Tag #Mining

Willy Woo’s new metric shows when smaller miners are ‘capitulating’, typically in bear markets and after halvings.

Willy Woo is well known for developing chain-based indicators for Bitcoin, including NVT. Now he has released another: the Bitcoin Difficulty Ribbon.

You can read a full explanation here, but essentially the ribbon is a collection of moving averages that track Bitcoin Difficulty. Showing shorter-term and longer-term moving averages on the same chart gives a sense of the ‘flow’ of Difficulty, as more miners come on board or, at times, are forced out of business. The result is a kind of twisting ribbon effect, which tightens (or turns downwards) when miners are feeling the pinch, and fans out when times are better.

Small and large miners

This is important, because not all miners are the same. Smaller miners are typically worse-placed to weather falling bitcoin prices, while large miners have both more cost-effective set-ups and greater resources to survive a crunch. The least efficient miners need to sell most of their coins to stay afloat, and are vulnerable to a supply shock (halving) or bear market.

The ribbon shows the rate of change of Difficulty. It’s very clear what happens and when. During major bear markets, the ribbon compresses because smaller miners are going out of business and hashrate is falling, leaving stronger miners who have more of a cushion against such a squeeze. That means more coins going to miners who don’t need to sell as many – so they accumulate, new supply falls, and the cycle starts again with more bullish action.

Halvings

What’s really interesting is that we can see miners capitulating in both bear markets and just after halvings. Obviously, dropping supply by 50% is enough to put many miners out of business. If miners are selling most of their coins to pay for electricity and can’t hold on until price catches up, they will fold. That has happened after both halvings to date, and we can expect it to happen again next year.

Woo uses this chart to make a comparison between the current bull market and 2012’s bull market. ‘Notice how the 2019 the 2012 bull market have the same structure, we saw severe mining capitulation (i.e. the ribbon flipped negative), the resulting vacuum in selling pressure lead to a shorter accumulation band before price breakout. Thus this bull market resembles 2012 more than 2016 structurally.’

The next halvening, in May 2020, may offer a strong buying opportunity. For now, the ribbon shows the bull run is just getting started.

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The 2020 Halvening is just one of a series of further supply reductions in Bitcoin’s future. What happens when miners rely solely on transaction fees for revenues?

Over the course of Bitcoin’s history, tx fees have played a changing role in the way miners are rewarded. In the past, the proportion of miners’ income that was composed of block rewards and transaction fees respectively has been quite different. 

In normal times, transaction fees currently account for around just 2% of miners’ income. At the time of writing, tx fees provide miners with 30-50 BTC per day, while block rewards provide 1,800 BTC. 

As block rewards decrease (May 2020 being the next Halvening event), tx fees will become more and more important – and so will bitcoin’s price. Bitcoin can only remain secure if the cost of attacking the network is high compared with the potential benefits of doing so. In other words, as overall rewards decrease, price must increase if Bitcoin is to survive.

Bitcoin’s daily rewards are currently around 0.01% of the value of its overall market cap. In the past, this has been much, much higher – for example, when MtGox first opened back in July 2010, it was 0.21%. Not only were block rewards higher (50 BTC instead of 12.5 BTC), but there were fewer BTC in existence, so the diluting effect of new coins was larger.

There have been a few rare occasions when tx fees made up a significant proportion of mining rewards. On one day in December 2017, tx fees accounted for a third of revenues: miners received over 900 BTC in tx fees, plus 1,800 BTC in block rewards. But that really was unusual. As Bitcoin’s rewards reduce over the coming decades, block rewards are going to drop dramatically. 

It is very difficult to game out what is likely to happen, but there are a handful of obvious conclusions:

• Since block rewards halve every 4 years, the importance of tx fees becomes disproportionately more important. Tx fees must do far more than double to offset the difference.
• The more txs Bitcoin supports per day, the better.
• However, since block space is limited, tx fees may need to rise significantly to ensure total revenues are high enough – much like they did in December 2017.
• Additionally or alternatively, regular miners will need to supplement revenues with income from second-tier solutions like the Lightning Network. 

In short, the cost of attacking the network must be sufficiently high as a proportion of network value, and in the long term that cost is directly related to miners’ income. History suggests that 0.01% of network value in mining rewards per day is easily enough to secure the network. It is unclear whether 0.001% or 0.0001% will be enough.

Bitcoin, after all, is still a colossal experiment. It’s one we love and think has a bright future, but there are no guarantees.

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