A reflection on the first large correction of and outlook for the remainder of 2021.
Dilution-proof, June 1, 2021
Cycling On-Chain is a monthly series that uses on-chain and price-related data to estimate where we are in bitcoin’s market cycle. It originally started as a monthly Twitter thread that was later adopted by Bitcoin Magazine. In this first edition of Cycling On-Chain, we’ll look back at the first leg up in the 2020–2021 bull run and the circumstances that turned out to be fertile soil for a firm downward correction that brought fear into the market. The second part will attempt to look forward by building a case for why we may not have seen the top of this market cycle, as well as some of its vulnerabilities.
The January Turnaround
Just like the previous two versions, 2020’s halving created a supply shock that triggered an exponential price increase. However, in comparison to the previous (2016) halving cycle, this cycle heated up much faster (figure 1).
As you would expect during such a rapid price increase, market participants started taking profits when the bitcoin price broke its all-time high in December 2020 and the period after (figure 2). Since forming a local market top in January 2021, profit taking decreased — despite the price still grinding up further during that period.
What usually happens during these exponential price increases (figure 3), is that long-term bitcoin holders (green) start to gradually sell, while new market participants (purple) start building their positions — until the market cycle reaches a top and both parties switch roles.
If we zoom in on the net position change of the long-term bitcoin holders (figure 4), we see that long-term holders were mostly selling up to the January 2021 local top, slowed down their spending afterward and have turned into net accumulators during this price dip.
A similar trend can be witnessed in the net position change of miners (figure 5), another class of market participants with clear long-term market experience and exposure.
Levering It Up
In March 2020, a large macro-driven price crash cleared the bitcoin market from all leverage and created more organic market conditions that turned out to lay the groundwork for this 2020–2021 bull run. Since then, a clear trend of decreasing bitcoin reserves on exchanges was witnessed, suggesting that a large supply shock was forming. After the bitcoin price broke its 2017 all-time high, this trend has accelerated on pure spot exchanges that don’t offer derivatives trading (figure 6).
However, the opposite is true when looking at exchanges that do offer derivatives products (figure 7). These derivatives exchanges have seen their bitcoin reserves increase, especially after the price started consolidating and correcting.
The bitcoin reserves on derivatives exchanges are (at least partially) held as collateral for (high) leveraged trading. In the months following the January 2021 local top, the amount of open interest on bitcoin futures more than doubled (figure 8), suggesting that market participants were increasingly comfortable taking risks — a possible sign of market euphoria.
As can be seen in figure 9, most of this open interest was representing long positions. When the market is massively (over)leveraged into one direction, there is a clear incentive for large market participants to push the price the other way. When the bitcoin price drops below a long position’s liquidation price, exchanges can force-sell the position, creating even more downward price pressure, potentially forming a cascading effect of long liquidations that is combined with a steep price decline, which is exactly what we saw on May 19, 2021.
A Change Of Scenery
A change of scenery could be witnessed in several other metrics during the first quarter of 2021. For instance, the bitcoin holdings of the Grayscale Bitcoin Trust that had seen steep increases based on institutional demand stopped rising in February 2021 (figure 10), while the premium on its (GBTC) shares actually turned deeply negative.
During the first quarter of 2021, the anticipation of Coinbase’s direct listing (sometimes referred to as their initial public offering or IPO) was another narrative that a lot of market participants were following. Both the bitcoin price (orange) and COIN price (black and white) were creeping up during the months up to this event, and found their all-time highs around their direct listing date on April 14, 2021 (figure 11). The direct listing was accompanied with large sell pressure from Coinbase executives that were selling part of their positions, creating a steep downward price movement in the price of their shares.
Another clear trend change that occurred after the January 2021 local top was the fast decline in bitcoin dominance that we have seen since then (figure 12). This declining bitcoin dominance means that altcoin price appreciation was outperforming that of bitcoin, which can likely be attributed to retail market participants entering the scene en masse.
Young Whales Crashing The Party
Since the January 2021 local top, a clear downward trend can be witnessed in the degree in which older coins are responsible for the on-chain volume (figure 13). This means that recent price movements can increasingly be attributed to relatively young market participants.
When zooming in on the on-chain movements of the largest players in the bitcoin market (“whales”), it is also clear that most of the on-chain movements were made by young whales. An example of this is visualized in figure 14, where the green circles highlight the (magnitude of) whale addresses that transacted on-chain during the May 19, 2021, capitulation event. These on-chain movements are likely a combination of these young whales (1) triggering the price crash itself, (2) selling out of anxiety, (3) getting liquidated from their long positions and (4) buying back at a lower price for tax benefits (“tax harvesting”).
A Mountain Without A Peak
The big question that remains — is this party over now…?
It is impossible to predict the future based on historical data since the context of that data continuously changes and future events can simply take a different course. Nonetheless, comparing current and historical on-chain data structures can be helpful to gauge to what extent (cyclical) investor behavior rhymes in terms of market psychology.
One example of this is illustrated in figure 15. Unlike the previous market cycles, whose tops were all marked by an exponential blow-off top that was combined with long-term holders massively selling into market strength, this cycle (so far) has had neither. Of course, this cycle does not have to be similar to the previous ones, but this does illustrate that it would be quite atypical if the current cycle indeed ends with a dud.
A New Hope(?)
As just pointed out, we cannot predict the future based on on-chain data; but we can monitor trends in its flows to help us understand recent market movements and more substantially speculate where the market might move next. Despite the steep price drop, some positive on-chain signals could be witnessed.
During the recent market correction, exchanges saw large net inflows of the short-term holders that were getting out of their positions (figure 16). As price declined, so did the net transfer volume from/to exchanges, even turning net negative again near the end of the price dip. This suggests that the lower prices triggered (new?) demand, increasing confidence that buyers will continue to step in during dips.
During this dip, there also were large outflows in over-the-counter (OTC) trade desks (figure 17). These OTC desks facilitate trading between larger entities that want to buy or sell bitcoin without moving markets.
Another possible sign of continued demand for (spot) exposure to bitcoin is the stablecoin reserves on spot exchanges that have continued to go up (figure 18).
Based on the number of accumulation addresses recently peaking to new all-time highs, the price dip also appears to have triggered market participants to dollar-cost average (DCA) into a bitcoin position (figure 19).
Finally, the recent spike in the net growth of entities on the Bitcoin network suggests that during the price crash more entities joined than left, also suggesting that the lower prices enticed some people to buy into a position (figure 20).
Although Twitter polls always need to be taken with a grain of salt, the results of the poll displayed in figure 21 provide another signal that market participants still have a positive mid- to long-term expectation for the bitcoin price. Respondents are neutral to mildly bullish on a weekly to monthly time frame but clearly still very bullish on a yearly time frame.
Besides price-related interest in bitcoin’s prospects, prospects about Bitcoin’s Taproot protocol upgrade may provide a more fundamental driver for enthusiasm throughout the remainder of 2021. Taproot improves some of Bitcoin’s on-chain privacy characteristics and unlocks new possibilities for scaling, smart contracts and Lightning. The protocol upgrade is expected to be locked into activation within the next two weeks and will be activated in November 2021 if successful.
A Note Of Caution
The recent unwinding of leverage and change of scenery provided a call for caution, as well as a warning that the bitcoin market has reached a very volatile and vulnerable phase, regardless of the direction in which it moves next.
During the past year, bitcoin has matured into a macro-asset that is increasingly adopted by institutional investors, moving the asset into a whole new playing field. It may, therefore, see regulatory headwinds that can spur anxiety into markets, even if those narratives are based on flawed information.
Another possible result of the increased institutional adoption is that its price developments may increasingly start following those of the larger overall macro cycle. Like we saw in March 2020, its price course may be impacted if a macro-economic breakdown were to happen.
A Possible Outlook For 2021
There are no guarantees that the bitcoin price will necessarily mimic the trajectories of its previous (halving) cycles. Nonetheless, models like the S2F and S2FX, time-based models or more simple previous cycle indexes that are displayed in figure 23 may be useful for getting a rough idea of what may be ahead if bitcoin’s four-year cycle indeed rhymes at least one more time.
Disclaimer: This article was written for educational, informational and entertainment purposes only and should not be taken as investment advice.
This is a guest post by Dilution-proof. Opinions expressed are entirely their own and do not necessarily reflect those of BTC, Inc. or Bitcoin Magazine.
The three mechanics are an important part of understanding Bitcoin on a technical level.
Learning Bitcoin With Charts: How Are Hash Rate, Difficulty And Fees Related?
Date: May 15, 2021
Bitcoin’s difficulty adjustment mechanism is one of its most important aspects, but learning how it works can be a daunting task. This article leverages on-chain data to visualize how this mechanism works and how it relates to hash rate, block intervals, transaction fees, and the mempool. After reading this article, you will have a better understanding of why at certain times using Bitcoin may appear to be relatively slow and expensive, but also how Bitcoin fixes this and why this process is so essential to ensure Bitcoin’s monetary properties.
Bitcoin’s Supply Issuance Schedule
If you have heard of Bitcoin, you have probably heard that its supply is hard capped at 21 million units (BTC), making it a perfectly scarce asset and thus the ultimate “hard money.”
When Bitcoin was created, miners received 50 BTC for each new block as a reward for their work. The software has a built-in rule that after every 210,000 blocks that are mined (approximately every 4 years, if the block interval is 10 minutes), this “block subsidy” is cut in half during an event called “the halving.” During this first “reward era”’ which ended November 28, 2012, 10.5 million BTC were mined — half of its maximum supply. During the second reward era, half of that amount (10.5 million / 2 = 5.25 million) was issued, followed by half of that (5.25 million / 2 = 2.625 million) during the third reward era — and so forth. After 32 halvings, the block subsidy equals the smallest unit in Bitcoin (0.00000001 BTC = 1 sat) and cannot be split after, which means the block subsidy falls away completely after that (believed to be in the year 2140, if block intervals were 10 minutes during its entire existence). The first 14 reward eras of Bitcoin’s issuance schedule are visualized in figure one.
The careful reader will have noticed that in the previous paragraph, we mentioned twice that the actual calendar dates on which these halving events occur depend on the block intervals and that we assumed 10 minutes here. Why is it important that this supply issuance schedule is predictable in regular calendar-times in the first place?
The Importance Of Relatively Stable Block Intervals
Let’s consider what it would look like if Bitcoin didn’t have a built-in difficulty adjustment mechanism, but simply had a fixed mining difficulty.
If that fixed difficulty had been set relatively high, early mining would have been very expensive and blocks would have come in at a very slow pace early on. Clearly, that wouldn’t have been ideal to bootstrap a new network and could have meant that it never succeeded in the first place.
On the other extreme, if the difficulty would have been set relatively low to incentivize early network participants to join, block intervals would have gotten smaller as more miners joined the network, and blocks would have come in at an increasingly quicker pace. It would have quickly run through its entire supply issuance schedule. Had this happened, the Bitcoin network likely wouldn’t have had enough time to develop the block space market needed to sufficiently incentivize miners to keep mining blocks in order to process transactions and secure the network after the block subsidy had run out.
To summarize, relatively stable block intervals are needed to spread out Bitcoin’s supply issuance over time, which in turn is needed to incentivize miners to keep joining the network over a relatively long bootstrapping period, as well as to gradually develop a block space market that will be able to keep the lights on after the block subsidy reward runs out.
To guarantee that block intervals will remain relatively stable over a multi decade period, Bitcoin has a difficulty adjustment mechanism. As can be seen in figure 2, even with this built-in difficulty mechanism, its block intervals were not very stable, averaging much longer than 10 minutes per block during its first year of existence. The block intervals became more stable after Bitcoin set its first market price in July, 2010, and have been relatively stable at just under 10 minutes for over five years now (no structural up or down trends in the orange line in figure 2) – works like a charm.
Bitcoin’s Difficulty Adjustment Mechanism
To mine bitcoin, miners use highly specialized computers to basically guess a certain number (slightly simplified explanation). When a miner finds the number that the network is currently looking for, that miner earns the right to create a new block on the Bitcoin blockchain, take its block subsidy, choose which transactions to include in that block, and collect the fees of those transactions. At the time of writing, all miners that are active on the Bitcoin network are estimated to have a total capacity (hash rate) of 170 exahashes per second (EH/s), which is 170,000,000,000,000,000,000 hashes per second.
In Bitcoin’s first year of existence (2009), it was still possible to mine Bitcoin on the Central Processing Unit (CPU; which is basically the central chip in a computer that takes care of lots of things) of an average consumer computer, as the network’s hash rate was just a few million hashes per second. Over time, more computers joined the network and eventually chips that were better at heavy number crunching via their Graphics Processing Unit (GPU), the chip in a computer that is applied for graphical tasks and linear algebra) or even hardware custom made for Bitcoin mining (an ASIC, or Application Specific Integrated Circuit) was used.
As you can imagine, as the network’s hash rate increased by a multi-trillion-fold from that first year until now, it was necessary to make it a lot harder to guess that certain number to ensure relatively stable block intervals of approximately 10 minutes each
In Bitcoin, “difficulty” is the measure for how hard it is to find that number that the network is looking for. Every 2,016 blocks (14 days if block intervals are 10 minutes), the Bitcoin software basically calculates the block intervals during that period and adjusts the difficulty so that at current capacity, the average block interval will be roughly 10 minutes again.
The interplay between Bitcoin’s difficulty (the 14-day moving average of the) hash rate and block intervals over the last three months is visualized in figure 3. During the first visualized difficulty adjustment period (the red column on the left), the hash rate was declining (downtrend in black line). As network capacity decreased, block intervals increased (uptrend in blue line), making it necessary to decrease the difficulty (small drop in orange line after this period).
In three difficulty adjustment periods after (first green column in figure 3), the hashrate was increasing again, blocks came in faster than planned and difficulty adjusted upwards three times. Mid-April, 2021 (right red column), there was a large power outage in China that caused a massive drop in Bitcoin’s hash rate, slowing down blocks a lot and making a huge downwards difficulty adjustment necessary after the period. After this happened (right green column), the power outage itself was solved and the downwards difficulty adjustment made it much easier for miners to create blocks again. As a result, some miners with less efficient hardware and/or more expensive energy could earn a profit mining again, actually overcompensating the previous loss of hash rate, actually sending it to new all-time highs.
This latest hash rate drop and recovery is a good example of why miners leaving the network does not have a cascading effect of more miners leaving the network (sometimes called the “mining death spiral” by critics), but the software simply increases the remaining miners’ profit margins, incentivizing other miners to (re)join the network.
A side effect of this mechanism that we all feel is its impact on transaction fees. During times when the hash rate increases and blocks are coming in faster than planned (green columns in figure 4), transactions can relatively easily be included in blocks. Since this means that there are less transactions queued up in line (in Bitcoin called the “mempool”) to be included in upcoming blocks, transaction fees can be relatively low.
The opposite is true during periods where hash rate drops and block intervals increase (red column in figure 4). When blocks are coming in slowly, the queue of transactions waiting to get included gets crowded, and people need to bid up their transaction fees to basically jump the line. As such, transaction fees spike especially when the network capacity decreases (hash rate drops) and is waiting to be bailed out by the next difficulty adjustment.
In this section, we discussed the fees of transactions that were included in blocks. For those looking to transact on the Bitcoin network, it is even more relevant to get a feel for how much all of the transactions that are still waiting in line to be included in future blocks are bidding for their needed block space.
As briefly mentioned above, the Bitcoin mempool can be interpreted as the total of all transactions which were broadcast on the network but are still waiting in line to be included in a future block. Technically, each of the thousands of Bitcoin nodes on the network has its own mempool, but since they are mostly well interconnected, visualizing them as a single waiting line is alright for general explanatory purposes.
Mempool.space is an industry-standard website that gives anyone not running their own node or simply looking to get a quick look at the mempool all the relevant data. Examples are the total size of the waiting line (mempool size), how many transactions are joining the queue (incoming transactions), if blocks are coming in faster or slower than expected (estimated difficulty adjustment) and estimations of how high the transaction fee of a new transaction needs to be to be included at low, medium, or high priority.
Figure 5 visualizes the mempool of the last three months. As you would expect, the patterns described in figure 4 can also be seen here. Between late February and early April 2021, when the amount of hash rate on the Bitcoin network increased and more blocks than planned were created, the mempool size (the size of the waiting line) decreased and transaction fees decreased correspondingly. After the mid-April hash rate drop, the mempool quickly increased and transaction fees skyrocketed, but both declined quite quickly after the April 30th difficulty adjustment, and subsequent hash rate growth to all-time highs.
The Future Block Space Market
As briefly mentioned at an earlier point in this article, Bitcoin’s block subsidy is designed to decay over time, and the development of a healthy block space market where transaction fees become the primary source of revenue for miners is essential to incentivize miners to keep processing transactions and securing the network in the long-run.
This is possibly the most important test that awaits Bitcoin in the future, and is the subject of my previous Bitcoin Magazine article titled “An Ode And Forthcoming Obituary To Bitcoin’s Four-year Cycle,” which is a recommended follow-up read. Finally, if you have any questions on the topics discussed in this article, feel free to send me a message on Twitter.
Disclaimer: This article was written for educational and entertainment purposes only and should not be taken as investment advice.
This is a guest post by Dilution-proof. Opinions expressed are entirely their own and do not necessarily reflect those of BTC, Inc. or Bitcoin Magazine.
What’s been behind the recent dips in the price of bitcoin, and what might the future potentially hold?
Navigating the stormy seas of the bitcoin markets can be a challenge. Luckily, Bitcoin uses a publicly available blockchain that contains valuable information about all transactions that were ever made on the network. By combining this on-chain data with other price and market data, bitcoin holders are more equipped to understand why its markets behave the way that they do, giving them tools to make more informed decisions or the confidence needed to keep sailing. This article is the fifth installment in a series of monthly market analyses that started out as a Twitter thread that was transformed into this article upon request.
This bitcoin market analysis looks at three overarching questions:
Why did we dip (again)?
Is there still demand?
Is there still room for growth?
Before we dive into those questions, let’s first have a look at the price chart (figure 1). Bitcoin started the month strong, rallying to a new all-time high at ~$69,000 but then dropped to ~$47,000 (-27.56%), where it found a lot of confluence for support (e.g., a key Fibonacci level, a large volume in the UTXO realized price distribution and large whale inflows).
Upon writing my monthly market analyses, I noticed a trend: I am writing about a price dip that happened near the end of the month. William Clemente III has recently noticed that same pattern (figure 2).
1. Why Did We Dip (Again)?
Based on responses on Twitter, an explanation for this phenomenon should be sought in the options markets. As explained here, this is related to something called “max pain,” which is essentially the art of making one’s trading counterparty suffer the most to reach optimal personal profitability. After the bitcoin price had rapidly risen in late 2020, an increasing number of options traders were expecting continued price growth. This created a scenario in which it became profitable to take the other side of this trade if price indeed went down.
The rapid bitcoin price growth is particularly visible in the Bitcoin Price Temperature (BPT). As can be seen in the second chart in figure 3, temperatures rose at a much faster pace so far this cycle (orange line) in comparison to the previous one (yellow line). As a result, price reached temperatures of around six (orange line in the other charts in figure 3) at an earlier post-halving date than during the 2017 bull run. Therefore, some exhaustion of price could be expected around these price levels.
Similarly to the options markets, an increasing number of futures market participants became excited about bitcoin’s prospects and took leveraged bets at an increasing rate, causing open interest on futures to skyrocket (figure 4). Not just the bitcoin price and its temperature needed to cool off — so did the leverage in the futures markets.
The amount of pain of those futures traders that massively went long on leverage during this parabolic rise is visualized in the long liquidations chart in figure 5. A lesson can be learned here: When everyone and their mother is going leveraged long, it pays to be short — especially if you are a whale that can help push the price down.
The latter is exactly what happened. The most recent bitcoin dip started with a large, somewhat old (August 2020) whale that took a profit (>400%), who was followed up by a younger (December 2020) whale that also took a profit (~100%), that cascaded all the way down to some newbie whales (<1 month old) that even ended up selling at a loss. I wrote a Twitter thread about this of which the first four tweets are summarized in the gallery showing figure 6a-d.
Figure 6: The first four tweets of a Twitter thread on whale profit-taking (Source).
The thread concluded with a chart of the Spent Output Profit Ratio (SOPR) that had just reset back to one (figure 7). This means that, on average, the bitcoins that were last sold and moved on-chain were neither in profit nor at a loss — an indication that market participants are no longer actively taking profits, which is a good sign during a consolidating price dip.
Around that same time, the bitcoin price was touching the Network Value to Transaction (NVT) ratio price model that had worked as a support during the previous bull runs (figure 8).
That week not just the bitcoin price dipped, so did its hash rate, likely thanks to a government-instituted power outage in China. This drop caused the hash ribbons to compress, creating a miner capitulation signal on the hash ribbon indicator. As soon as the hash rate starts to recover, the indicator then gives a “buy” signal (blue dots in figure 9) that can soon be expected to occur on the bitcoin price. Although it is unclear if the unique circumstances of this specific hash rate drop invalidate the signal, its miner capitulation and buy signals have historically been very good opportunities to buy bitcoin.
Since then, the bitcoin price bounced back resiliently, even closing the month at ~$57,800, which is barely even a red candle (-1.7%). What is encouraging, is that this rise was accompanied by some very negative net flows on spot exchanges (figure 10), possibly indicating continued institutional interest in the asset.
Perhaps an even more comforting thought is that this latest price rise was not accompanied by a rise in funding rates (figure 11), which is a sign that it was primarily spot-markets driven and more likely to be sustainable. This means that the traders that irresponsibly leveraged long during the run up and were rekt are now either on the sidelines or learned their lesson and bought spot bitcoin without leverage.
To gauge the current market sentiment, I held a Twitter poll last week. Although the sample size was modest, the results were quite clear (figure 12): Respondents were indifferent short-term but very much bullish on bitcoin mid- to long-term.
The previous 10 charts showed a clear picture that, during the last few months, bitcoin markets were (over)leveraged after a rapid price rise and simply needed a bit of time to cool off, causing this consolidation with several dips. To get out of a dip, you clearly need demand for the asset though, which brings us to the second question.
2. Is There Still Demand For Bitcoin?
To assess this, we will have a look at the trends in a number of different metrics. Perhaps the exchange balances chart that has been in an incredible downtrend since the March 2020 COVID-19–related market panic is the most famous. Figure 13 shows that, although that downtrend has had a few minor bumps along the way, its larger trend is still intact.
A similar pattern can be witnessed in the balances of Over-The-Counter (OTC) trading desks (figure 14). The supply shortage is real; there is a decreasing amount of bitcoin that actively circulates on the markets.
That trend becomes even clearer when you see that the liquid market supply has decreased on a daily basis all year so far (top chart in figure 15) and thus the illiquid supply — the coins in the hands of holders with no history of selling — keeps growing (bottom chart in figure 15).
A similar pattern can be witnessed when looking at miner positions. Miners were taking profits in January but have stopped doing so since late March and have been accumulating bitcoin ever since (figure 16).
If there is an increasing supply shortage on the markets, and newly created coins are not coming to market to fill it, who will?
The answer is clear: Existing coins need to become available to the market to meet the new demand. The problem is that long-term holders are not selling — they are buying (figure 17)!
Since neither miners nor long-term holders are selling their bitcoin and balances on exchanges are declining, an increasing number of addresses on the Bitcoin network is in accumulation mode, as can be seen in figure 18.
The steep rise in the number of accumulation addresses is even more encouraging when we consider that the number of new entities coming to the network is also growing at an all-time high (figure 19).
The previous charts are all observing historical data, but the relatively high stablecoin balances on exchanges in figure 20 suggests that that there could currently be money waiting on the sidelines, ready to buy the next dip — or perhaps FOMO in if price runs away.
These charts all suggest that the trends that signaled a high demand for bitcoin in the past are still present.
3. Is There Still Room For Growth?
It is hard to predict future demand for any asset, but the fact that bitcoin has moved in a very expressive four-year cycle (which I described in detail in this recent Bitcoin Magazine article) means that there is clear cyclical historic data to compare the current cycle with.
One of these metrics is the Market-Value-to-Realized-Value (MVRV) ratio, that compares bitcoin’s current market valuation to the value of all individual unspent transactions on the network at the last time they moved on-chain — the realized value. Like we saw with the BPT before, the MVRV (Z-score) reached relatively high levels recently, but since then it has dropped because the realized value itself went up (figure 21). The current cycle also did not reach similar MVRV Z-score levels as it did during the previous cycles, suggesting that if this cycle is like the others, there still is room for growth.
Similarly, the Puell Multiple — a metric that quantifies to what extent the daily coin issuance is increased in compared to its one-year moving average — was also at relatively high levels but recently decreased after the hash rate drop on the network (figure 22).
When we shift our attention to the confidence of long-term holders which is captured by the Reserve Risk, the results are less pronounced. The Reserve Risk suggests that, while long-term holders have gradually started taking some profits throughout the bull market so far, we are only halfway through the cycle in comparison to the previous cycles.
Where the Reserve Risk assesses long-term holder market behavior by looking at the age of the coins that were moved on-chain, the Realized HODL (RHODL) ratio does so by looking at the age of the long-term holders’ coins that didn’t move on-chain (figure 24). The conclusion is similar nonetheless: Compared to previous cycles, a relatively large portion of long-term holders are still keeping their cards against their chests, waiting for higher prices to part with their bitcoin.
To close off this analysis, we’ll have a look at my Halving Cycle Roadmap chart (figure 25), that combines the BPT (Bands) metric that was introduced earlier with several popular predictive price models. By doing so, we get a rough idea where the bitcoin price might be heading next — off course, assuming that its four-year cyclicality holds. As the BPT recently cooled off toward green, the bitcoin price is now lagging behind most of the predictive price models. (When) will it catch up?
To finalize this market analysis, several conclusions can be summarized:
Compared to the previous bull run of 2017, the price increase in this current bull run was relatively steep and intense, so some exhaustion could be expected at these levels.
The bitcoin futures markets were (over)leveraged but now less so.
The demand for bitcoin appears to be strong as ever.
Under the assumption of four-year price cyclicality, there is still room for growth left on most on-chain market cycle metrics.
Disclaimer: This article was written for informational purposes only and should not be taken as investment advice.
This is a guest post by Dilution-proof. Opinions expressed are entirely their own and do not necessarily reflect those of BTC, Inc. or Bitcoin Magazine.
A reflection on Bitcoin’s four-year market cycle—and how a healthy block space market will eventually kill it for its own good.
Dilution-proof, April 28, 2021
On January 3, 2009, Satoshi Nakamoto launched the Bitcoin network by mining the first block (the “genesis block”) in the Bitcoin blockchain. Today, a bit more than 12 years later, the network stores over $1 trillion in value and transfers more than $20 billion in on-chain volume on a daily basis. To get there, bitcoin went through multiple boom and bust cycles in which it was praised to the moon and declared dead many times over—every time to resurrect from the death. This process kept repeating in a roughly four-year cycle that led many to believe that there is a certain predictability to long-term bitcoin prices, of which PlanB’s popular Stock-to-Flow (S2F) model is the most well-known attempt.
In this article, we’ll first take an in-depth look at why the bitcoin price moves in a four-year cycle related to its halving schedule. We then dive into how this market cycle influences more fundamental properties of the Bitcoin network itself that are related to the behavior of miners and users. Finally, I introduce a hypothesis for how the maturation of the Bitcoin network itself will eventually extinguish its four-year cycle, and explain why this would be a good thing for the network and its users.
Bitcoin’s Fixed Supply Issuance Schedule
When Satoshi Nakamoto launched the Bitcoin network, there was a need to (1) bring the bitcoin units into circulation and (2) incentivize early users to actually participate in the network by running their own mining nodes to secure the network and gradually decrease the chances of a single entity attacking the network via a majority attack (or 51% attack).
To do this, Satoshi Nakamoto decided on a coin issuance schedule where Bitcoin network participants would receive a 50-bitcoin mining reward (also called “coinbase,” not to be confused with the eponymous exchange) per created block. Every 210,000 blocks (~4 year, assuming 10-minute block-intervals), this reward halves. After the first halving (November 28, 2012), miners received 25 bitcoin; after the second halving (July 9, 2016), 12.5; since the last halving (May 11, 2020), they received 6.25, and so forth.
By combining this coin issuance schedule with Adam Back’s ingenious proof-of-work mechanism, Bitcoin’s monetary policy regarding its supply (figure 1, blue line) and monetary inflation (figure 1, orange line) became set in stone on a per-block basis as soon as the network launched—unlike its central bank predecessors.
Impact of the Halving on Supply, Demand and Price
Intended or not, the roughly four-year halving that has occurred three times in Bitcoin’s existence so far appears to have been a consistent trigger in pushing up the price every time. As can be seen in figure 2, after every halving event (white striped vertical lines), the bitcoin price (white line) has moved up dramatically in the year after those events. The average bitcoin price during a four-year moving window (black line in figure 2) has been positive during its complete lifespan as a result.
Before each halving event, the bitcoin price is a dynamic equilibrium between
the supply of newly mined bitcoin that enters the market;
the demand for bitcoin by new market participants and recurring purchases;
the degree in which that new demand comes from long-term HODLers that take the respective bitcoin off the market; and
the degree in which increased market prices or other triggers entice existing long-term HODLers to increase the supply available on the market by selling bitcoin.
After the halving, the supply of newly mined bitcoin that enters the market is cut in half. If the demand for bitcoin remains unchanged, this means that a supply shortage is gradually formed. Since bitcoin’s supply is perfectly inelastic, this supply shortage cannot be solved by creating more bitcoin. As a result, the only way for the market to unlock supply to satisfy the demand for bitcoin is to entice current holders to sell their bitcoin—which means that the market price has to move up. Due to bitcoin’s status as a Veblen good, this rising price tends to attract even more demand, exacerbating the already existing supply shortage and driving up the price much faster than it organically would. Those price developments resulted in a temporary bubble each time that ended with a market crash and subsequent multi-month to multi-year bear market that was necessary for supply and demand to find a new equilibrium—each time at a (much) higher level than during the previous cycle.
Although the post-halving price increases, the bitcoin price charts are already pretty distinct and the causal mechanism for such a cycle to exist is quite self-evident; it is nice to get more robust evidence for the notion that the bitcoin price indeed moves in a four-year cycle. In this published article on April 15, 2021, @btconometrics performed a Fourier analysis to prove that this is indeed the case. Although the statistical methods used are relatively complicated and explaining them is beyond the scope of this article, the graphical representation of the results is actually straightforward to interpret. As can be seen in figure 4, the highest values are reached very close to the red line that represents the four-year cycle, illustrating that the cyclicality in bitcoin is indeed very close to that.
The Bitcoin Price Temperature (BPT)
Now that we have insight into the mechanism that is driving bitcoin’s four-year cycles, we can take a more in-depth look at what this price cyclicality looks like. To do so, I have created a metric called the Bitcoin Price Temperature (BPT), which is described in detail here.
In short, the BPT is calculated by subtracting every daily closing price by the average bitcoin price during the previous four years, and then dividing that number by the price’s standard deviation during that time span. The result is a metric that reflects to what extent any historic bitcoin price deviates from its four-year moving average while taking its volatility into account, and, thus, how “hot” or “cold” the price is—hence the name, Bitcoin Price Temperature. By utilizing the bitcoin price’s standard deviation into the metric, the BPT metric adjusts for price volatility, unlike otherwise similar indicators like the Mayer Multiple.
The top chart in figure 5 illustrates the BPT. As shown, the bitcoin price has actually rarely been below its four-year moving average (the blue horizontal line at zero), and it has historically reached its four-year cycle tops at a price temperature of eight or higher. On a smaller time frame, the bitcoin price has also changed its bullish or bearish trajectory several times at temperatures of around two and six. While these levels have been determined based on a limited sample and thus need to be taken with a grain of salt, they are interesting price levels to monitor during bitcoin’s current and future four-year cycles—assuming those will continue to be similar to the past cycles, which will be discussed later in this article.
Another way to look at the cyclicality of the BPT and bitcoin price itself, is to “reset the clock” at every halving, creating a chart where the BPT and/or bitcoin price itself per cycle are overlaid, making them easier to compare. As can be seen in the top chart in figure 5, the price temperature gradually moves up after the halving at an increasing pace, historically creating a blow-off top circa 12 to 18 months after the halving, taking the remainder of the four-year cycle to cool off again and find an equilibrium somewhere around its four-year moving average.
The bottom chart in figure 6 illustrates the actual bitcoin price in United States Dollars (USD) with an overlay of the BPT and BPT Bands. Every time the price temperature reaches the cooldown period of its four-year cycle, the bitcoin price has found an equilibrium at a price level that is (at least) an order of magnitude higher than the previous cycle.
This is also why dollar-cost averaging (DCA) into bitcoin and HODLing it for the long haul (or at least four years) has historically been such an effective strategy. It doesn’t matter if you have bought the top or the bottom; as long as you have held onto your bitcoin for at least four years, you’ve historically done very well—without the additional costs of time, anxiety and in some countries (like the United States) tax burdens that come with active trading.
Impact of the Market Cycle on Bitcoin’s Hash Rate and Coin Issuance
In anticipation of each bitcoin halving, articles spreading fear, uncertainty and doubt (FUD) about something called ‘the mining death spiral’ start appearing. The mining death spiral FUD suggests that since the block subsidy is split in half, miners are faced with a 50% cut in their profitability, which will cause (some of) them to stop mining. In turn, this would make the network less secure, making it less valuable, making the price go down, further decreasing miner profitability, making them turn off more miners and so forth.
While it is true that in the short-term some miners are turning off hardware that is less efficient or running on more expensive energy, that dip is barely visible on long-term charts and ensures that the remaining mining activity on the network is actually very efficient and healthy. More importantly, that temporary dip is actually completely undone by the positive side effects of the halving-induced price increase that was described earlier.
As a result of the increasing bitcoin price following the halving-induced supply shortage, mining profitability increases again, incentivizing miners to (re)join the network. As a result, the network’s hash rate actually increases, making the network more secure and thus more valuable. This means that on a multiyear horizon, we are actually seeing the complete opposite of what the mining death spiral FUD suggests will happen—all thanks to bitcoin’s four-year cycle.
In figure 7, the almost continuously increasing hash rate of the Bitcoin network is illustrated. As can be seen, the hash rate barely drops after each halving (white striped vertical lines), and as the bitcoin price and thus the BPT measure that we introduced in the previous paragraph increases, hash rate growth accelerates. During the second half of the cycle, when price is cooling down, hash rate growth stagnates a bit—until the next halving occurs and a new market cycle incentivizes more rapid growth of this network characteristic that is so important for its overall security, actually making the network itself more valuable.
To ensure that new blocks are created every ~10 minutes (which is necessary to make the network relatively stable to transact on and that the supply issuance is actually spread out over time), the network has a built-in difficulty adjustment mechanism. Every 2,016 blocks, which is every ~14 days, the network makes it a bit easier to mine if the hash rate on the network is relatively low, or a bit more difficult to mine if the hash rate on the network is relatively high.
This means that during these periods of the cycle where the hash rate keeps going up, more new bitcoins are created than would be expected based on the original supply issuance schedule that assumes 10-minute block times. This inspired David Puell to explore the ratio of the daily coin issuance and the average daily coin issuance over the past year, which resulted in the Puell Multiple.
The Puell Multiple is displayed in figure 8, along with several levels that appear interesting based on visual inspection (which is subjective and should thus be taken with a grain of salt). As can be seen, the daily coin issuance takes an abrupt decline on the day of each halving, which is due to the halving of the block subsidy. In the months after, as price increases, mining becomes more profitable, a new hash rate floods onto the network, and the daily coin issuance ramps up again. When the bitcoin price growth stops and the market cycle finishes with a blow-off top that is followed by a cooldown period, mining profitability decreases, causing the daily coin issuance to go down again. The Puell Multiple is, therefore, regularly seen as an interesting indicator to monitor bitcoin’s cyclicality from an on-chain perspective.
Besides the hash rate growth and resulting temporary increase in daily coin issuance that are particularly indicative of cyclical miner behavior, the Bitcoin blockchain holds valuable information regarding another important group of market participants; those that use bitcoin to transact on-chain.
Influence of the Market Cycle on the Mempool and Transaction Fees
Intuitively, the first thing that you might think of to visualize the behavior of that group might be to create a chart of the number of daily transactions. If we were to do so, we would indeed see an overall trend that, as time passes, more transactions are made on a daily basis, but as the Bitcoin network matures, that growth stagnates. That stagnation can be easily explained; a Bitcoin block can only include a certain amount of transactions, so the metric wouldn’t be an ideal proxy for how crowded it actually is on the network. What happens when most or all of the newly created blocks are full, is that the number of transactions that are cued up increases. In Bitcoin, this cue is called a “mempool,” which is visualized in figure 9. As is evident based on that figure, the number of transactions that are waiting to be included in the blockchain have increased rapidly after breaking the all-time high price of ~$20,000 in December 2020.
The mempool is currently in a state where it hasn’t cleared in approximately five months, which means that, when any miner created a new block during that time span, they had plenty of unconfirmed transactions to include in the block. A logical conclusion is that miners are financially incentivized to include the unconfirmed transactions that are offering the highest transaction fee to reward the miner for including their transaction, which is indeed how most of the current miners operate.
As a result, unconfirmed transactions with a high transaction fee are included in new blocks first, while transactions with a low fee remain stuck in the mempool longer. This is visible in figure 7, where the mempool is currently particularly filled with unconfirmed transactions that pay a fee of 1-5 satoshis per vByte, while the mempool is regularly cleared from transactions of a higher fee rate.
An implication of this mechanism is that, during busy times on the network, anyone that is looking to make an on-chain transaction on the network needs to bid up their transaction fee to get their tiny share of block space on the Bitcoin blockchain that is needed to get their transaction confirmed. As such, a block space market (sometimes called “fee market”; which is technically incorrect because the block space on the Bitcoin blockchain is being bid on) develops.
Since the value of the transaction fees that are included in Bitcoin blocks essentially represents the magnitude of this developing block space market, it is a better proxy for network activity than simply looking at transaction counts. Figure 9 visualizes the average bitcoin transaction fees in United States dollars (USD) over time, overlaid by the BPT metric that we introduced before. In anticipation of each halving, the average transaction fee is already gradually increasing, but its growth particularly accelerates when the bitcoin price increases after each halving. After the market cycle reaches a blow-off top and prices start to cool down again, network activity decreases again and finds a new equilibrium when the overall bitcoin market cycle bottoms out.
Besides the cyclicality, a clear, increasing trend in the average bitcoin transaction fees can be observed in figure 9. While this may seem like a bad thing (don’t we all prefer to pay less for transacting?), this is actually of the utmost importance for Bitcoin’s long-term existence. After all, if the block subsidy declines every four years and at some point in the future disappears altogether, miners still need an incentive to keep mining and process transactions.
The Contribution of Transaction Fees to the Block Reward
Figure 11 visualizes the percentage in which transaction fees (red) and the block subsidy (blue) account for the overall block reward that miners receive when creating a block. When first glancing at these percentages on a continuous scale (top figure), it seems like transaction fees are relatively irrelevant, as the block subsidy has accounted for the vast majority of the block reward during all of Bitcoin’s history. While this is true, when these percentages are displayed on a logarithmic scale (bottom figure) , it becomes more apparent that over time, there is actually a clear upward trend in the degree to which transaction fees play a role in the block reward. On a cycle-by-cycle basis, you can even see that the percentage increases by roughly an order of magnitude, underlining how large this growth actually is.
While it is difficult to predict exactly when the point will be reached where transaction fees will (consistently) account for the majority of the block reward (based on eyeballing the charts above; perhaps after one to three more cycles?), as long as there is at least some activity on the Bitcoin network, it is a given that this point will be reached at some point in the future because the block subsidy trends toward zero by design.
When this point is reached, there is one more incredibly important question that we’ll get an answer on: will the hash rate on the network stay relatively stable at a level that is sufficient to guarantee the network’s overall security? If the answer to that question is “yes,” Bitcoin will have passed the biggest test in its existence and have passed the final exam toward its full maturity. Perhaps it could even be the point where the Bitcoin Core software versioning is upgraded toward 1.0 and above. While we cannot establish with absolute certainty that the question above can ultimately be answered with “yes,” a case can be made to be optimistic about the outcome, as was done by Dan Held in this May 2019 article.
This brings us to the final part of this article, where we’ll hypothesize how that perspective would impact the four-year cycle, and what that future for Bitcoin would look like.
How a Healthy Block Space Market Will Kill the Four-Year Cycle
The subtitle of this article already gave away the direction of my take on this: when Bitcoin gets to the “full maturity” mentioned above and a healthy block space market exists that is able to sufficiently incentivize miners to structurally keep the lights on, I expect the four-year cycles as we know them today to fade into oblivion.
The easiest way to substantiate this claim is to fast-forward all the way to the late 2130s, when Bitcoin’s block subsidy is estimated to run out. In the absence of a block subsidy, 100% of the new demand for bitcoin will have to be satisfied by purchasing bitcoin from existing holders (and to some extent miners that sell some of their fee revenue to pay for expenses, which will likely be just a fraction of the total supply that is available for sale on the market), creating a perfectly inelastic situation where price changes become a perfect reflection of changes in demand for bitcoin. To visualize this end state, @Croesus_BTC’s visualization of the demand/supply mechanic has been adjusted to this new situation in figure 12.
Now that we have established that the halving cycles will, by design, end at some point during the next ~118 years, it is helpful to rewind to the present and assess what the short-term path toward that end state will look like in the near future.
To understand those implications, it is important to grok that the relative impact of each halving on the block subsidy is the same (block subsidy divided by two), but the absolute impact of each halving on the block subsidy decreases over time. For example, the fourth-annual inflation rate dropped by -50% in 2012, but then by -33.3% in 2016, -9.6% in 2020 and will drop by just -3.8% in 2024, -1.7% in 2028 and -0.8% in 2032. More simply put, the larger the percentage of bitcoin’s finite supply has already been issued, the smaller the impact of a change in the remaining issuance rate on the supply that is already circulating on the market.
Now that we have established that the block subsidy is literally designed to decay into oblivion over time, the final step is to understand when the halving of the block subsidy will indeed start to lose its relevance.
The way I see it, this probably won’t be attributable to a single point in time, but it will be a gradual process that will happen when transaction fees overtake the block subsidy as the primary source of miner revenue (figure 13). After all, the smaller the contribution of the block subsidy to the portion of the miner revenue becomes, the smaller the impact of halvings will be on the supply that is available for sale on the market.
How the Death of the Four-Year Cycle Will Impact Bitcoin’s Future
When the earlier described process has progressed to a point where transaction fees have become the primary source of miner revenue and the four-year cycle has indeed decayed into irrelevance, it will impact bitcoin’s future in several ways.
First, the decay of the four-year cycle would mean that pricing models that depend on the assumption of a halving-related market cycle being present will lose accuracy and, at some point, break. This would apply to the Bitcoin Price Temperature (BPT) and BPT Bands that were discussed earlier but also for the popular S2F and S2FX models. The big question regarding the latter; would those models break to the downside (e.g., via diminishing returns as long-term volatility declines) or to the upside (e.g., via a steepening adoption curve and/or hyper-inflation-like event)?
Second, as the percentage of bitcoin’s finite supply that has already been issued increases, the bitcoin price becomes an increasingly pure reflection of the market demand for bitcoin. This means that in a long-term post-halving-cycle future, cyclicality in bitcoin will likely be more closely related to the actual economic activity of its market participants and thus their economic cycle (sometimes also called “business cycle”).
Third, if the bitcoin price increasingly becomes a pure reflection of the market demand for bitcoin, the likelihood of a dramatic exponential price rise past what we have seen so far increases. After all, due to the ever-decreasing supply issuance rate, demand for bitcoin has an increasingly direct influence on the bitcoin price. With gold, large increases in demand can be answered by increasing the supply rate via additional mining, but this is not possible in bitcoin—making it the ultimate hard money. If Bitcoin were to reach mass adoption and follow a similar technology adoption curve to what we’ve seen in the use of the internet or mobile phones (figure 14), the likelihood of a “supercycle” happening in the bitcoin price increases (or a mixture between that and its traditional four-year cycle as a more fluid transformation). Something similar to this has also been described by @Croesus_BTC in a June 2020 Twitter thread.
Fourth, another consequence of the absence of a four-year cycle as we know it could mean that the bitcoin price eventually becomes less volatile. As was recently pointed out in a note by JP Morgan, that development would be a positive for institutional interest in the asset, which would further validate it as a macro store of value.
Finally, if a healthy block space market will indeed kill bitcoin’s four-year cycle, it means that transacting on the Bitcoin blockchain will likely have become quite expensive. This means that in the future, most of us won’t be transacting via the Bitcoin base layer on a regular basis. More likely, the block space fee pressure will incentivize more effective batching of transactions (or, as Nic Carter put it during Baltic Honeybadger 2018, “container ships, not parcels,”) and broader adoption of layers (e.g., the Lightning Network) that have been built on top of Bitcoin’s base layer, which most of us will probably primarily use to interact with bitcoin, aside from occasional channel opens or closes or large transactions.
Special thanks go out to @GeertJancap for the useful feedback on the draft of this article. Follow @dilutionproof on Twitter for continued discussion on this topic. Disclaimer: This article was written for educational and entertainment purposes only and should not be taken as investment advice.
This is a guest post by Dilution-proof. Opinions expressed are entirely their own and do not necessarily reflect those of BTC, Inc. or Bitcoin Magazine.