Don’t let go of bitcoin just yet

By the end of 2017, bitcoin was reaching record highs, pushing towards $20 000 a bitcoin. The frenzy was palpable. Every auntie, uncle and their dog were buying bitcoin. Nobody wanted to miss out on the thing that was going to make them rich beyond imagination in a very short period of time!

Such is the nature of bubbles.

Early in 2018, of course, the bubble popped, and bitcoin now trades at around $4 000 a coin (at the time of writing on 5 December).

It was not entirely unexpected. In March, I wrote about how bitcoin is likely to form a repeating bubble pattern every four years, based on how it has performed in the past.

The reasoning was based on several different drivers; the “frenzy effect” that takes hold every time it rallies beyond what is normal (compared with traditional asset classes); the changing supply-demand dynamic as miners enter and exit the market due to difficulty in solving blocks, varying as these miners enter and exit the market; profitability of mining bitcoin due to the changing difficulty rate; and of course, the mining reward halving every four years.

The frenzy effect

The frenzy effect is a force driven primarily by individuals that are buying (or selling) a certain asset – in this case bitcoin – out of fear of some sort. In the case of bitcoin in 2017, this was a fear of missing out.

Everybody was talking about it and people were making real money, very, very fast. This got the attention of every media outlet around the world. For months bitcoin was the hottest topic out there.

The frenzy got to a point where people who have never traded a share, or even invested in financial instruments, were reportedly selling cars or taking loans to raise money to buy bitcoin. The belief was that it would never stop going up as it would change the world in a very short period of time. As it turns out, this was false.

Now we are seeing almost the exact opposite of what we saw last year. People refer to bitcoin as a useless technology with no real-world application. Some reckon its value will drop to zero. This too, I believe, is false.

Again, the frenzy of fear is at work. But this time it is the fear of losing money.

I believe that if bitcoin were to retake the $20 000 level and push 50% beyond it (to $30 000), the frenzy effect will kick in once more and drive hordes of speculators to buy again. Again, prices will be driven to stratospheric heights (much higher than in 2017, but a smaller percentage move).

As a disclaimer though, I do not foresee this happening until mid-2021. For now, we are coming out of the tail end of the “fear of losing money”-cycle, and prices will likely remain depressed for some time as people in general have no faith in bitcoin at the moment.

Understanding blockchain

It is important to the supply-demand dynamics of bitcoin. In its most simple form, bitcoin is a public ledger of transactions grouped together into blocks that are linked together in sequential order, hence the term “blockchain”.

These transactions are processed by miners (processing nodes on the bitcoin network) who compete against each other to group these transactions and have their unique group of transactions accepted as the next official block in the chain.

In order for a miner to have its block accepted as the next official block in the chain, it must solve a complex mathematical problem before any of the other miners on the network do. So, in a sense, it’s a race between these miners to solve the block before anyone else can.

Once the block is solved, it is communicated to all miners on the network and is accepted as the next immutable block of transactions in the public ledger. The race is then on to solve the next block. This process happens every ten minutes. The miner who solves the block is rewarded for the work done (to process transactions) by receiving bitcoin.

As the price of bitcoin rises, more people buy specialised computers to process these transactions, hoping to earn bitcoin. But as more computers are added, the bitcoin network automatically increases the difficulty of the mathematical problems to be solved in order to have a block accepted as the next official block in the immutable public record of transactions.

Also: The more computers join, the more computing power is required to solve problems quickly. With rising prices for bitcoin, though, more miners continue to enter as the reward outweighs input (computer hardware, cooling systems and electricity costs).

Every four years the reward is halved by the network, which means less efficient miners (i.e. those who have less sophisticated computer hardware) become less profitable or unprofitable altogether, as the input costs now outweigh the profit they make by earning bitcoin and selling it for normal currency.

This allows miners to demand higher prices for bitcoins as there is now in effect lower supply due to the reward being halved. This drives prices higher and starts the frenzy driven by the fear of missing out.

But, because so many computers have joined during a period of rising bitcoin prices, the mathematical problems are now much harder and the chances of them solving a problem first, and thus earning the reward, is significantly lower. Nonetheless, inefficient miners stay on the network because of the rapidly increasing price of bitcoin.

Higher prices continue to attract more miners and inefficient (older) miners are forced to shut down their mining computers and sell their bitcoins to recover costs. This mass and rapid shutdown brings a large number of bitcoins to the market, and suddenly the market finds itself in a state of oversupply.

Prices come down, frenzy driven by fear of losing money sets in. The bubble pops.

Bitcoin prices fall between 80% and 90%, driving out many more miners, at which point the network once again automatically adjusts the difficulty lower as there is now less competition. Miners operating the newest state-of-the-art hardware are once again profitable at lower prices. We then see a gradual fluctuation in prices over time, bitcoin disappears from the radar and bitcoin prices happily churn sideways in a relatively stable pattern for about two years as miners enter and exit the network at different price points.

Eventually the reward for “finding a block” is again halved and the process starts all over again.

This has happened three times already since bitcoin came about in 2009. Well, we are in the third cycle right now. The price has come down around 80% from the highs and miners have packed up operations. Already the difficulty of the mathematical problems to be solved to find a block have started to decrease and people in general are talking about bitcoin less and less.What next?

So, what now? Well, the same as what I had said in March. I expect that bitcoin should stabilise in a range over the next two years with the near $4 000-level being the bottom of the range and near $8 000 the top (which will mean, in percentage terms, its performance is in line with what it was four years ago).

Eventually nobody (in mainstream media) will be talking about it anymore and the people using it will be doing so to facilitate cross-border and online transactions (as is its purpose).

The mining reward will be halved and if the pattern holds true, in 2021 it will take out the highs of $20 000 made last year. Then the talk will begin again, and a new frenzy driven by fear of missing out will start.

I am of the belief that this pattern will repeat itself every four years until bitcoin is around 250 times its current level, at $1m, by approximately 2040.

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

This article originally appeared in the 20 December edition of finweek. Buy and download the magazine here or subscribe to our newsletter here.

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