’re likely looking to maximise profits and minimise disruption to Bitcoin’s price by using OTC trading desks and timing some sales to occur at higher price points, they don’t have a particularly significant impact on price anyway. Therefore, reducing the number of bitcoin they can sell shouldn’t be that impactful. However, as CoinMetrics pointed out in a recent issue of their State of the Network newsletter, miners may have an outsized influence on Bitcoin’s price as they permanently withdraw cash from the market while most other traders just cycle funds between different cryptoassets or temporarily cash out to buy back in at a lower price. With this in mind, I agree that Halvings may be more beneficial to Bitcoin’s price that I previously believed, though I still suspect their impact is relatively small compared to many other factors.

Selling from miners represents net capital outflows from the space and the fiat obtained by miners is unlikely to ever return to the market, which is not necessarily the case for other trading volume. Therefore, miner selling has an outsized influence on the rest of the market — Kevin Lu & The Coin Metrics Team

In fact, ‘small compared to other factors’ is probably the best summary of the Halving’s impact. I wouldn’t necessarily expect anything dramatic to take place simply because a Halving happened, but on some occasions they may feed into and potentially exaggerate trends that were already occurring.

For example, we may well see a large number of miners shutting off machines following this next Halving because there’s still a large number of less-efficient, previous-generation machines in operation that would have been phased out anyway and because many miners have already taken a pretty substantial financial hit this year following March’s Coronavirus-related selloff.

The environment around the next Halving will likely be completely different, just as the conditions surrounding each of the previous Halvings were completely different, and that means the events that follow it will also be quite unique.

In short, Halvings are a bit like birthdays: they’re milestone moments that can be fun to celebrate, but they’re ultimately quite insignificant.

Bitcoin Doesn’t Care

Let’s imagine, for the moment, that Halvings really did have a sizeable impact on things. Let’s imagine that immediately after this Halving, or another in the future, large numbers of miners found themselves running with unbearable losses, forcing them to shut down.

What would happen? Would Bitcoin be in trouble? Could it die?

It seems reasonable to think that a large number of these crucial operators going offline at once would be quite disastrous for Bitcoin, but, in reality, it would be little more than a short-term inconvenience.

Remember, the guessing game that all these miners compete in to win block rewards automatically adjusts itself on a regular basis, so even if a large number of participants dropped out it wouldn’t be long before the game was updated to account for this. Previously, I said these adjustments take place every 2 weeks, but in reality they take place after a set number of blocks — 2016 — have been created. So, if the blocks were being produced much slower than usual, it would actually be a bit longer than 2 weeks between adjustments.

For example, if as many as 50% of miners decided to call it quits at once, then there would be a period where new blocks were created after about 20 minutes instead of 10. That might be a bit annoying if you had some particularly important transactions to make in that time, but it’s certainly not the end of the world. And then, after about a month at this slower pace, the game would update itself to become easier to win, and everything would return to normal.

In these circumstances, the miners that managed to persevere through the difficult and potentially unprofitable times are rewarded after the adjustment with a much greater chance of discovering a winning solution to the guessing game and netting block rewards.

This acts as encouragement for many miners (particularly those with lower-costs or who negotiated long-term, pre-paid electricity contracts) to stick around during tough times, and it virtually guarantees that Bitcoin will never experience a hypothetical event known as a ‘miner death spiral’ where so many miners cease operations so quickly that no new blocks can be found and Bitcoin just grinds to a halt.

From this, you can hopefully see that even if Halvings did have a dramatic negative impact on the price of a bitcoin or the profitability of miners, it really wouldn’t matter for long: Bitcoin is far too resilient a system for these things to make any real difference to its operation.

Transitioning To Fees

While Bitcoin may be largely unaffected by each individual Halving and other abrupt changes to the system, could the cumulative impact of many Halvings and the steady reduction of block rewards cause issues later on? Will miners still be sufficiently incentivised after 10 Halvings? What about 20, or 33? Will transaction fees be enough encouragement alone?

Remember, if one miner is able to accumulate enough computing power to trial solutions to Bitcoin’s guessing game faster than all the other miners combined, they’re likely to produce more blocks than everyone else and can effectively become Bitcoin’s ‘controller’, giving them the power to meddle with Bitcoin in all kinds of detrimental ways. We’ve assumed that it’d be really difficult for someone to accumulate this much computing power, but if many miners are forced offline as Bitcoin’s financial incentives dwindle, this becomes an easier feat to achieve. For this reason, some people are quite concerned about Bitcoin’s security as it transitions purely to transaction fees.

Today, transaction fees form only a small portion of miner income, often combining to a total of less than one bitcoin in each block, but the hope is that more people will become interested in and make use of Bitcoin as the years go by and that will drive transaction fees higher.

In a few decades when the reward gets too small, the transaction fee will become the main compensation for nodes. I’m sure that in 20 years there will either be very large transaction volume or no volume — Satoshi Nakamoto

We’ve already seen something like this happen during the 2017 Bitcoin bubble, when there were so many transactions taking place that users had to pay tens or even hundreds of dollars to ensure miners paid attention to theirs and included it in a block. This drove cumulative transaction fees to highs around 11 BTC in some blocks — almost matching the block reward at the time.

This proves that transaction fees can, at times, total enough to incentivise miners — now we just need to find ways to consistently and sustainably maintain that without such a significant compromise to the user experience. Various developments are in the works to assist this, but the general idea behind many of them is to combine large numbers of transactions into just one or two that are actually recorded in blocks, either reducing the number of times users have to make costly transactions or allowing large groups of users to split a high fee between them.

So, although we can’t be absolutely certain that Bitcoin will survive its transition to a purely transaction fee-based incentive model, there’s a lot of reasons to be optimistic that it will.

Summary

So, we’ve seen that Bitcoin relies on miners to function and remain secure, and that miners are economically incentivised using freshly created bitcoin from block rewards and recycled bitcoin from transaction fees.

To maintain a hard supply cap, the block reward is slashed in half every four years in events known as Halvings, eventually reducing miner incentives to transaction fees alone.

While the reduced incentives may make some miners unprofitable and force them offline, Bitcoin is able to react quite easily to short-term changes in the number of miners, and also appears well placed to manage the eventual transition to a fee-only model as the 21 million bitcoin supply cap is reached.