I don’t normally like to hear the word “halving” associated with one of my investments. If your investment gets halved, you had better hope that there was a stock split. Otherwise, something went terribly wrong.
Of course, “halving” means something very different for Bitcoin and other cryptocurrencies. In case you missed it, Bitcoin just underwent a “halving,” the third in the cryptocurrency’s history, on March 11.
To understand what exactly that means, we need to do a quick refresher on what Bitcoin is and how it works.
Bitcoin runs on a blockchain, the open, distributed ledger that keeps track of every transaction made in the cryptocurrency. Because the ledger is distributed across every computer on the network, it’s nearly impossible to hack.
There is no centralized server in an office building somewhere that can be tampered with. Every transaction in the entire history of Bitcoin is recorded on every computer in the blockchain network and public domain to see. I can’t say it’s impossible to hack. I’m sure there’s some eccentric James Bond-villain hacker out there stroking a Persian cat and laughing maniacally as he hacks my account now.
But let’s just say it’s a lot harder than ripping my credit card number or hacking my checking account.
Nothing is Free
While Bitcoin was born of an idealistic, libertarian experiment, running the network isn’t free. It requires a lot of computational power and electricity usage to maintain the blockchain that supports Bitcoin.
While I’m sure there are some true believers out there that would do it for free, the rest are properly incentivized by being allowed to mine new Bitcoin. (In case you’ve wondered, Bitcoin mining actually does serve a purpose — the mining activity is what runs the payment system.) The algorithm that underpins Bitcoin rewards miners for volunteering their computer resources by giving them freshly mined Bitcoin.
This gets us to halving.
Halving is where the reward for mining gets cut in half. The same amount of processing generates half the number of new Bitcoins.
Why Does the Bitcoin Halving Happen?
We all know why gold and diamonds are valuable. They’re both rare.
Well, so is Bitcoin — by design. The supply of new Bitcoins is controlled by the mining process, and halving slows down the creation process.
By throttling the creation of new Bitcoin, the system avoids inflation.
Bitcoin prices fluctuate wildly due to supply and demand among traders, of course, just like gold, diamonds or any other finite commodity. But it can’t be printed at will by a panicked Fed Chairman.
It’s an Expensive Printing Press
Mining Bitcoin is wildly expensive and uses a ton of energy. A report last year found that Bitcoin mining globally used roughly the same amount of electricity as the entire country of Switzerland. The average cost to mine a Bitcoin was $6,851 before the halving. Now, the cost is around $13,000.
I know it’s folly to try to assign a fundamental value to something as speculative as Bitcoin, but I’m going to do it anyway. If it cost $13,000 to mine a coin, then the price needs to be $13,000 or higher to justify mining. At any price below that, the miner is actually losing money.
If the price of Bitcoin stayed below the cost to mine it for long, there would be no incentive to continue mining. As with any other business endeavor, you can’t operate at a loss forever.
This is where it gets interesting. If miners drop out, the number crunching that supports the blockchain gets easier and less energy intensive. This creates an equilibrium of sorts in which mining costs (what you can think of as the crypto’s “intrinsic value”) stay relatively close to market prices.
We’ll see what the future holds for Bitcoin. While Bitcoin itself has built-in inflation protection, there is nothing to stop inflation in the sheer number of competing cryptocurrencies. I like the concept of the cryptocurrency, but Bitcoin’s lack of monopoly power makes me stop short of betting the farm on it.
Still, it does have first mover advantage over the competitors. And if you’re looking for hedges against dollar devaluation, having a little Bitcoin along with some gold isn’t the worst idea.
• Money & Markets contributor Charles Sizemore specializes in income and retirement topics, and is a frequent guest on CNBC, Bloomberg and Fox Business.
Follow Charles on Twitter @CharlesSizemore