Mining is the process by which a constant amount of Bitcoins are added into circulation, in return for verifying and recording payments in the public ledger. All transactions are publicly announced, timestamped and hashed together in a chain, with each additional timestamp reinforcing the ones before it. This blockchain is essential to prevent double spending when not relying on a trusted central authority such as a mint or a bank.
The blockchain is distributed and anyone can access or add to it. However, it is necessary to maintain a single authoritative blockchain to ensure that a coin has not been spent earlier. Even if we decide to accept just the longest blockchain, there are several issues of accuracy and fairness. Deciding the end of the chain can be subject to race conditions. Nodes with higher transaction volumes would also get an undue advantage.
For these reasons, the Bitcoin protocol requires a proof-of-work scheme to make the chaining more difficult and the blockchain growth rate predictable. The hash must begin with a certain number of zero bits. In computing the hash, the block is combined with a nonce and the nonce is incremented until the hashed value meets the required number of zero bits. This work is exponential in the number of zero bits and requires extensive CPU usage to compute.
Mining is thus an incentive to supply CPU power to the Bitcoin network. Proof-of-work is essentially one-CPU-one-vote. The more CPU power you contribute, the higher your probability of mining Bitcoins.
The Bitcoin protocol increases the hashing difficulty every 2016 blocks, to ensure a rate of one block every ten minutes. The reward for finding the hash is halved every 210,000 blocks.
In the beginning, miners were just enthusiasts playing with the Bitcoin client on their desktops and laptops. Very soon, the evangelists jumped in and sprouted exchanges. Once Bitcoin was pegged to a USD value, there was a gold rush to acquire Bitcoin before all 21 million bitcoins are mined. This in turn triggered a computational arms race.
From using CPUs to GPUs to FPGAs to custom designed ASIC chips, to purpose-built mining rigs with arrays of such ASICs, miners have deployed compute nodes with hash rates of upto trillions of hashes per second. Increased computation automatically increases the difficulty. Like the Red Queen’s Race, it takes all the running you can do, to keep in the same place. At current difficulty, the average time to find a block with 1 TH/s is six years.
That’s a long time to get a few dozen bitcoins. The next step then is to join a mining pool, where a network of miners combine their compute power and share the rewards. GHash, Slush and BTCGuild are a few such pools.
Mining now requires ASIC hardware with an upfront investment anywhere from $2,000 to $20,000. These rigs consume from 300W to 2000W or more. That kind of power consumption promises serious ongoing electricity and cooling expenses. Continual desire for more powerful hardware and an expanding Bitcoin network conspire to make mining rigs unprofitable and obsolete within six months.
CEX.io provided cloud mining capability to start mining Bitcoins without having to invest in hardware. Mining contracts allowed anyone to rent capacity with an upfront Bitcoin payment and ongoing BTC or USD payments for operating expenses. Mining contracts themselves could be traded. CEX.io thus functioned as an exchange to hedge on mining capacity. They even started futures trading with a small discount to buy mining capacity which would be installed at a future date.
Six months ago, a 1TH/s contract would cost 5 BTC while expecting to yield 2.05 BTC over six months. After that, the contract would earn 0.01 BTC month while costing 0.04 BTC in maintenance fees per month. The contracts could only be profitable by a combination of mining rewards while holding them and increased contract prices while selling them in the short term. Leading Bitcoin proponents had begun suspecting that the contracts might turn out to be Ponzi schemes.
Naturally the economic model faced increasing pressure as the BTC weakened against the dollar. According to this mining calculator, with BTC at 250 USD, a no-cost, zero-pool-fee 1TH/s 1200W rig is unprofitable on electricity costs alone, that too at a low price of 0.10 USD/kWh. Even if you use BTC to buy the rig and pay pool fees, you would still be paying for electricity and data center facilities in USD or equivalent currency. That, in a nutshell, is the squeeze.
Right now, many of those who got into Bitcoin early have ploughed their profits into faster mining rigs. Others, lacking resources, can no longer profitably mine Bitcoins. However, the economics now favors those with access to low cost energy. Oregon, for example, has relatively cheap hydro-electricity. In other places, electricity is subsidized, costs much less and can even be “free” for those with the right connections.
Miners colocated in such geos can buy older generation hardware dirt cheap and run more of it to yield profits. They can then afford to invest in the next generation of ASIC hardware utilizing 28nm or 14nm fabrication processes. Having 51% of the mining capacity located in China or Russia might trigger concerns within the US bitcoin community.
Bitcoin mining is estimated to consume 5,000 MW of electricity, comparable to the energy demand of Ireland. That level of power can serve 4.5 million air-conditioned residences in Texas for a year.
Paradoxically, the Bitcoin network would work just as well even with a small fraction of the computational power. Overall mining rate would be unchanged even at a few GH/s. This is yet another example of how supposedly rational economic behavior of individuals can, in the aggregate, create systemic inefficiencies.
Regardless of the CPU power allocated to the Bitcoin network, the payment processing rate is artifically limited to seven transactions per second. For comparison, last year, the VisaNet retail payments network stress tested its systems for 47,000 transactions per second.
Add in the environmental impact of manufacturing hardware that can only do SHA-256 hashing and gets thrown away within six months, and you get a sense for the true costs of the Bitcoin network.
The right of the lord to mint money, now refers to the difference between the value of money and the cost to produce and distribute it. For example, it costs the U.S. Mint five cents for each 25-cent quarter it produces, thus earning more than $6.3 billion in seignorage from the “50 State” series of quarters.
The cost of creating a new Bitcoin is the capital depreciation, electricity, network bandwidth and data center leases. However, as we have seen, this cost is not fixed. Rather, it tracks the market exchange value of Bitcoin.
The rise in BTC price attracted more miners and more computation, making it cost more to mine bitcoin. As BTC falls, miners may continue to operate at a loss in the hope of future BTC appreciation. The CEX.io shutdown illustrates that miners will likely shut down their hashing systems at just below break-even. There will be no ongoing seignorage, only arbitrage.
In the near-term, mining profits will accrue to those willing to amortize computational capacity and resource use over long time periods. As the mining reward halves, those with access to cheaper energy will increase their share of the hashing capacity. This will lead to consolidation and centralization.
When rewards asymptote to zero, transaction costs will have to be recouped from the parties spending and receiving bitcoins (if any). One motivation for staying in the game is that the few remaining miners can control the market and profit as intermediaries.
Those with significant accumulated bitcoins have no choice but to stay in the game. Centralization can lead to a less secure network, and a 51% attack can result in bitcoin theft and fraud through double-spending. They are thus locked into mining as a form of demurrage.
In the face of price volatility, proponents have championed the blockchain as the real value of Bitcoin network. However, these economic factors will generally affect any use case that attempts to build on blockchains.
Other crypto-currencies have been designed to mitigate these economic effects.
Bitcoin pioneered the peer-to-peer network for transactions without relying on trust. The community self-organized and innovated in operating the network, even as speculators have raised the stakes. Bitcoins and blockchain show signs of increased adoption.
Understanding the underlying economics is critical to ensure we do not tie the financial system to an energy hogging monster.
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