How Mining Difficulty Affects Bitcoin Price
With many declaring the end of the “crypto winter” with bitcoin surging in price to highs not seen since August 2018, it’s instructive to take a look at some other metrics of the leading cryptocurrency that are important for investors and traders to consider.
What is Bitcoin Mining Difficulty?
Put simply, the Bitcoin Mining Difficulty is a way of keeping the average time between new blocks stable, as the hashpower on the Bitcoin network changes.
Bitcoin was designed by Satoshi to keep the time between the addition of new blocks to the blockchain at an average of 10 minutes. When the hashpower on the Bitcoin network goes up for example, in order to keep this time constant, the difficulty of mining a new block must go up.
The difficulty is a measure of how hard it is for miners to “solve” bitcoin blocks to receive the bitcoin reward (or more technically how hard it is for miners to correctly guess a valid hash below the target value. The lower the target value set by the protocol, the harder it is to guess). The difficulty adjusts every 2016 blocks – on average every 2 weeks.
The Bitcoin Difficulty is an important metric for traders and investors to consider for several reasons.
Why is it Important?
Firstly, last year saw some analysts worry about a potential “bitcoin death spiral.” In brief, this is a concern some expressed that as Bitcoin prices drop, eventually miners who are losing money after mining costs decide to shut off their machines, and if the difficulty doesn’t drop as fast as the price, bitcoin will soon spiral to zero.
While many at the time rebuffed the claims, pointing to the fact that difficulty will eventually adjust accordingly, the last-resort possibility of a hard-fork, and miners longer-term incentives, the latest data in the chart below shows that the worries of the crypto winter were unfounded.
As the chart shows, since the beginning of 2019 – near the depths of the bear market – while mining difficulty has increased 33%, the bitcoin price has increased a huge 100% – pointing to a robust and healthy incentive for miners to maintain the bitcoin network.
Furthermore, there may be a correlation between price and difficulty…
Is there a correlation between bitcoin price and difficulty?
There are quite a few theories as to the possible correlation between bitcoin price and difficulty (or price and hashrate – which dictates the difficulty).
Some believe that the hashrate and difficulty follows bitcoin price. According to this dynamic, as the bitcoin price begins to rise, more and more miners get incentivized to get in on the act – effectively as speculators on the future price of bitcoin, driving up the hashpower and correspondingly the bitcoin difficulty.
Others, such as Wall Street veteran Max Keiser, believe that the relationship works the other way round, that price follows hashrate (and therefore difficulty) – a correlation that has been his “mantra” since BTC was at $3.
Some more controversial theorists think that there exists a “power law” between the bitcoin price and difficulty. Plotting the history of bitcoin price against difficulty produces a formula they believe can be used to determine the price of bitcoin based on the difficulty.
What does this mean for traders and investors?
Whether hashrate and difficulty follows price, or the other way round, or whether a precise formula can be discerned for the correlation between the two, it seems clear that there is some correlation. Monitoring bitcoin difficulty therefore, should form part of any investor’s strategy.