Bitcoin Halving 2024 Part 1: Block Reward, Transaction Fees, and Difficulty

The Mining Process

Block structure and the process of mining

The technology at the heart of the BTC network is designed to bundle together transactions (called blocks) and validate them approximately once every ten minutes. A reward is issued to network participants (miners) that contribute computational resources to making this process secure. With huge rewards promised to the miner that creates a new block, and the rapidly increasing computational power that is thrown at the task, how is this interval kept constant? To answer this, let’s take a look at the structure of a block, and the process a miner completes when mining each block.

Blocks on the network are essentially chunks of data: each chunk starts with some information about itself and the preceding block, and a list of transactions, and a random string of letters. The miner’s job is to compile this data and broadcast it to the rest of the network. Only then do they get to claim the block reward, alongside transaction fees.

The network chooses a miner to validate a block by holding a lottery: the first miner to find a winning ticket gets to “mine” the block and keep its reward. A miner can generate their lottery ticket by feeding the block’s chunk of data through a specific algorithm to generate a (essentially) random number. A miner can generate a new lottery ticket (without changing the transaction data in the block) by changing the “nonce” – a “nonsense” string at the end of the block.

If the miner can find a nonce that, when added to the block data and fed into the algorithm, is low enough to be accepted, then it is valid and the miner wins the lottery. By requiring that this random number is lower than some value, the network is able to control the number of winning tickets available. The lower this requirement is, the fewer winning tickets there are to find, and the more guesses that must be made before a miner wins the lottery.

What is Bitcoin difficulty and hashrate?

Difficulty is the mechanism by which the network balances the number of lottery tickets against the number of miners entering the lottery in order to ensure a winner is found once every ten minutes on average. When the mining network makes double the number of guesses per second, the number of available winning tickets must be halved to ensure the same frequency of a winner being found (and difficulty doubles). Therefore, it is also a measure of the computing power that must be expended before a block is expected to be mined, both for individual miners, and the network in aggregate.

Bitcoin difficulty does not respond immediately to changes in computing power on the network. It is recalculated every 2016 blocks, which (with a target time between blocks of ten minutes) is roughly once every two weeks. The difficulty is changed to ensure that the average number of guesses per second made by miners (in aggregate) over the previous 2016 blocks results in a winner of the lottery once every 10 minutes. This measure of computing power is called the hashrate - how many “nonces” the network can try per second.

Since Bitcoin’s inception, hashrate has increased exponentially as more miners have joined the network. This has led to a subsequent exponential increase in difficulty since the timeframe to mine 2016 blocks has repeatedly fallen below the desired timeframe of 2 weeks. To counteract this, and keep to the desired block time of 10 minutes, Bitcoin difficulty increases, making it harder for miners to find a valid “nonce”.

Why mine?

Mining is an expensive and highly computationally intensive task that has become exponentially more difficult. Nonetheless, miners have continued to throw exponentially more computational power at the task over the last 15 years, with very little volatility along its trend. So what makes mining so attractive?

Whenever a miner finds a winning lottery ticket, they are rewarded with freshly minted bitcoins from the block reward. If the expected cost to mine a bitcoin is lower than the cost to buy one on an exchange, then the equation is simple – keep hashing.

In addition to the bitcoin block reward, a miner also gets to keep all of the transaction fees paid by Bitcoin users for the privilege of being included in a block. When demand to be included in a block is large, such as during large price swings, these fees can occasionally rack up substantial income for miners.

However, minting fresh bitcoin in each block can’t last forever without diluting the existing supply. To deal with this, Bitcoin block rewards halve roughly once every four years to manage the flow of new supply. This is tough for miners – the most reliable part of their income is slashed in two!

The Halving Effect

What is a halving?

The reward for mining a Bitcoin block is halved every 210,000 blocks mined (corresponding to roughly every 4 years). The reward for mining each of the first 210,000 blocks was 50 bitcoin, and that amount has dropped by half every four years since. At the next halving (due 19th April at time of writing), the block reward will drop from 6.25 to 3.125 bitcoin per block.

After the final halving in (around) 2140, the block reward will fall to zero. This release schedule will result in a total of 21 million bitcoin in circulation (less if some are lost) and no more coins will be created. From there, miners will have to subsist on transaction fees alone, a big difference to a miner's current reward structure.

Repeated inter-halving rallies in BTC price mean that the forthcoming halving will have the biggest dollar-denominated impact on a miner's bottom line since Bitcoin’s inception. While transaction fees have grown, they remain too small relative to the block reward to offer much respite. Since the previous halving in May 2020, transaction fees per block have accounted for just 5% of a miner’s total income reward on average, meaning that they are not close enough to compensating a miner for the anticipated drop in miner reward due to the halving of the block reward.

How have previous halvings affected miners?

As the block reward currently dominates a miner’s income, previous halvings have seen hashrate fall in each post-halving period as miners elect to stop mining. Assuming that transaction fees remain broadly stable during the event, miners must mine just under two blocks in order to expect to earn the same amount of bitcoin as before the halving. Therefore the effective cost to mine each bitcoin is almost doubled.

As the chart above shows, around 25% of the network’s hashrate has left the network on average in the 20 days after a halving event. For those miners who have the highest costs, the reward no longer outweighs the costs and so they switch off their mining rigs and remove their hashrate from the network.

Difficulty will only fall at the next adjustment, which can be up to 2016 blocks later. Until difficulty adjusts to compensate for the lost hashrate, blocks are found by the network at a slower rate than the goal of 10 minutes since there are fewer miners guessing the winning lottery numbers. Once difficulty adjusts, we see hashrate begin to recover as miners switch machines back on.

In the aftermath of each halving event, the Bitcoin protocol has decreased the difficulty, thereby increasing the number of winning lottery tickets and increasing the probability that each hash will result in a mined block. Easier (and cheaper) mining attracts more miners back to the network, increasing hashrate, decreasing block time, and resulting in an increase in difficulty at the next adjustment. As seen in the chart above, it has taken more than 5,000 blocks (~35 days) to be mined post-halving for difficulty to be increased once again in each case.

While hashrate has fallen following each halving, the magnitude of the adjustment to difficulty is also dependent on the number of blocks remaining after the halving to the next difficulty adjustment block. This effect can be seen in the chart above, which shows the last difficulty adjustment occurring 336, 672, and 1,008 blocks before each halving event respectively.

If a difficulty adjustment block arrives just before the halving block, the majority of the 2,016 blocks considered for the next difficulty adjustment would be produced under the slower, post-halving hashrate and so the first adjustment will be a significant decrease in difficulty.

Shifting Sources of Income

Despite currently making up just 5% of a miner’s reward on average, with each halving and as network adoption increases, the structure of a miner’s income is changing. We expect to see a consistent shift in the proportion of the reward that is attributed to transaction fees, eventually leading to a diminished impact of a halving event on a miner’s income.

Indeed, we see some evidence of the beginning of this effect in the previous three previous halvings – considering the average total block reward (of block reward and transaction fees) in the 30 blocks before and after each halving event, each halving has resulted in a loss of -49.44% (where miners lost $ 301.75 in revenue), 49.24% (a $8,110.13 loss), and 46.60% (a $54,703.88 loss) respectively. The “halving” in block reward is becoming less and less of a halving in miner income.

As at the time of writing, the average total block reward over the previous 30 blocks is an astonishing $464,441.25, highlighting just how significant the next halving will be on a miner’s bottom line. However, if current transaction fee and price levels continue until the halving, we expect to see a 43.66% drop in miner total reward -- yet another fall in the impact to a miner’s total reward.

Growing transaction fees

Transaction fees have grown consistently in USD terms, albeit with incredibly high volatility around their longer-held trend, as adoption on the network has increased and driven demand for use of the network.

However, the impact of transaction fees in the block on a miner’s take home reward has thus far been difficult to see because their growth has been far out-paced by BTC’s spot price. This has meant that they have been falling when denominated in BTC terms, outpacing the fall in block reward (by just ½ every 4 years), and so have not increased as a proportion of block reward.

Falling block reward

Despite 2024’s halving event promising to impart the largest dollar-denominated blow to a miner’s income that we have seen from a halving so far, the drop in the block reward is likely to begin to become smaller in each successive halving – even in USD terms. Even though the drop in bitcoin terms is becoming exponentially smaller, the reason that each previous halving has had a progressively larger impact on a miner’s dollar-denominated income is due to the BTC dollar price recording multiples of 53.75x and 13.5x respectively:

In each case so far, the halving in block reward (in the number of bitcoin awarded) has been far-outpaced by a more-than-doubling in BTC spot price between halvings. But, if the growth in price continues to slow between halvings and we do not see BTC spot price increase by more than 100% between this and the next halving, then the USD impact on a miner’s bottom line will max out at the current halving at around $202K.

Furthermore, if BTC spot price doesn’t increase enough to compensate miner’s for the drop in reward post halving, then transaction fees will need to make up the difference. Otherwise, miners will choose to switch off their mining rigs, leading to a fall in hashrate.

Transaction Fee Dominance

When transaction fees come to dominate a miner’s income, the percentage change in a miner’s income due to the halving of the block reward will be far less than 50%. In that case, only a small increase in transaction fees post-halving would compensate for the lost reward. This means that the hashrate will not fall as much, which in turn will mean that difficulty will not need to fall as much to incentivise miners to rejoin the network.

But do transaction fees increase after a halving? Can miners expect extra rewards from users to compensate for their lost income? We have seen evidence of this effect in the halvings we have seen already.

Post halving transaction fee jump

When miners stop mining, the network in aggregate produces hashes at a slower rate and we see an increase in the time taken to find each bitcoin block. This is because there are fewer miners looking for a winning lottery ticket, and so it takes longer on average for each one to be found.

The consequence of this is that the supply of space for transactions on the network falls – there are still the same number of transactions per block, but a longer wait time for each block means a fall in the number of transactions that can be processed per second. Users who do not want to wait to have their transactions included in a block have two options: wait for their transaction to be included in the next block, or increase the fee they’re willing to pay. We have seen evidence of this effect in the pre-difficulty adjustment period after both of the last two halvings.

The longer wait time between blocks immediately after the halving has corresponded to an increase in the dollar amount that users are willing to pay for a transaction – an increase that we cannot explain by a price-rally induced increase in network activity. In both cases, transaction fees per block remained elevated until the following difficulty adjustment that increased the number of winning lottery tickets and brought the frequency of block production back down, closer to the target 10 minutes.

Halvings in the future

The effect of a halving on miners will diminish as transaction fees make up a greater proportion of a miner’s reward. If this is the case, then post halving, fewer miners will leave the network since their compensation will be impacted by only a small amount. This would mean that fewer miners are forced to stop mining during a halving event, and less hashpower will leave the network.

Therefore, transaction fees will not rise as much in the interim period between a halving and the following difficulty adjustment as block time will not slow, and miners will not receive a boost to their transaction fee revenue. But when transaction fees make up a larger proportion of their income, miner’s will not need to see as large a boost to transaction fee revenue in order to keep mining.

We are not in the future yet. Owing to the much faster rally in BTC spot price than either the rate of halving or adoption of the network, transaction fees are still only an insignificant proportion of a miner’s average income. However, we have already seen the signs of the shift towards transaction fees, a falling impact of halving events, and the slowing in BTC price. Therefore, the question of this shift is not if, but when.

While we have well understood how we expect halvings to impact the reward side of the mining equation in future halving events, we are yet to discuss how costs factor into the decision of whether or not to mine. We expect this to continue to be a key determinant of a miner’s decision to mine. This topic will be the basis of a future report.

Price Impact of a Halving

Economic theory states that when supply falls and demand stays constant, price rises. In the case of Bitcoin, the rate at which new supply enters the market falls after each halving period. Intuitively, this should have an impact on BTC price, and historically, has done so. If halvings are known events, and people are bullish, is this information priced in already? Why not? Will this instance be any different?

Supply side of the argument

The most well known theory is the Stock-to-Flow model (S2F) which attempts to quantify the change in rate of new supply relative to the existing stock – much like traditional commodities analyses. The total supply of Bitcoin is 21M coins, of which nearly 19.69M have already been mined. New supply is currently produced at a rate of 6.25 bitcoins per block, meaning that under the current supply of 19.69M coins mined, the current S2F ratio is ~57.55. This means that it would take 57.55 years to produce the existing supply at the current rate of production.

Empirically, the theory is based on a linear relationship between Log(S2F ratio) and Log(BTC price). According to the model, a higher S2F ratio suggests greater scarcity that leads to higher prices. As BTC’s flow is stable and its stock is very large, the largest change in the S2F ratio occurs during a halving event. Therefore, a halving event should result in a large change in price.

However, this information is well-known: bitcoin’s supply schedule has been known since its inception in 2009 and the model is calibrated to publicly available price data. If the model predicts a stable, final equilibrium price for BTC, why is this not already priced in?

One reason offered up by the model’s creator is an appeal to the Efficient Market Hypothesis – the market is digesting and pricing in unquantifiable risks such as:

1. Bitcoin becoming obsolete
2. Regulatory/Government risks, including a central bank backed coin
3. Exchange hacks
4. Miner death spiral after a halving

Therefore, the actual BTC price is lower than what is suggested by the S2F model. It is also possible that movements in the strength of the dollar, against which we are valuing bitcoin, may lead to deviations from any supply-focused model regardless of change in supply.

While these factors are true – compensation for facing each of these risks does indeed explain the large returns offered by BTC – we see no reason that the risk premium should be priced out according to a stepwise function that follows the jumps in stock-to-flow. Markets do not digest and resolve risks on a 4-year schedule.

The S2F model’s close tracking of BTC price can be explained by the fact that any two time series with exponential growth will have high correlation when plotted on a scatter chart with log axes. Bitcoin price has grown exponentially alongside adoption of the technology, and the 4-year halving schedule of flow means that the S2F ratio grows exponentially by design. Two such series will always draw out a (nearly) straight line with the gradient dependent on their relative growth rates.

What is left to explain is why we have seen rallies occur soon after a halving in each of the three previous cases.

An alternative argument

If we reject the commonly accepted supply-side argument on the grounds that the supply schedule is known and so should not impact price, how are we to explain price growth between halvings? Demand and volatility.

Bitcoin is an asset with a (known) finite supply. Since the first block was mined in 2009, activity on the network has surged exponentially. Demand to transact on the network and for a store of value has translated to demand for bitcoin that has pushed prices ever higher. Demand is difficult to quantify, but we can see this impact in many ways: number of active Bitcoin addresses, mempool, and transaction fees.

There is recent evidence of this too. This halving is unlike the previous three: we have never rallied to all-time highs on the way into a halving, as we did in March 2024. Net BTC flows indicate that this too is demand-side driven, from a new source of Bitcoin investors.

As the chart above shows, the Q1 2024 rally correlated with a massive new source of untapped demand – institutional access to bitcoin. Since the inception of 9 (and conversion of Grayscale) spot Bitcoin ETFs in January 2024, we have seen investors snap up a net 218,401 extra bitcoin.

The rally to all-time highs began in October, when ETF-fever really began (when the information began to be priced in) and came to a halt on the 13th of March, aligning with the date that institutions stopped snapping up coins.

Volatility

While the exponential growth in the user and investor bases of Bitcoin explains the exponential growth in price, it does not explain BTC’s rallies to all-time highs in each cycle.

It’s possible that halvings may be a self-fulfilling prophecy: media attention due to the event sparks interest in the market, leading to increased adoption and over-extended valuations. However, we offer an alternative explanation for the 2017 and 2021 bull markets – macro volatility.

Both rallies can be explained at least in part by macroeconomic factors – particularly the strength of the US dollar – that drove prices in the two years that followed the halving. The rally that culminated in an all-time high 18 months after the halving in July 2016 coincided with a weakening in the dollar – driven by a multitude of macroeconomic and geopolitical uncertainties, including president Trump’s struggles to pass key campaign policies.

We see a similar pattern in the rally that followed the May 2020 halving. The Covid-19 pandemic had forced the Fed to ease rates aggressively and begin a program of quantitative easing. As a result, the dollar became weaker against other currencies and assets, including crypto-currencies. While the loss in strength of the dollar does not explain the full extent of the rally to new all-time highs, it is possible that the bull-run in BTCUSD was sparked by a weakening in the base currency.

Popular consensus still holds that halvings are bullish events for Bitcoin. However, when we evaluate the particular drivers of previous post-halving rallies, we see them as macro-induced volatility around the longer held exponential trend in adoption of Bitcoin. There is strong evidence in the rapid inflows into January’s ETFs that adoption is still in the acceleration phase of the S-curve, and that adoption continues to drive price.