Crypto Moves #2 – The Worst in Pricing Supply Shocks
Investopedia defines a supply shock as an unexpected event that changes the supply of an asset, leading to price fluctuations. I missed most of my lectures at university, so I cannot confirm or deny the accuracy of that definition. I assume, though, that the tool most used by Wall Street professionals, Investopedia, is correct.
Since I am not schooled on Wall Street, I am flipping the definition upside down, so in this analysis, a supply shock is a perfectly certain event, however, the result is similar to what Investopedia tells you, as it still brings along price changes. This is due to the fact that market participants broadly act as if nobody told them about the expected supply shock. What a coincidence, the definition now aligns perfectly with the track record of Bitcoin.
The economics of mining
As many may know, Bitcoin utilizes the consensus mechanism known as proof-of-work to verify transactions on the network. This mechanism functions by miners using a ton of computational power to compute calculations. In return, miners are rewarded with transaction fees and the issuance of new bitcoins. These rewarded bitcoins, however, are largely dumped on the market as soon as miners receive them, leaving miners with the role of the single largest crowd of Bitcoin sellers.
As to why miners dump bitcoins, it is crucial to comprehend the mining industry as a whole. There are few industries as competitive as the mining of bitcoins. In a perfectly competitive mining environment, it is somewhat easy to set up mining operations, so the profitability of mining is constantly driven towards minimal levels due to the entry and exit of miners. If miners earn excess profits, then additional miners enter the market, whereas miners leave the market in case it is no longer profitable to mine bitcoins.
The Bitcoin protocol maintains a state of mining equilibrium by considering the entry and exit of miners. This is achieved by considering the combined computational power used in bitcoin mining, often referred to as hashrate. The hashrate is used to systematically adjust the mining difficulty every 2,016 blocks, or roughly every two weeks. An increased hashrate corresponds to an increased level of difficulty in Bitcoin mining and vice versa.
Since miners sell at the same price, not a single miner possesses pricing power, so the profession is all about being extremely cost-effective. In the long term, the slightly less cost-effective miners are gradually squeezed out of the market, leaving only the most cost-effective ones. The latter, however, is still under constant margin pressure, by racking up some hefty bills, particularly in terms of hardware and electricity. To raise cash for these expenses, the miners have a one-way street of bitcoins to exchanges to dump the majority of their newly mined coins. This is not an insignificant number of bitcoins. In 2023, miners have received an average daily payment of $26.14 million worth of Bitcoin. This amounts to some 307,800 bitcoins paid in rewards to miners this year so far alone.
Chart 1: Mining Rewards in USD
Looking at the miner reserve, it is evident that miners send all their rewards to exchanges. On top of this, they have arguably also sent some of their holdings to exchanges intended for a rainy day, as the reserve of miners has been on a slight downward trajectory year-to-date. If they were accumulating their newly mined bitcoins, the reserve would increase slowly but steadily.