BLOCKCHAIN REVOLUTION — Miners and Incentive Economics (Book Review Part 6/9)

Leading by Reading
Apr 5, 2018 · 9 min read

■ Miners Economics

Becoming Miners (Nodes)

  • Miners are a supportive and incentivized community that processes Bitcoin’s transactions and keep everything running smoothly 54
  • A node is a powerful computer that runs the Bitcoin software and helps to keep Bitcoin running by participating in the relay of information. Some nodes are mining nodes (usually referred to as “miners”). 55
  • Anyone can run a node and mining nodes. 56
  • The service miners provide is not only transaction validation. Every full node can validate transactions.
  • Miners’ role is critical in that they preserve the distribution of power: the power to decide which transactions to include in each block, the power to mint coins, and the power to vote on the truth. 57
  • There’s no official statistics on the number of active bitcoin miners, but it was estimated there are about 100,000 or more miners globally as of 2015. 58 The number can be higher today.
  • As of 2017, it is estimated that about 100,000 Venezuelans are “mining,” although it is impossible to have an exact figure because many are protecting themselves by using servers in foreign countries. 59

Capital Intensive Investment

  • Miners consist anonymous individuals including hard-core online gamers, mining pools, and mining companies.
  • The costs of being a mining node are considerable, not only because of the powerful hardware needed (if you have a faster processor than your competitors, you have a better chance of finding the correct number before they do), but also because of the large amounts of electricity that running these processors consumes. 60
  • Mining pools are groups of miners who work together to mine, under the agreement that they will share block rewards when they are unlocked. The rewards are allocated in proportion to the contributed mining hash power of each member of the pool. 61
  • This capital intensive nature may keep ordinary want-to-be miners from joining, creating a concentration of wealth creation to a capable few in such a way only those who can afford intensive capital can take opportunities. This is against the Bitcoin’s promise of the equitable(egalitarian), distributed and inclusive system.

Concentration Tendency (Mining Process, Capital and Geography)

  • Mining is now predominantly executed in large, specialized warehouses with huge amounts of mining hardware, so hashing power is typically directed towards mining pools in these venues. 62 √
  • The process of mining for bitcoin has become so complex that the amount of computer power, and as such electricity, required in mining has become sizeable. Therefore, mining tends to gravitate towards countries with cheaper electricity. 63
  • In each country, the top handful of mining companies have harnessed a large amount of network hash power in their mining efforts, creating a more centralized structure of the mining process. 64
  • There are only a few countries that can boast of a concentrated mining effort, able to sizeably export bitcoins. They are Georgia, China and US. 65
  • As of Jan 2018, it is reported bitcoin miners are shifting outside China amid State clampdown. 66
  • While the moves are unlikely to have a noticeable effect on Bitcoin transaction speeds, they could reshape the cryptocurrency mining industry. Miners have until recently flocked to China because of the country’s inexpensive electricity, local chip-making factories and cheap labor. They now have little choice but to look elsewhere. 67
  • As miners function as a true distributed power, any concentration issue can cause a problem for the bitcoin network to function as distributed technology.

Decreasing Rewards and Profits

  • The mining cycle depends on the price of Bitcoin.
  • As of today, 80% of bitcoins have been already mined. The number of bitcoins awarded as a reward will decrease from current 12.5 because it halves every four years or so. The next one is expected in 2020–21. 68
  • The reduced future rewards can cause miners’ operation unprofitable to cover their investment cost for mining equipment.
  • The market value of Bitcoin relative to cost of electricity and hardware could go up over the next few years to partially compensate this reduction, but it’s not certain. 69

Bitcoin Value versus Miners versus Security

  • When the Bitcoin price drops, some bitcoin miners park their supply, but they continue to play the lottery until the price increases. Others who can’t afford to park and play may join mining pools, pooling their computing power with nodes with the hope of increasing their odds and at least getting some fraction of the winnings rather than nothing at all. 70
  • If miners decide to desert the network due to reduced incentives either by zero bitcoin reward after 2140, or by low Bitcoin price, then the network can be exposed to concentration issue that can lead to potential 51 percent attack.
  • A huge mining pool or a cartel of large mining pools can control 51 percent of the hash rate. The result is that, with that much firepower, they would constitute a majority vote of miners and could hijack block generation and force their version of the truth on the bitcoin network. 71

Implications on Other Consensus Models

  • While 51 percent attacks on PoW models stem from concentrated mining power, attacks on PoS models come from concentrated coin control, and coin exchanges are typically the biggest stakeholders. 72
  • Permissioned blockchains don’t have miners and mining. They rather opt for a small number of specific known validators(nodes) in the private space rather than relying on random, anonymous miners in the public space. Therefore, they are faster.
  • However, its easiness to change rules and small scale of the network raise security issue. The easier it is to change the rules, the more likely a member is to flout them. 73

■ Incentives (Rewards) Economics

Fixed Supply of Bitcoin as Incentives

  • The deflationary monetary policy with the fixed supply of coin increasing the value over time, provides incentives for a miner to commit to a long term project with future reward. 74
  • Rewards comprise two elements: rising value of coin and transaction fees miners get.
  • The economic incentives miners have to continue their proof-of-work keep the public blockchain honest without any oversight, indiscriminately and free of censorship. 75
  • They also ensure ledger accuracy and prevent tampering. In the same context, a blockchain lacking such built-in safeguards becomes easier to hack. 76
  • The bitcoin-mining process is neither cheap nor simple: Proof-of-work requires the use of application-specific integrated circuits(ASIC), computer peripherals that can cost several thousand dollars. 77

__________

  • It means if the cost to create bitcoin exceeds the reward, miners theoretically lose incentive, which ultimately leads the network security issue prone to attack in case miners leave.

Once All the Bitcoins Have Been Minted

  • Once all bitcoins have been minted by around 2140, transaction fees will become the sole reward for miners. 78
  • Because each block has a fixed maximum size, there is a limit to how many transactions a miner can include. Therefore, miners will add transactions with the highest fees first, leaving those with low or zero fees to fight for whatever space might be left over. 79
  • If your transaction fee is higher enough, you can expect a miner to include it in the next block; but if the network is busy and your fee is too low, it might take two, three, or more blocks before a miner eventually records in the blockchain. 80
  • Without fees to incentivize miners, the hash rate would likely drop. If the hash rate drops, network security declines. 81

Reliance on Anonymous Incentivized Miners

  • A distributed technology is maintained by ‘distributed powers’ such as anonymous miners, which itself contains both strength and weakness.

__________

  • While Bitcoin claims to be “trustless,” it’s just created a precarious house of cards whereby everyone has some incentive not to let it topple. However, miners can still shut off their computers and freeze the network if they wanted to. 82
  • Unlike centralized system or permissioned blockchains, for public blockchains such as the bitcoin network, without this incentive structure designed in the system, there’s no way to control or direct anonymous miners. 83
  • Incentives are the sole driver in keeping the system maintained. √

Reaching Break-Even Cost amid Bitcoin Price Instability

  • As of March 15th, 2018, it was reported that bitcoin traded at the break-even cost of mining a bitcoin, at $8,038. 84
  • If the cost to create bitcoin exceeds the reward, miners theoretically lose incentive. In some cases the miners may simply turn off the machines until the price comes back. 85 √

__________

  • Bitcoin mining today requires not only custom hardware that can cost several hundred to a few thousand dollars but also the need to regularly replace equipment accounts for more than half the cost of mining. 86
  • Chinese miners have an incentive regardless, because miners can access very cheap electricity produced by hydropower and they can produce bitcoin regardless of cost because it allows them to send money overseas and evade the government’s capital controls. 87
  • Four out of the five largest Bitcoin “mining pools” in the world are Chinese. 88
  • As of Jan 2018, bitcoin mining is considered so profitable in China that the cryptocurrency could fall by half and miners would still make money, according to Bloomberg New Energy Finance. Even at the country’s highest regulated electricity tariff, miners can profit from bitcoin as long as it’s worth more than $6,925. 89
  • The price at which most miners would really start shutting down their operations is around $3,000 to $4,000 per bitcoin. 90

__________

  • It is reported that miners’ earnings have roughly halved in March 2018 from December due to a surge of interest in Bitcoin mining. 91
  • The median transaction fee, another source of revenue for miners, has also fallen below 50 cents from as high as $34 in late December, according to bitinfocharts. 92

Satoshi Nakamoto’s Identity

  • It is understood that Satoshi Nakamoto owns a “massive cache” of the currency, estimated at 1 million bitcoins, or 7 percent of the total supply, spread under various anonymous accounts. This person or group could wreak havoc on the currency if those bitcoins were suddenly sold into the market, potentially devaluing all bitcoin. 93
  • Even if he sells only a few, others will notice, causing a crash as everyone panics and sells theirs before Satoshi can dump. 94
  • In this regard, the importance of Satoshi’s identity goes well beyond bragging rights. At its heart is how widely Bitcoin’s value can fluctuate — and how much influence s/he (or they) potentially has over that fluctuation. 95 √

Incentives versus Leadership (or Absence of It)

  • Under absent leadership, decision making is done by community’s consensus, which is slow and sometimes hard to reach.
  • We cannot rule out the possibility that the core principlethe fixed supply of 21 million bitcoins — can also be compromised if a majority of “miners” agree. This will be the most critical compromise affecting negatively for all the stakeholders’ incentives. 96
  • Likewise, for other cryptocurrencies, miners are prone to the risk where/when leadership suddenly decides to sell their holdings devaluing the coin’s value, affecting miners’ incentives in a negative way. √

Compromise of Network Integrity Affecting Miners Incentives

  • As was shown from the case of Bitcoin XT in 2015, any design change to the original Bitcoin protocol, whether through an altcoin or an upgrade, must keep in mind appropriate economic incentives to sustain miner decentralization, so that the network gets good value from miners in exchange for the large sums of bitcoin.
  • Smaller miners in geographically dispersed locations should be able to compete with larger miners that are geographically centralized large mining pools in Iceland or China. 97

(End of Part 6. To be continued in the next article)

Original article on leadingbyreading.org : https://leadingbyreading.org/2018/04/04/blockchain-revolution-miners-and-incentive-economics-book-review-part-6/

Leading by Reading

Written by

| leadingbyreading.org | In-depth Business Book Reviews by Jay (MBA, CFA candidate) •strategy •leadership •economics •finance •investment •politics and others

More From Medium

Welcome to a place where words matter. On Medium, smart voices and original ideas take center stage - with no ads in sight. Watch
Follow all the topics you care about, and we’ll deliver the best stories for you to your homepage and inbox. Explore
Get unlimited access to the best stories on Medium — and support writers while you’re at it. Just $5/month. Upgrade