After reading my first post, entitled Finding Equilibrium in March 2014, one could argue that I was a bit bearish on Bitcoin — believing that it would trade sideways and down, until certain fundamentals were in place. At that point, most people inside the Bitcoin community expected Bitcoin to retest its previous high of c. $1255 in 2013 and easily break $2k. In fact, when I surveyed the audience at CoinSummit in 2014, barely anyone would take the contrarian view. I did. And this was coming from the same person who correctly predicted that Bitcoin would hit $1,000+, just the year before.

To summarize my previous post, I argued the following:

Bitcoin is not a currency, but a commodity (it has since been declared as such by numerous bodies, including the CFTC).

Mainstream consumer adoption was lagging (and it still is to a large extent)

“Smart Contracts” will be a particularly important use case for Bitcoin

Merchant adoption was outpacing consumer demand

Lack of trust with exchanges and limited ability to purchase Bitcoin

Loss of momentum (Bitcoin was on the way down, not up)

Miner margins were being squeezed (forcing more coins to be sold)

How 25 months makes a difference in the world of technology! If we examine the points above, the following changes are clearly visible:

Merchant adoption has slowed (as a %) and consumers are catching up — mainly early adopters, but the delta between the two has virtually reversed. Smart contracts have become the latest buzzword, along with “Blockchain” and other chains such as Ethereum. My new startup, Civic, is now using Blockchain technology to create a secure personal identity platform for consumers, for example. Miners margins are looking a lot more more healthy, from the lows of $200 last year. Bitcoin is on the way up, not down, creating upward price momentum. There is a strong trust in exchanges and platforms for purchasing Bitcoin, such as Bitstamp, which recently got EU regulatory approval, Coinbase, Kraken, Circle, BitX and others.

So, purely upon the basis of my previous arguments against the price rising, I believe the headwinds that were holding back Bitcoin, will take the price up to the $1000+ mark, this year.

However, as the title to this post suggests, there has been an awakening. I’ve casually been speaking about some tailwinds for about a year now and some of these ideas have been gaining momentum, so I wanted to summarize them here into 3 categories:

Industrial use cases are coming to the fore

Venture capital has been pouring into Blockchain and Bitcoin startups at an unprecedented rate, now topping over $1bn. These startups, such as Chronicled & Stem (disclosure, I’m an investor in both), are building out solutions which utilize Blockchain technologies in industries, where prior solutions were either not possible or financially viable.

The banking sector is investing heavily in what they call “Blockchain”, but specifically avoiding using Bitcoin. I personally think the tide will turn on this point, as soon as one of these projects get compromised, from a security perspective. That said, many foreign banks are investigating and using the Bitcoin Blockchain for innovating around their processes. I think we have to accept that we will live in a world where there is a “chain of chains”, all interlinked in some way. Bitcoin may not rule the finance world chains but it may act as an intermediary platform for settling across chains.

The coming short squeeze

The most important driver of the pending price surge, IMHO, is going to be what I term as the “Mother&*!er of all short squeezes”. A short squeeze is basically what happens when people that are short (selling) an asset discover that the price has risen and they need to buy (cover) to ensure they do not make further losses.

In the Bitcoin world, this happens under a number of scenarios:

Traders/speculators who have taken a view that the Bitcoin price will go lower, would borrow coins via exchanges such as Bitfinex and sell those coins into the market, waiting for the price to drop to buy them back cheaper, repay the exchange and make a profit. Miners who want to lock in profits. These ordinarily would be called “hedging”, because they produce enough coins per day that they are able to pay out of their future production, HOWEVER, halving day is approaching. Halving day is the day that a certain block number is reached and the rewards per block is halved (to 12.5BTC per block, from the current 25). This is expected to be in early July 2016. The problem this has for miners, is that if they are trying to lock in their profits right now by borrowing and selling coins, which they intend to repay AFTER halving day, unless they have spare coins lying around, they will be forced to buy coins on the open market if they cannot produce enough coins through their mining operations. It’s the same as selling crops in the futures market and then being hit by a storm that wipes out half of your fields. The only way, technically, that this doesn’t happen, is if the price doubles on halving day (it won’t).

Because Bitcoin trades at the margin (which means that only a percentage of the total coins issued are traded), there is less liquidity and extreme changes like a 50% drop in the rewards per block will have a more marked impact on the price than one would expect, triggering a short squeeze.

One would argue that the market has already factored this in, but it hasn’t. The reason is that the hash rate will fluctuate very rapidly over the halving day period and that is going to cause a lot of volatility for miners and traders. Also, the true deflationary rate of Bitcoin is not known, as I will now explain.

Real inflation vs Nominal inflation in Bitcoin

Bitcoin was created as “deflationary” currency. The total supply is 21m units and it will never be changed. There are about 15.5m coins in circulation and about 3600 new coins minted per day, so roughly 100,000/coins per month, which amounts to nominal inflation (relative to actual coins issued) of around 8%/year. This will arguably drop to 4% after halving day. Or will it?

If we assume that 4m coins will not move anytime soon, then the active circulation of BTC is closer to 12m coins (based upon coins in issue today). Assuming that we are minting 100k/coins per month, then real inflation is at 10%, not 8%. So, if halving day takes effect, then real inflation drops to around 5%/year.

Based upon research by John Ratcliff, I’d like to construct a new view of the real inflation rate of Bitcoin. For various reasons, it appears that 25% of bitcoins are not in active circulation (lost, cold storage, Satoshi, etc), even if we assume Craig Wright is Satoshi (which would mean his coins won’t move until 2020). All numbers are rounded.

In 2014, Bitcoin nominal inflation was 10.3% & real inflation was 15.1%

In 2015, Bitcoin nominal inflation was 9.3% & real inflation was 10.1%

In 2016, Bitcoin nominal inflation will be 6.4% & real inflation will be 8.7%

In 2017, Bitcoin nominal inflation will be 4% & real inflation will be 5.3%

Inflation in Bitcoin has an interestingly different application than inflation in the real world, in that prices aren’t going up because governments are printing money. Prices are going up because of scarcity (supply/demand). If you note that real “inflation” is dropping nearly 2/3 in around just 3 years, it means that for the current volume of Bitcoin buying to be satisfied, Bitcoin will need to find a new, and higher equilibrium point/clearing price. I don’t think these calculations have been adequately factored into the market price…

Bitcoin as a strategic global asset will trigger an “arms race”

Currently, the market cap of Bitcoin ($7bn) is simply too small to facilitate a large buy of Bitcoins from any governmental organization. If Bitcoin started to surge globally, and as a result of strategic interests from any one government, if other governments decided to own a piece of the limited 21m coins in issue, I believe this would trigger something akin to a digital commodity race. Imagine if China started buying up large amounts of Bitcoin — would the rest of the world governments stand idly by and watch? I don’t think so — so my prediction here is that by 2017, governments will become the largest buyers of Bitcoin, pushing the price up to new highs.