By the end of 2017, bitcoin was reaching
record highs, pushing towards $20 000 a bitcoin. The frenzy was palpable. Every
auntie, uncle and their dog were buying bitcoin. Nobody wanted to miss out on
the thing that was going to make them rich beyond imagination in a very short
period of time!

Such is the nature of bubbles.

Early in 2018, of course, the bubble
popped, and bitcoin now trades at around $4 000 a coin (at the time of writing
on 5 December).

It was not entirely unexpected. In March, I
wrote about how bitcoin is likely to form a repeating bubble pattern every four
years, based on how it has performed in the past.

The reasoning was based on several
different drivers; the “frenzy effect” that takes hold every time it rallies
beyond what is normal (compared with traditional asset classes); the changing
supply-demand dynamic as miners enter and exit the market due to difficulty in
solving blocks, varying as these miners enter and exit the market;
profitability of mining bitcoin due to the changing difficulty rate; and of
course, the mining reward halving every four years.

The
frenzy effect

The frenzy effect is a force driven
primarily by individuals that are buying (or selling) a certain asset – in this
case bitcoin – out of fear of some sort. In the case of bitcoin in 2017, this
was a fear of missing out.

Everybody was talking about it and people
were making real money, very, very fast. This got the attention of every media
outlet around the world. For months bitcoin was the hottest topic out there.

The frenzy got to a point where people who
have never traded a share, or even invested in financial instruments, were
reportedly selling cars or taking loans to raise money to buy bitcoin. The
belief was that it would never stop going up as it would change the world in a
very short period of time. As it turns out, this was false.

Now we are seeing almost the exact opposite
of what we saw last year. People refer to bitcoin as a useless technology with
no real-world application. Some reckon its value will drop to zero. This too, I
believe, is false.

Again, the frenzy of fear is at work. But
this time it is the fear of losing money.

I believe that if bitcoin were to retake
the $20 000 level and push 50% beyond it (to $30 000), the frenzy effect will
kick in once more and drive hordes of speculators to buy again. Again, prices
will be driven to stratospheric heights (much higher than in 2017, but a
smaller percentage move).

As a disclaimer though, I do not foresee
this happening until mid-2021. For now, we are coming out of the tail end of
the “fear of losing money”-cycle, and prices will likely remain depressed for
some time as people in general have no faith in bitcoin at the moment.

Understanding
blockchain

It is important to the supply-demand
dynamics of bitcoin. In its most simple form, bitcoin is a public ledger of
transactions grouped together into blocks that are linked together in
sequential order, hence the term “blockchain”.

These transactions are processed by miners
(processing nodes on the bitcoin network) who compete against each other to
group these transactions and have their unique group of transactions accepted
as the next official block in the chain.

In order for a miner to have its block
accepted as the next official block in the chain, it must solve a complex
mathematical problem before any of the other miners on the network do. So, in a
sense, it’s a race between these miners to solve the block before anyone else
can.

Once the block is solved, it is
communicated to all miners on the network and is accepted as the next immutable
block of transactions in the public ledger. The race is then on to solve the
next block. This process happens every ten minutes. The miner who solves the
block is rewarded for the work done (to process transactions) by receiving
bitcoin.

As the price of bitcoin rises, more people
buy specialised computers to process these transactions, hoping to earn
bitcoin. But as more computers are added, the bitcoin network automatically
increases the difficulty of the mathematical problems to be solved in order to
have a block accepted as the next official block in the immutable public record
of transactions.

Also: The more computers join, the more
computing power is required to solve problems quickly. With rising prices for
bitcoin, though, more miners continue to enter as the reward outweighs input
(computer hardware, cooling systems and electricity costs).

Every four years the reward is halved by
the network, which means less efficient miners (i.e. those who have less
sophisticated computer hardware) become less profitable or unprofitable
altogether, as the input costs now outweigh the profit they make by earning
bitcoin and selling it for normal currency.

This allows miners to demand higher prices
for bitcoins as there is now in effect lower supply due to the reward being
halved. This drives prices higher and starts the frenzy driven by the fear of
missing out.

But, because so many computers have joined during
a period of rising bitcoin prices, the mathematical problems are now much
harder and the chances of them solving a problem first, and thus earning the
reward, is significantly lower. Nonetheless, inefficient miners stay on the
network because of the rapidly increasing price of bitcoin.

Higher prices continue to attract more
miners and inefficient (older) miners are forced to shut down their mining
computers and sell their bitcoins to recover costs. This mass and rapid
shutdown brings a large number of bitcoins to the market, and suddenly the
market finds itself in a state of oversupply.

Prices come down, frenzy driven by fear of
losing money sets in. The bubble pops.

Bitcoin prices fall between 80% and 90%,
driving out many more miners, at which point the network once again
automatically adjusts the difficulty lower as there is now less competition.
Miners operating the newest state-of-the-art hardware are once again profitable
at lower prices. We then see a gradual fluctuation in prices over time, bitcoin
disappears from the radar and bitcoin prices happily churn sideways in a
relatively stable pattern for about two years as miners enter and exit the
network at different price points.

Eventually the reward for “finding a block”
is again halved and the process starts all over again.

This has happened three times already since
bitcoin came about in 2009. Well, we are in the third cycle right now. The
price has come down around 80% from the highs and miners have packed up
operations. Already the difficulty of the mathematical problems to be solved to
find a block have started to decrease and people in general are talking about
bitcoin less and less.What
next?

So, what now? Well, the same as what I had
said in March. I expect that bitcoin should stabilise in a range over the next
two years with the near $4 000-level being the bottom of the range and near $8
000 the top (which will mean, in percentage terms, its performance is in line
with what it was four years ago).

Eventually nobody (in mainstream media)
will be talking about it anymore and the people using it will be doing so to
facilitate cross-border and online transactions (as is its purpose).

The mining reward will be halved and if the
pattern holds true, in 2021 it will take out the highs of $20 000 made last
year. Then the talk will begin again, and a new frenzy driven by fear of
missing out will start.

I am of the belief that this pattern will
repeat itself every four years until bitcoin is around 250 times its current
level, at $1m, by approximately 2040.

Petri
Redelinghuys
is a trader and the founder of Herenya
Capital Advisors.

This
article originally appeared in the 20 December edition of finweek. Buy
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