Bitcoin Mining

When analyzing a Bitcoin mining investment, it is vital to understand one key factor; the halving effect. In short, the halving effect is the effect that the periodic block reward halving has on the potential long-term revenue of a mining operation.

I have mentioned the halving effect in my analysis of the 100TH mine, but it seems that there is still some confusion about how or even if this effect will influence pricing. I’m here to tell you how this effect works and what, how mining operations are affected, and in a fair market, the effects should be.

Block Reward and Transaction Fees

The income from mining operations is defined by the current block reward plus any transaction fees levied on transactions since the previous block. The block reward is currently 25BTC and the transaction fees are currently around 45BTC per day, which means a transaction reward per block of around 0,32BTC for a total mining reward of 25,32BTC.

This mining reward will be distributed for every block that is solved by the miners and thus represent an upper boundary for how much a mining operation can earn.

However, this mining reward isn’t fixed. First, the transaction reward varies depending on how many transactions are performed, which in turn depends largely on Bitcoin adoption but also on miners’ willingness to process transactions.

The bigger impact, however, comes from a built-in halving of the block reward. The current block reward is 25BTC per block, but this hasn’t always been the case, nor will it be. In fact, initially, the block reward was 50BTC and it dropped to half in November 2012.

This halving is due to Bitcoin’s built-in anti-inflation policy. To control the production of new money and make Bitcoins more and more scarce, the block reward halves roughly every four years. The next time this happens is in late 2016, at which point the block reward will be 12.5BTC per block.

You may be excused for thinking this is far into the future. After all, Bitcoin mining moves at an incredible rate and we’ve only just seen the first doubling ever a few months ago. Who cares about what happens in 2016?

A Bit about Mining Asset Valuation

As with any security traded anywhere in the world, investors expect to get a return on their investments (ROI). This isn’t even limited to securities, it applies to anything we do. We want to do something because it gives us more in return, whether that is more money, a loving spouse, better health, or a good conscience.

With mining investments, the return is quite simple. Assuming you don’t buy shares, contracts, or hardware for the sentimental value, your ability to receive a return is based on how many Bitcoins, Litecoins, or other cryptocurrencies your investment produces. You invest because you evaluate that the ability of the company allows for a return higher than your goal.

However, what happens if that ability is suddenly reduced by 50%? Obviously, your ability to get an ROI is also cut in half.

If a company produces 100 dollars in dividends per a year, you may wish to invest 1000 dollars, knowing that each year, you get a return on investment of 10%, a fair number if a reasonably safe investment.

However, if the company suddenly loses half the ability to produce dividends, your investment of 1000 will now yield only 5%. Of course, other investors looking to get 10% too will only pay $500 for your stake, so effectively you’ve lost $500 on your shares’ value unless you decide to hold the shares and be satisfied with the lower return.

If you knew in advance, however, when the yield would drop, you could calculate the drop in share price along the lines of (Y/X)2 per year, where Y is the price of your shares and X is the number of years until the drop happens. For example, if you know that the rate of return drops by 50% in 5 years and you paid 1000 for your shares, the formula would be (1000/5)/2, or $100 per year.

The problem, of course, is that now those $100 per year doesn’t really give you any ROI yield at all. You get $100 per year in return but your shares fall $100 in value too. Effectively, you are lending money to the company with no interest or chance of return. Obviously, you need a much higher return rate than 10% if these were the numbers.

In Bitcoin and cryptocurrency mining investments, you face this exact situation every four years. At that interval, the block reward halves and thus the bulk of the income for miners goes down.

But Four Years is a Long Time!

Well, not really, but the time doesn’t matter. The effect happens every year. In fact, with Bitcoin investments, you can even calculate this per week or day if you want and you’ll see the expected drop in value every day.

You may, of course, gamble that the market doesn’t know about this effect (or doesn’t find this article) or that they don’t take it into account. However, if the market doesn’t take this into account now, it will definitely do so closer to the next halving when calculating ROI over even one year  means including the profit drop.

If the market ignores this effect until then, the drop will just be that much higher at once. Rather than drop $100 per year, it will drop $500 in one year, but the drop will still be the same.

But it Didn’t Happen Last Time!

When the first halving in Bitcoin history happened in November 2012, several mining assets were operating already. However, there wasn’t a massive drop in prices just when the halving reduced potential profits by 50%.

There may be several reasons for this. Most mining assets at the time was either issued and purchased within a year of the halving so people may have been aware of the effect and priced that into their calculations. Another reason may be that a lot of mining operations were growing at the time, so the halving effect would be cancelled out by increasing market share.

But the Transaction Fee Will Counter That!

Well, if it does, it only makes the situation worse.

You see, the transaction fee doesn’t follow the block halving, it follows Bitcoin adoption. The transaction fee is simply a mechanism to control supply and demand; miners are already free to charge whatever fee they like so they could easily charge 25BTC per block if they so desire. They won’t because there are simply nobody willing to pay that amount to transmit Bitcoins, so adoption isn’t nearly high enough to make demand for transaction processing expensive.

If it comes to that, however, the situation doesn’t improve. Transaction fee increases happen gradually unless all miners come together and decide at the same time to increase transaction fees, and it takes only one of them to disagree to cause cheaper transactions to just slow down and not stop completely.

Of course, if Bitcoin transactions became very expensive or slow, people would look to other coins for transactions, such as Litecoin. In effect, Bitcoin demand would again drop to a level where demand was lower and transaction fees could no longer be levied at the same level.

Back to the transaction fee increase; it will most likely happen over time and thus will either begin before the halving (making return on mining increase artificially just before the halving, or it will start after the halving, in which case revenue will drop due to halving before recovering later.

Either case will cause a substantial loss in mining revenue at the halving time in late 2016. No matter how you look at it; unless demand skyrockets to a point where the bloc reward is insignificant, transaction fees will not counter the effect of the block reward dropping.

But You’re Selling a Mining Asset!

Yes I am. BFMines is indeed a mining contract. And I am acutely aware of the halving effect, which is the main reason I sold out of ASICMiner a couple of months ago.

However, when I do my calculations for BFMines, I’m using a time frame shorter than the next halving. This is for two reasons.

  1. Likely, the future earnings of BFMines will have dropped to a level where calculating profitability isn’t important. In fact, I may have shut down and bought out the contracts by then.
  2. Even if profitability remains at a reasonable level, speculating about the difficulty changes (which is the key factor in mining contract value) so far into the future is futile.

As such, I’m very aware of the halving effect and that it does indeed affect my asset too. However, by focusing on achieving a good return on investment before the next halving, the effect will be less important.

All long-term assets, however, for example ASICMiner, and mining contracts or equipment bought closer to the date of the block reward halving will need to take this effect into account or be very surprised about their profitability a few years down the line.

Please check out the list of US bitcoin exchanges.