Bitcoin’s monetary policy, inflation rates and implications of the derivatives market
This is a special episode on Bitcoin as the halving is happening in a few days.
I'm testing a new format. Newsletters will be a summary of each weekly episode. Watch it on YouTube or spotify. Let me know if you love or hate it!TLDR below. This is not financial advice.
General Conclusion
This halving is going to be unlike the previous 2 halving with the establishment of the derivatives market and the change in inflation rates. Every halving, we see a new segment of participants in the Bitcoin market, which affects the function of the cryptocurrency. Whilst we can’t say how prices will increase or decrease, we can analyse the price movement in the long run.
1. Bitcoin’s Monetary Policy is Loved
Bitcoin’s monetary policy is modeled after gold. A fixed supply with a hard-coded baked in supply schedule is attractive in the world today of unlimited debt and cash flow by central banks.
Loose monetary policy in the financial market has seen endless printing of money and increase in debt under all government. There is no incentive to reduce spending due to reelection implications. Bitcoin is not subjected to such human interactions, which allows for a “purer” monetary policy.
2. Implication of Inflation
This particular halving drops the inflation rate of BTC below FED’s 2% inflation target, making it a deflationary asset. Trillions of dollars is pumped into the market, and we are expected to see inflation coming around in the next 2-3 years, minimum.
A shift in the demand for deflationary asset baskets like gold and bitcoin is on the rise. Case in point: Paul Tudor Jones.
3. Derivatives and EMH
This halving is different because of the existence of the derivatives market. Investors can express their expectations with futures, swaps and options using leverage. Miners are also able to lock in future bitcoin prices to cover their expenses, reducing the uncertainty on the supply side.
Previously, only spot prices were available. Now, with predictable supply (as was in place before) and more efficient price discovery with the derivatives market, we can have a better understanding on the price movement of bitcoin.
4. What Does this Mean
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Miners are less incentivised as block rewards are halved. This also shifts towards transaction fees playing a more significant role.
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If bitcoin is seen more as a store of value and less a means of transfer, this reduces the transaction volume, which can be dangerous when we are more reliant on transaction fees. Less block rewards and less transactions occurring, could this spell trouble in the near future of bitcoin’s security?
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The stock to flow ratio increased, meaning 1) lower price elasticity of supply, 2) increasing the measure of scarcity and 3) inflation rate of the asset decreases.
5. What’s Next
Since bitcoin’s supply is predictable and common knowledge, the predictable supply schedule with lowered inflation is priced into the market. With derivatives, investors and miners can hedge their holdings and bet on the future of bitcoin. This is priced in in the mid-term range.
The move to a more efficient market infrastructure can see more efficient price discovery with information being priced in.
6. Implications to the Physical World
We could see the emergence of a deflationary asset basket to hedge against the inflation, with bitcoin as an asset. Bitcoin is not in an efficient market yet, but it is getting there. The players in bitcoin started from techno-anarchists to retail speculators and now sophisticated traders. This diverse set of players make the market slightly more efficient, which is good.
Whilst we cannot say how much bitcoin prices will increase or decrease, we can use the market price as a guide to information being priced in.
At the end of the day, I am not a cryptonut or anti-crypto. I just believe in the technology and how it can be used to shape our world of tomorrow. Hence, these use-cases and economic design of the infrastructure are tremendously fascinating to me.
TLDR: BTC’s inflation is lower than FED’s 2% inflation growth, making it deflationary. The derivatives market allows the existence of longer capital market structure, which allows for efficient price discovery. The increasing inflation in the physical world, due to the pandemic, increases the attractiveness of such deflationary assets, changing BTC’s function from means of payment to store of value. All in all, an inelastic supply function with lowered sell pressure and increasing demand from sophisticated players could see a movement of BTC prices in the upward direction.