BITCOIN MINING AND ITS PHYSICS

By James Bone, Skytop Contributing Author May 27, 2021

James Bone is an Industry leader and practitioner with more than 20 years of senior risk leadership experience. Thought leader in cybersecurity and enterprise risk management. Author of Cognitive Hack: The New Battleground in Cybersecurity…the Human Mind and founder of innovative solutions for the human element of risk management. Frequent speaker and contributing writer for the Institute of Internal Audit magazine, Corporate Compliance Insights, Compliance Week, Forbes magazine and others.

Founder of Global Compliance Associates, LLC and TheGRCBlueBook a risk advisory service to the GRC technology community for 11 years providing strategic product development services including market positioning and insights to understand the integration of effective risk solutions. Lecturer-In-Discipline ERM Risk Management Columbia University. Founder and creator of several courses in the School of Professional Studies ERM program including: Traditional Risk & ERM Practices, Company Failure, Behavioral Science and Cognitive Bias.

Led the development of industry leading enterprise risk management, cybersecurity and operational risk and risk advisory programs for organizations including Fidelity Investments, Department of Treasury (Making Home Affordable), Liberty Mutual, Freddie Mac, private equity, public accounting and public consulting firms.

Graduate of Drury University, BA Business Administration, Boston University, MEd Organizational Design, Harvard University Extension School, MA Management

___________________________________________________________________________________

The Covid pandemic rally in Bitcoin has been touted as proof of the inevitability of digital currencies turning skeptics into true believers. The recent surge in price has created a FOMO effect, or the fear of missing out, resulting in what some believe is irrational exuberance in bitcoin buying. There is no doubt that Bitcoin has proven more resilient than many had expected but the real story may lie in a more mundane aspect called bitcoin mining.

Digital currencies like Bitcoin are created on a technology called Blockchain. “A blockchain is a network of computers that all work together to update and verify a digital ledger. The digital ledgers are created and maintained by bitcoin miners in the blockchain. Unlike centralized systems like your bank, blockchain relies on a decentralized protocol to keep the ledger secure”, according to David Hamilton at Securities.io (in an article titled What is Bitcoin Mining? A Beginners Guide to New Users” dated February 23, 2021). Traditional currencies are issued by central bankers through the banking system to influence economic equilibrium in the money supply, interest rates and financial stability. As such, the issuance of national currencies is “centralized” by a country’s banking system. 

Bitcoin was created as an alternative to the central banking system via a peer-to-peer e-currency system. Proponents of Bitcoin claim that a decentralized currency offers more financial freedom from control by government, individuals, or groups but the mechanics of bitcoin mining tell a different story (sourced from the Federal Reserve Bank of Cleveland’s website clevelandfed.org an article from July 16, 2019 titled Bitcoin’s Decentralized Decision Structure”). There are benefits to the bitcoin “experiment”. A paper appeared that established the philosophy and implementation of Bitcoin (Nakamoto, 2009). Bitcoin introduced an innovative approach to processing payments, wherein a trusted third party in a transaction, such as a bank, is replaced by anonymous people who verify the accuracy and trustworthiness of the transaction over the internet. 

Central Bankers are Skeptical

According to the Federal Reserve Bank of Cleveland, “A payments system incorporating a trusted third party with decision-making authority has an inherent problem: The goals of the third party can diverge from the goals of the users of the system. For example, the users of a paper currency would prefer that the currency not be inflated, but a government issuing the currency might decide to inflate it to increase the revenue it makes from putting money into circulation (“seigniorage”).” Central bankers have methods to mitigate these risks, but bitcoin miners have few incentives to implement the protections and controls used by central bankers. This leaves uncertainty over whether the benefits outweigh the potential costs of decentralization in the Bitcoin market.

Mechanics of Bitcoin Mining

Bitcoin transactions are verified and cleared by anonymous, unconnected individuals called “miners” from around the globe. Bitcoin miners act as “clearing agents”, meaning they verify that each transaction is valid. A sender of bitcoin is verified by miners and completes the transaction by adding the transaction to a public record (digital ledger) of all bitcoin transactions (called the blockchain). Individuals who want to buy or sell bitcoin must establish a Bitcoin Wallet. Bitcoins are “sent” from the seller’s wallet to the “receivers”, or buyer’s wallet electronically. The “blocks” in bitcoin transactions represent hundreds to thousands of grouped transactions of 1MB in size (as sourced from a cryptoadventure.org article from May 23, 2020 titled  “Bitcoin Mining-How Do Miners Process Transactions Inside the Blockchain”). The transactions are sent over the blockchain network to a pool of unconfirmed transactions. Miners randomly select these transactions and add them to new blocks after confirming the validity of the wallet and funds to make payment. This process determines how fast the transactions are confirmed. Miner’s prioritize transactions that include higher transaction fees, which are optional, to encourage faster confirmation. 

Miners who have enough transactions to add a block to the network must do so by finding the solution to a mathematical algorithm called SHA-256, a one-way cryptographic hash function. Miners compete to be the first to solve the algorithm but only one is recognized as the winner. The other miners must also verify that the winning solution is correct. 

Miners who solve the algorithm first are credited with a small number of bitcoins (reward) for their work called a coinbase transaction. The “reward” Bitcoins to miners is generated out of the winning miners’ processing of blockchain transactions. The coinbase transaction has special rules. It is allowed to have only one input which has no previous output and really no value. It is allowed to create outputs which have a total value of the block subsidy (currently 12.5 BTC) plus the transaction fees from that block. Those coins aren’t issued by any entity; the miner just creates the output(s) and is allowed to do so. This rule is enforced by all of the full nodes on the network who will reject that miner’s block if he pays himself too much money. Simply put, the miner is allowed to just pay him/herself money that is produced out of nothing. Some observers have attempted to attribute this process to the “value” of Bitcoin but that is not how it works. 

After each block is confirmed, it is added to the chain in sequential order. Currently, new blocks are added to the chain every 10 minutes. To ensure a steady supply of bitcoin is introduced to the chain regularly a difficult adjustment algorithm (DAA) protocol is required to answer the SHA-256 equation. The DAA protocol is adjusted depending on the total hashing power of the network. As more miners enter the fray, speed and processing power takes precedence. 

Dominance by Bitcoin Mining Rigs and Mining Pools

Competition among bitcoin miners has resulted in an “arms race” of processing power to solve the algorithm the fastest. Smaller players who can’t keep pace with technology have been leaving in droves. In the early days of Bitcoin, hobbyist and novice investors were the norm, now manufacturers of Bitcoin rigs and mining pools dominate as the value of Bitcoins has increased. The world’s biggest manufacturer of bitcoin mining rigs is Bitmain, a privately-owned firm in Beijing, China. A “Moore’s law” like effect in Bitcoin mining operations is driving the development of ever faster hashing power.

Bitmain manufactures ACIC (application specific integrated circuit) mining rigs that are designed to operate thousands of times faster at solving the SHA-256 algorithm. To compete with this raw power, bitcoin mining pools have formed to dominate the market. Contrary to the decentralized ideals of Bitcoin enthusiasts, a concentration of power in mining operations is changing who controls the future direction of the Bitcoin market. In a report by the University of Cambridge, using a Bitcoin Mining Map, “showed that China accounts for 65% of the world’s hash power. About half of the country’s hash rate is produced in just one place, the autonomous Xinjiang region, which makes up 35.76% of the global total”(also referenced is a Bitcoin.com article from May7, 2020 titled  “65% of Global Bitcoin Hashrate Concentrated in China” by Jeffrey Gogo). In comparison, the US accounts for only 7.24% of total global hash power. 

Ironically, as the value of Bitcoin rises so has the power of one country to play a dominant role in its future and influence by bitcoin mining pools over the direction of digital currencies. The largest Bitcoin mining pool in the world, F2Pool, controls 20% of the total collective hash power of the network. F2Pool’s founder, Mao Shixing, calls China the best place to mine cryptocurrency (sourced from an asiacryptotoday.com February 27, 2019 article titled F2 Pool Founder: China Best Place to Mine Bitcoin”). According to Mao, 800,000 miners left the market during the recent Bitcoin “bear” market for digital currencies, however China offers the best chance of success because of the low cost of power in China, large talent pool, and the advantage of chip manufacturers in China. 

Hurdles are Emerging for Bitcoin

Energy usage is a key factor in the growth of Bitcoin mining operations. Returning to the University of Cambridge Mining Map, if Bitcoin were a country, it would rank 29th out of 196 countries in annual energy consumption in the world (sourced from a visualcapitalist.com article from April 20, 2021 titled Visualizing the Power of Bitcoin Mining” by Marcus Lu). Bitcoin’s energy consumption is fast approaching the combined consumption of all the world’s data centers and the state of New York and currently exceeds the energy consumption of Norway, Argentina, and Bangladesh. Said another way, Bitcoin would score poorly on environmental, social and governance (ESG) and sustainability metrics (sourced from a nasdaq.com article from March 3, 2021 titled  Why ESG is Undermining Bitcoin” by contributor dkorth@finsum.com). 

Bitcoin also has a reputational risk problem (as noted in an article dated January 14,2021 from thetimes.co.uk titled “President of the European Central Bank Christine Lagarde Calls for Global Regulation of Bitcoin” by Philip Aldrick) . Christine Lagarde, president of the European Central Bank has declared Bitcoin, “a funny business”, that is used for money laundering and should be regulated. Lagarde’s comments, if followed by other central bankers, may prevent Bitcoin from becoming a true fiat currency on a global basis. Bitcoin’s promise of security is also being eroded with massive thefts of coins becoming more commonplace (as noted in a May 17, 2019 CNBC article by Arjun Kharpal titled  Hackers Steal Over $40 Million Worth of Bitcoin From One of the World’s Largest Cryptocurrency Exchanges” and a New York Post article dated April 13, 2019 by Michael Kaplan titled  “Hackers are Stealing Millions in Bitcoin – and Living Like Big Shots”).

Cryptocurrency exchanges, the repositories of crypto wallets, have become targets of cybercriminals. Binance, a cryptocurrency exchange, lost 7,000 coins in a sophisticated cyber-attack. Binance said the theft occurred from the company’s so-called “hot wallet,” which accounts for about 2% of its total bitcoin holdings. A wallet is a digital means of storing cryptocurrency. A “hot wallet” is one that is connected to the internet as opposed to a “cold” one which stores digital coins offline. More recently, North Korean hackers have been linked to a scheme of web skimming to steal cryptocurrency from online shoppers at large retailers in the U.S. and Europe (sourced from an article dated April 20, 2021written by Ionut Ilascu in bleepingcomputer.com titled “North Korean Hackers Adapt Web Skimming for Stealing Bitcoin”). 

Cryptocurrency Sustainability is Challenged but the Jury is Still Out

As the market for cryptocurrency grows along with an interest in mining, entrepreneurs have created new ways for investors to enter the fray. Cloud mining has sprung up for anyone who wants to become a Bitcoin miner without the costs and technical expertise of manufacturers of mining rigs. Cloud mining platforms rent out their hashing power to users at agreed rates to lower the upfront investments needed. Not surprisingly, scammers have followed digital miners into the cloud. Therefore, finding a reputable vendor is critical. 

Yet, with all these risks and hurdles facing cryptocurrency, hard-core fans have continued to push the price of Bitcoin higher. The most baffling part of Bitcoin’s rise is that no one seems to have a good grasp of how “value” is created in digital currency (sourced from an article dated April 23, 2021 from bluepnume.medium.com by Daniel Brain titled “You Don’t Need S2F to Value Bitcoin”). Many observers have attributed financial securities modeling to the price of Bitcoin (sourced from an article written by Lyn Alden in November 2017 onlynalden.com titled “How to Value Bitcoin and Other Cryptocurrencies”). The metrics and logic behind the models are baffling; Stock to flow, demand, scarcity, PoW metrics. The underlying assumptions don’t add up. Correlations in price to models don’t represent causation.

The most baffling part is that investors in Bitcoin don’t seem to be worried that a currency created out of “thin air”, with little to no intrinsic value, uses massive amounts of energy to produce, has no underlying real assets as a proxy for the price movement of a “derivative-like” security, and is used in the dark web to launder the proceeds of clandestine activity is safe.

Bitcoin Also Has a Scalability Problem

The Bitcoin experiment has worked but what happens when Bitcoin bumps up against the self-imposed limits of 21 million coins issued? Currently, only 21 million Bitcoins can be issued and, as of February 24, 2021, 18.638 million bitcoins have been mined, which leaves 2.362 million yet to be introduced into circulation (sourced from an article written by Adam Hayes on February 28, 2021 in investopedia.com titled  “What Happens to Bitcoin After All 21 Million are Mined?”). The bitcoin mining process itself is currently the limiting factor. The blockchain network transaction processing capacity is limited by the average block creation time of 10 minutes and block size limit of 1 megabyte. These two constraints are significant but various solutions are being explored to address them (sourced from Wikipedia, Bitcoin Scalability Problem).

In the meantime, the mining process itself serves as a buffer until a more permanent solution is found. “The Bitcoin mining process rewards miners with a chunk of bitcoin upon successful verification of a block. This process adapts over time. When bitcoin first launched, the reward was 50 bitcoins. In 2012, it halved to 25 bitcoins. In 2016, it halved again to 12.5 bitcoins. As of February 2021, miners gain 6.25 bitcoins for every new block mined—equal to about $294,168.75 based on February 24, 2021, value. This effectively lowers Bitcoin’s inflation rate in half every four years.” In eight-twelve more years, Bitcoin mining will pay 1.5625 BTC for adding a new block in the chain. Solving the scalability problem may be the least of challenges the Bitcoin market may face in the near future.

While market analysts and prognosticators debate the future price of Bitcoin it may be wise to also follow the market in Bitcoin miners as well. Disruption in the Bitcoin miners’ market may become the Achilles Heel that cripples this grand experiment.