Game of Hashes
In the period between December 2017 and December 2018, the price of Bitcoin reached an all-time record of almost 20’000 USD and a minimum price of about 3’200 USD. In this short study, we analyze and explain some of the driving forces that negatively influenced the price of Bitcoin during the last quarter of 2018. Our purpose is to understand some of the mechanisms behind the price fluctuations of cryptocurrencies. Since many of the technical factors that alter the price of cryptocurrencies, such as forks or moves in the mining hash power, can be foreseen by observing social media and metrics in the network — like the fees paid to the miners, or the block time — we argue that active management of cryptocurrency portfolios might be able to anticipate some of the future (positive or negative) sharp moves in the price of cryptocurrencies.
In order to analyze the development of the Bitcoin price, we first introduce and explain various technical concepts that are necessary to understand the explanation. We start introducing mining in “Proof of Work” protocols and the role of hash power in the probability of writing valid blocks. We continue by introducing forks, which are changes in the original protocol that yield new currencies. Only after introducing these concepts we analyze and explain the development of the Bitcoin price in the last quarter of 2018.
Understanding Proof of Work Mining
Bitcoin is a currency that is created by computers, which are commonly referred as “miners”. Miners follow the Bitcoin protocol, which is the set of rules that defines how new bitcoins are created and how bitcoin transactions are validated. New bitcoins are created whenever a miner writes a valid block. A block is a piece of information (that can be understood as an entry in an accounting ledger), which refers to the history of all previous valid transactions by means of a cryptographic hash and adds information about new transactions. A valid block confirms the new transactions made by bitcoin users. A valid block is a block that respects the rules of the Bitcoin protocol. Valid blocks are created in a random manner, such that miners…