Game Theory: Nash & Bitcoin Miner Rewards, and more

10/08/2023 0 Comments

1. Game Theory: Nash & Bitcoin Miner Rewards

Applying the Nash Equilibrium to Bitcoin Mining

The world of cryptocurrency, especially Bitcoin, is often painted with the brush of complex algorithms, cryptography, and the transformative promise of decentralized finance. However, underlying these elements are fundamental economic behaviors and strategic interactions, best described through the lens of game theory. 

To understand how the Nash Equilibrium applies to Bitcoin mining, one must first perceive mining as a strategic game. Each miner, or player in this game, is driven by the incentive to maximize their rewards. These rewards come in the form of newly minted bitcoins (known as block rewards) and transaction fees from the transactions they validate and add to the blockchain.

The decisions made by each miner, such as which transactions to include in a block, when to mine, and even whether to join a mining pool or go solo, are strategic choices. These choices are made in the context of what other miners are doing and what they believe other miners will do in the future. It’s a continual game of anticipation and reaction.

In the Nash Equilibrium context, a stable state in the mining game is achieved when no miner can gain more by changing their strategy if all other miners stick to their current strategies. For instance, if all miners are following a specific approach to select transactions based on transaction fees, no single miner can benefit by deviating from this commonly accepted strategy, as long as everyone else is sticking to it.

Economic Incentives for Miners

In the expansive realm of Bitcoin and the broader cryptocurrency universe, miners play a role that is as foundational as it is lucrative. These individuals or entities provide the computational power that validates transactions and secures the network. In return for this service, they are rewarded through a system that is both intricate and delicately balanced, ensuring the continued security and decentralized nature of the blockchain.

At the core of the mining process is the block reward. Introduced as a way to incentivize participation in the network’s early days, the block reward is a set amount of new bitcoins given to miners for every block they successfully add to the blockchain. Initially set at 50 bitcoins per block, this reward undergoes a halving event approximately every four years, a design choice meant to mimic the decreasing yield of precious metals like gold. 

This diminishing block reward brings us to the second crucial source of miner revenue: transaction fees. Every Bitcoin transaction comes with a fee, which is a payment to miners for including that transaction in a block. As the block reward diminishes, the role of transaction fees in compensating miners becomes increasingly important. 

However, this balance between block rewards and transaction fees has implications for both the profitability and the security of the Bitcoin network. As the primary incentive shifts from block rewards to transaction fees, miners will naturally prioritize transactions with higher fees. 

Future Predictions: Nash Equilibrium and Bitcoin’s Evolution

Bitcoin’s journey since its inception in 2009 has been nothing short of meteoric, with its value, adoption, and influence on the global financial landscape growing exponentially. This decentralized digital currency operates on a delicate balance sustained by miners, who are, in turn, driven by economic incentives. The dynamics between miners, akin to a strategic game, have often been analyzed through the prism of the Nash Equilibrium, which provides intriguing predictions about Bitcoin’s future evolution.

One of the most significant upcoming events in the Bitcoin ecosystem is the “halving”, where block rewards given to miners for validating transactions are slashed by half. Such halvings are pre-programmed to occur approximately every four years, a testament to Bitcoin’s deflationary nature. As block rewards decrease, the immediate consequence is that miners’ revenue will significantly depend on transaction fees. 

Furthermore, as Bitcoin matures and its price potentially stabilizes, the profitability of mining might come under pressure, especially during periods of low network activity when transaction fees are minimal. Such scenarios could disrupt the Nash Equilibrium. If miners can’t break even, some might exit the mining game, leading to reduced computational power and potentially compromising the network’s security. However, Bitcoin’s adaptive nature could counteract this.

Conclusion

The balance between miner incentives and the principles of the Nash Equilibrium will be pivotal in shaping Bitcoin’s evolution. As this pioneering cryptocurrency faces future challenges, its adaptability and robust foundation will likely ensure its continued growth and relevance.

Disclaimer: This is promotional marketing content. The presented material by no means represents any financial advice or promotion. Be sure to do your research and acknowledge the possible risks before using the service of any trading platform.

2. Preparing for the Next Bitcoin Halving

“Halving” is an automatic event that occurs every four years on the bitcoin blockchain. Not only is halving a massive technical happening that serves as an anti-inflationary model for bitcoin, but it is also of considerable interest to investors: for all past halvings (in 2012, 2016, and 2020) were followed by massive bull runs that propelled the value of BTC to historic highs.

The fourth halving event is expected to happen in April or May 2024 — and the future may look different from the past.  What are the implications for the price of BTC? Can we expect another historic bull run in crypto? What is the optimal investment strategy for investors during a halving event?

In this article, we explore the answers to all these questions — and more — in our in-depth analysis of BTC halving events in the run-up to 2024.

Bitcoin, Halving, and Scarcity on the Blockchain

One of the key features of bitcoin is a mechanism of forced scarcity. The reasoning is that for something to hold value, it must be finite and scarce. Consequently, the main feature of bitcoin is a limited supply – only 21 million BTC will ever be created.

New bitcoins are issued through a complex cryptographic process called mining, a complex and computationally (and financially) demanding process whereby transaction validators compete for the potential to earn returns in the form of bitcoin.

The blockchain forces a system of diminishing returns to control the supply of bitcoin – miner rewards reduce by half every four years, or roughly the time it takes to add 210,000 blocks to the blockchain. Hence, bitcoin “halving” events.

This system helps ensure that bitcoin does not suffer from the same inflationary tendencies plaguing fiat currencies by controlling the currency flow and reducing the returns from mining. Hence, the timeline for bitcoin production extends out for the foreseeable future.

The History of Bitcoin Halving Events

Bitcoin was born on January 3, 2009, with the mining of “Block 0” – the “Genesis Block” – of the bitcoin blockchain. The genesis bitcoin miner was Satoshi Nakamoto, the enigmatic creator of the blockchain.

Initially, miners were awarded 50 BTC for adding a block to the network. Satoshi Nakamoto accumulated nearly 1.1 million BTC as mining rewards in this period. As the blockchain became more popular, other miners entered the space.

Historically, bitcoin users can be broadly divided into four overlapping categories – early investors/blockchain evangelists, tech enthusiasts, retail users, and big institutional investors.

In the pre-halving era, bitcoin was mainly traded among its original investors and enthusiastic early adopters. The new cryptocurrency was virtually worthless at this stage. In July 2010, bitcoin first started trading at $0.08.

By 2011, the launch of the first bitcoin exchanges brought new users to the ecosystem, driving the price above $1 for the first time. The same year, bitcoin surged to $31 before suffering a 99% crash in value due to security breaches and hacks.

First BTC Halving (2012)

The first halving of BTC occurred on November 28, 2012, with the writing of block 210,000 to the network. The mining rewards were halved from 50 BTC to 25 BTC. The inflation rate, which was 50% the previous year, was reduced to just 12% after the halving.

Bitcoin was in a steady recovery phase in 2012. After crashing to $0.01 in June 2011, the crypto slowly clawed back to $12 by November 2012. Since the 2012 halving was the first-ever event of its kind, it didn’t have the same level of anticipation as the later events.

The vast majority of users didn’t know what to expect. And bitcoin had not evolved into a speculative investment asset at this point. So, the halving did not immediately impact the price of bitcoin.

The closing price for BTC on December 31, 2012, was $13.45. However, everything changed in the new year – by April 2013, the price rose to $250 before facing a 50% correction. Further price consolidation and another massive rally drove the price to $1,100.

However, we cannot entirely attribute those later gains to the halving. It was later revealed that the price manipulation by a single individual using bot accounts at the Mt. Gox bitcoin exchange may have significantly pushed the price of BTC above $1000.

Still, 2013 proved to be a landmark year for bitcoin. The cryptocurrency’s market cap crossed the $1 billion mark for the first time, catching the attention of mainstream media and investors in a big way. The first halving did play a significant role in the price history of BTC.

Second BTC Halving (2016)

Driven by memories of 2012 – 2013, expectations were relatively high in the crypto community in the build-up to the 2016 halving event. The stature of bitcoin has also changed drastically since 2012, attracting more speculative investors.

The 2016 event occurred on 9th July and reduced mining rewards from 25 BTC to 12.5 BTC. Inflation was reduced from 12% in 2012 to around 5% post-halving in 2016.

BTC started that year at $434. The price started increasing noticeably a few months before the halving. It peaked at $735 on June 21 before undergoing a minor correction and eventually settling at $663 on the day of the halving.

Over the next three months, there were minor corrections and recoveries in the price of bitcoin. The next big rally began in October and propelled BTC to $975 in the final week of December 2016. This bullish trend pushed bitcoin above $1,000 in the first week of January.

By September 2017, bitcoin had breached the $5,000 mark for the first time. After a significant correction, the crypto continued its upward trajectory, reaching an all-time high of $19,783 in December.

Yet again, experts cited market manipulation as a significant factor behind the massive bitcoin rallies in 2017. This time, researchers alleged that individuals used the stablecoin Tether to create price support for bitcoin during bear runs in a coordinated strategy.

However, there is no doubt that investor frenzy also played a big part in the bitcoin bull run of 2017. And the ultimate catalyst for this series of events was the second BTC halving of 2016.

Third BTC Halving (2020)

After the historic gains in 2017, expectations ran high for the third BTC halving. However, the COVID-19 outbreak crashed the price of BTC in March 2020, complicating matters.

The halving event occurred on 11th May, reducing block rewards to just 6.25BTC. Inflation in BTC was also pushed down further to under 2%.

BTC had a strong Q1 in 2020, starting at around $7,200 in January before reaching $10,000 in mid-February. This was followed by a pandemic-induced collapse in March-April, driving prices below $6,800.

However, bitcoin recovered to $9,900 by May 9, attributed to rising excitement about the upcoming event. The third halving event further decreased the inflation levels in bitcoin, driving it even below gold.

However, the collapse of traditional markets in the latter half of 2020 pushed bitcoin to new heights. From $9,000 before the halving, the value of BTC soared to $28,000 by the end of the year, driven by a massive increase in the inflow of investor money.

In hindsight, COVID-19 was both a blessing and a curse for bitcoin in 2020. After triggering an initial collapse, the pandemic soon facilitated capital inflows into crypto. It played a significant role in elevating bitcoin to the rank of a bonafide investment option in the mainstream.

Upcoming Fourth Halving (2024)

The fourth halving of bitcoin is expected towards the end of April or early May 2024, with a tentative date of April 25. Since we cannot accurately predict the speed at which blocks are mined, the actual timing of the event can vary.

Potential Impacts and Speculation

Once miners add block number 840,000 to the blockchain, the mining rewards will fall from 6.25 BTC to 3.125 BTC. A likely reduction in the annual inflation rate of Bitcoin from 1.8% to 0.9% due to the decrease in supply will likely follow.

These are the intended outcomes of the halving event – why Satoshi Nakamoto chose to design the system as it exists today. However, with each successive event, the actual direct impact of the halving has a smaller footprint on BTC prices.

Since more than 92% of BTC has already been mined, the supply shock from the halving will be relatively low. The volatility will be driven mainly by investor sentiment, particularly outsiders, due to FOMO and speculators looking for short-term gains.

The main impact will be keenly felt in the mining arena, where lower rewards and high costs potentially trigger an exit of nearly 30% of the total operations. The overall impact of this development on network security remains to be seen.

3. What Should Investors Look for After a Bitcoin Halving Event?

Under the existing protocol, bitcoin will undergo 33 halving events between 2012 and 2140. Although a sample size of 3 events is small in the grand scheme, we can still identify several patterns from these past halving events.

Changes in Miner Trends and Behaviors

For miners, each halving event doubles the production costs per BTC earned. However, until now, this was offset by the massive increases in bitcoin price that followed after each halving event.

The hash rate is an important metric that shows the total processing power committed to securing the blockchain by miners. A higher hash rate indicates the presence of more mining equipment and, possibly, more miners.

According to the hash rate chart for BTC, there has been a constant increase in mining operations since the second halving event in 2016. Although the market crash drove down the price of BTC in 2022, the mining curve is still relentlessly going up.

This has grave implications for miners in 2024. As of 2023, the average BTC cost is around $15,000. After the halving, this will double to $30,000. Unless the price of BTC surges back to pre-2022 levels, many mining operations could shut down in 2024.

Profitability concerns have already been affecting many bitcoin mining companies since 2022 due to rising energy costs and a fall in the value of bitcoin. With the halving of rewards to 3.125BTC, experts estimate that 15% to 30% of mining operations will stop in 2024.

Miners are investing heavily in equipment upgrades in 2023. The newer mining rigs can improve energy efficiency by up to 25%. Miners not investing in better ASICs may see their profits dwindle to zero after the 2024 halving.

Halving events also have severe implications for network security. The network may become more vulnerable to 51% attacks if the hash rate falls significantly. However, given the sheer size of the BTC blockchain, it would take a massive fall-off in miner activity to make the system dangerously insecure.

Shifts in Market Sentiment and Investor Reaction

It is much harder to gauge the potential impact of halving events on bitcoin market sentiment. There are far too many variables at play. For instance, in 2020, the unprecedented pandemic played a pivotal role in bringing liquidity to the crypto markets.

However, we can analyze past market sentiment and investor reaction. The run-up to a halving event has been accompanied by rising excitement, minor volatility, and relatively smaller bull runs in BTC.

In all previous instances, the actual event was followed by minor corrections. Major rallies have occurred after a few months, often driven by investor excitement and a lower supply of BTC.

As outlined in the graphs below, the typical aftermath of a halving event has looked something like this:

-An initial bull run that lasts for anywhere from 365 days to 540 days.

-A bearish correction lasting close to 400 days.

-A sideways run until the next halving, lasting around 450 to 500 days.

A cursory glance at the halving data also shows that the impact of each successive halving event on BTC prices may be weakening. Over 92% of the total supply of bitcoin has already been mined by now. With most of the coins already in circulation, future reductions in supply will have a lower impact on the price of BTC.

Much of the volatility will come from investor sentiments in 2024. Here, a distinction can be made between the reactions of the various communities of bitcoin investors:

The HODLers: Long-term BTC enthusiasts and early adopters will play a small role in the market. The standard playbook for them is to keep HODLing no matter what – seasoned investors typically make purchases during market downtrends like the ones in 2022.

The Speculators/Newcomers: Fear of missing out (FOMO) also plays a huge role in the crypto markets. As media coverage of the halving increases, there could be an influx of new investors into crypto. Speculators who only care about short-term gains will also become more active and add to the overall volatility.

Institutional Investors: Whales, financial institutions, private companies, and even governments hold bitcoins worth billions of dollars in 2023. The actions of these investors are driven mainly by factors including interest rates, the performance of traditional markets, and other economic/political factors and are much harder to predict.

How Can Investors Prepare for Bitcoin Halving?

There are better times for serious investors to make any moves in the market than a bitcoin halving event. Most investors and HODLers try to accumulate BTC at favorable rates before the halving event.

This allows you to avoid market volatility and increase the chance of high returns. “Buy low and HODL” remains our preferred strategy for BTC in 2023. The optimal accumulation period is usually between the market bottom (the most recent event was in 2022) and the next halving – an average of around 500 days.

Based on historical data, the best time to move into BTC has been 900 to 1000 days (just short of 3 years) after a halving event. That is the typical time the market ends its bull and bear runs, leaving BTC at historic lows as panicked short-term investors try to offload their holdings.

While halving events can generate massive levels of hype, it is crucial to keep perspective – with each cycle, the impact of halving on BTC prices has decreased. Investor sentiments and external events have primarily driven the volatility after halving.

In 2023-24, the cryptocurrency markets face unprecedented pressure from external factors like energy prices, rampant inflation in traditional markets, and regulatory pressure from governments worldwide, especially the United States.

Under the circumstances, our strategy is to avoid getting caught up in the trading frenzy in the immediate run-up and aftermath of a halving. We believe investors preparing well in advance are more likely to see gains.

Investor Takeaway

Halving remains a pivotal event in the evolving story of bitcoin–and will remain that way for the foreseeable future. However, its actual impact on the price and supply of BTC is trending downward with each event. External factors like interest rates, regulatory developments, and energy costs have a far more significant impact.

The main impact of the halving is more psychological these days – massive gains recorded during the previous cycles generate hope and FOMO in the minds of many investors. Although gains made by BTC after halving have steadily declined over the cycles, we can never rule out another massive bull run.

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