This is Part 1/chapter 8 in The Blockchain Economy serialised book. For the index please go here.
In this post/chapter we return to the infrastructure portion of the book.
101: “Bitcoin Mining” is the process of solving a cryptographic puzzle using a computer in order to verify a Bitcoin transaction and in so doing to earn some Bitcoin. This is called Proof Of Work. Think of it like a decentralised, permissionless credit card network. Anybody can be a Bitcoin Miner.
The Past of Bitcoin Mining
This was the artisanal phase.The founding ideal was that everybody can mine Bitcoin with their own PC. This was the way early adopters made some Bitcoin when it was dirt cheap and, if they did not spend it all on pizza, they became wealthy. (In 2010, the first Bitcoin transaction was two pizzas for 10,000 BTC, worth over $100m as I write). The Bitcoin true believers want a return to this world, but it is highly unlikely. It would be like all of us running our own servers for email and online publishing. It is certainly possible, but most people make an instinctive assessment on where they should spend time and effort and so they use outsourced cloud services. Many ventures promise a bit of cash via Bitcoin for no effort if you make your spare computing cycles available via Cloud Mining. Other ventures simply highjack those cycles via hacking and keep all the profit and, given how lax most of us are about computer security, this is likely to be the more profitable line of business. There is no premium to being artisanal in Bitcoin Mining (unlike say artisanal cheese or beer), so this phase will remain in the past.
The Present of Bitcoin Mining
Today we have huge Data Centers in China with specialised equipment and subsidised cheap electricity. The biggest cost for a Bitcoin Miner is electricity so the subsidies were/are critical. The server cost may fall in obeisance to Moore’s Law, but clean energy has not yet followed that same trajectory. The Chinese government likes to encourage manufacturing by subsidising electricity costs. Viewed in this way, Bitcoin Mining is simply another form of manufacturing, except for three problems:
1. Bitcoin Mining does not employ many people and mass employment is the the best way to ensure social stability (which is biggest concern of the Communist Party).
2. Bitcoin is one way to avoid exchange controls and maintaining control of their currency ranks very high in the priority list of the Communist Party.
3. Eventually the environmental costs of using coal to generate electricity get factored into the equation, yet clean energy is not quite ready to pick up the slack.
All of these factors make China a less accommodating environment for Bitcoin Mining than it has been in the past.
The Future of Bitcoin Mining
I see 4 threads to the future of Bitcoin Mining
1. Bitcoin Mining moves to countries with real cheap electricity creation and a Bitcoin friendly jurisdiction. By real I mean cheap electricity creation, not subsidized electricity prices. It is not sustainable to subsidize electricity prices for long. One country to benefit from this is Iceland, due to cheap hydrothermal electricity. However, the second criteria is also critical – a Bitcoin friendly jurisdiction. Which brings us onto the second thread.
2. Bitcoin Mining will be regulated and taxed. Bitcoin Mining data centers are too big to hide in the underground economy. That is not a problem as long as the rules are clear and the tax is not prohibitive. Bitcoin must be legal in that jurisdiction and the tax rules must be clear and simple to administer. A lot of money is not much use if you are in jail.
3. Multi-level transaction verification does a 10x plus 10x to the market. Once Lightning Network goes live (probably during 2018), most transactions won’t require verification via Mining Proof Of Work; they will be done Offchain in Layer 2 networks. The easiest analogy is how we may sign hundreds of contracts (Layer 2, Offchain) but only very occasionally take a contract to a court of law when there is a dispute (Layer 1, Onchain). That does not quite explain it right, because you may do many small transactions in Layer 2, Offchain, but settle the net position in Layer 1, Onchain even if there is no dispute; that example is more like “running up tab” at a bar. What I mean by 10x plus 10x is that cost of transactions Offchain will fall by 10x (probably a lot more, it maybe 100x or 1,000x) but volumes will go up by a similar amount; supply and demand is a golden rule. In short, Bitcoin Mining will remain a good business, but anybody who forecasts 10x growth in volume without a corresponding fall in price has their head in the sand (or are deliberately misleading).
4. Chinese firms dominate Bitcoin Mining but not necessarily in China. This could follow the same trajectory as the offshore outsourcing industry in India. Both grew to scale based on a simple arbitrage. This arbitrage was labor cost in India and cheap electricity in China. Thanks to this simple arbitrage, firms got to scale. Once the arbitrage disappeared (as arbitrages always do in a free market), the firms used their scale and expertise to go global. For example, Bitcoin Mining maybe done in Iceland by Chinese firms.
What about Etherum and Proof Of Stake?
To date, the only proven method of doing decentralised, permissionless transaction verification is Proof Of Work. Ethereum, the second largest cryptocurrency, also uses Proof Of Work but they are actively planning to launch an alternative called Proof Of Stake.
101: Proof Of Stake is a different way to validate transactions based on the size and age of the stake (the amount of crypto currency put at stake by the user). There is no block reward, users get paid only through transaction fees.
The ideas behind Proof Of Stake have been around a while and been experimented with in many minor cryptocurrencies. The big news will be when Ethereum does a hard fork upgrade called Casper to transition from Proof Of Work (POW) to Proof Of Stake (POS).
If this is successful, it will disrupt the whole Bitcoin Mining business. Success for Proof Of Stake will require months of testing at scale as hackers try to cheat the system. There is no question that POS is more energy efficient. If POS also proves to be as secure as POW, it will be game changing.
What happens when all 21m Bitcoin have been mined?
The fixed supply is a key driver for Bitcoin price. After 21 million “they ain’t making any more of it”. This does mean that Miners will no longer be paid in new Bitcoin and will have to rely on transaction fees. Optimists point out that the cost of POW Mining will fall due to Moore’s Law, but this is uncertain. If the arrival of 21 million Bitcoin coincides with POS being proven at scale on Ethereum, the profitability of Bitcoin Mining will come into question.
You can reach out directly to discuss our advisory services by sending an email to julia at dailyfintech dot com