The Bitcoin Halving: Why This Time Could Be Different

The fourth Bitcoin halving is almost upon us, and this one has the potential for some very interesting surprises. This halving marks the reduction of the Bitcoin supply subsidy from 6.25 BTC every block to 3.125 BTC per block. These supply reductions occur every 210,000 blocks, or roughly every four years, as part of Bitcoin’s gradual, disinflationary approach to its final capped supply in circulation.

The finite supply of 21 million coins is a, if not the, foundational characteristic of Bitcoin. This predictability of supply and inflation rate has been at the heart of what has driven demand and belief in bitcoin as a superior form of money. The regular supply halving is the mechanism by which that finite supply is ultimately enacted.

The halvings over time are the driver behind one of the most fundamental shifts of Bitcoin incentives in the long term: the move from miners being funded by newly issued coins from the coinbase subsidy — the block reward — to being funded dominantly by the transaction fee revenue from users moving bitcoin on-chain.

As Satoshi said in Section 6 (Incentives) of the whitepaper:

“The incentive can also be funded with transaction fees. If the output value of a transaction is less than its input value, the difference is a transaction fee that is added to the incentive value of the block containing the transaction. Once a predetermined number of coins have entered circulation, the incentive can transition entirely to transaction fees and be completely inflation free.”

Historically the halving has correlated with a massive appreciation in the price of bitcoin, offsetting the impact of the miners’ subsidy being cut in half. Miners’ bills are paid in fiat, meaning that if the price of bitcoin appreciates, resulting in a larger income in dollar terms for the lower amount of bitcoin earned per block, the negative impact on mining operation is cushioned.

In light of the last market cycle, with not even a 4x appreciation from the prior all time high, the degree to which price appreciation will cushion miners from the effects of the halving is an assumption that might not consistently hold true. This coming halving, the inflation rate of bitcoin will drop for the first time below 1%. If the next market cycle plays out similarly to the previous one, with much lower upwards movement than seen historically, this halving could have a materially negative impact on existing miners.

This makes the fee revenue miners can collect from transactions more important than ever, and it will continue to become more central to their sustainability from a business perspective as block height increases and successive halvings occur. Either fee revenue has to increase, or the price needs to appreciate at a minimum by 2x each halving in order to make up for the decrease in subsidy revenue. As bullish as most Bitcoiners can be, the notion that a doubling in price is guaranteed to happen every four years, in perpetuity, is a dubious assumption at best.

Love them or hate them, BRC-20 tokens and Inscriptions have shifted the entire dynamic of the mempool, pushing fees from somewhere in the ballpark of 0.1-0.2 BTC per block prior to their existence, to the somewhat volatile average of 1-2 BTC as of late — regularly spiking far in excess of that.

The New Factor This Time

Ordinals present a very new incentive dynamic to the halving this go around that was not present at any prior halving in Bitcoin’s history. Rare sats. At the heart of Ordinals Theory is that satoshis from specific blocks can be tracked and “owned” based on its arbitrary interpretation of the transaction history of the blockchain, based on assuming specific amounts sent to specific outputs “send that sat” there. The other aspect of the theory is assigning rarity values to specific sats. Each block has a coinbase, thus producing an ordinal. But each block is different in importance to the scheme. Each normal block produces an “uncommon” sat, the first block of each difficulty adjustment produces a “rare” sat, and the first block of each halving cycle produces an “epic” sat.

This halving will be the first one since the widespread adoption of Ordinal Theory by a subset of Bitcoin users. There has never been the production of an “epic” sat while there was material market demand for it from a large and developed ecosystem. The market demand for that specific sat could wind up being valued at absurd multiples of what the coinbase reward itself is valued at in terms of just fungible satoshis.

The fact that a large market segment in the Bitcoin space would value that single coinbase drastically higher than any other creates an incentive for miners to fight over it by reorganizing the blockchain immediately after the halving. The only time such a thing has happened in history was during the very first halving, when the block reward decreased from 50 BTC to 25 BTC. Some miners continued trying to mine blocks rewarding 50 BTC in the coinbase after the supply cut, and gave up shortly after when the rest of the network ignored their efforts. This time around, the incentive to reorg isn’t based around ignoring the consensus rules and hoping people come along to your side, it’s fighting over who is allowed to mine a completely valid block because of the value collectors will ascribe to that single coinbase.

There are no guarantees that such a reorg will actually occur, but there is a very large financial incentive for miners to do so. If it does occur, the length for which it will go on ultimately depends on how much that “epic” sat could be worth on the market to pay for the lost revenue from fighting over a single block rather than progressing the chain.

Each halving in Bitcoin’s history has been a pivotal event people watch, but this go around it has the potential to be much more interesting than past halvings.

How An Epic Sat Battle Could Play Out

There are a few ways this could play out in my opinion. The first and most obvious way is that nothing happens. For whatever reason, miners do not judge that the potential market value of the first “epic” sat mined since Ordinals adoption took off is worth the opportunity cost of wasting energy reorging the blockchain and foregoing the money they could make by simply mining the next block. If miners do not think the extra premium the ordinal can fetch is worth the cost of giving up moving on to the next block, they simply won’t do it.

The next possibility is a result of nuanced scales of economy. Imagine a larger scale mining operation can afford to risk more “lost blocks” engaging in a reorg fight over the “epic” sat. That larger miner with more capital to put on the table can afford to take a larger risk. In this scenario, we might see a few odd reorg attempts by larger miners with smaller operations not even trying, and essentially minimal disruption. This would play out if miners think there is some premium they can acquire for the ordinal, but not a massive premium worth serious disruption to the network.

The last scenario would be if a market develops bidding for the “epic” sat ahead of time, and miners can have a clear picture that the ordinal is valued massively above the market value of the fungible sat itself. In this case, miners may fight over that block for an extended period of time. The logic behind not reorging the blockchain is that you are losing money, you are not only forgoing the reward of just mining the next block, but you are also continuing to incur the cost of running your mining operations. In a situation where the market is publicly signaling how much the “epic” sat is worth, miners have a very clear idea of how long they can forgo moving onto the next block and still wind up with a net profit by attaining the post-halving coinbase reward with the ordinal. In this scenario the network could see substantial disruption until miners begin approaching the point of incurring a guaranteed loss even if they do successfully wind up mining this block without it being reorged.

Regardless of which way things actually play out, this is going to be a factor to consider each halving going forward unless the demand and marketplace for ordinals dies off. 

16 January 2024 16:00