Bitcoin, Hashrate, and Network Decentralization - VegaX Research Report
The previous installment of the Bitcoin Educational Series established a basis for understanding the bitcoin protocol by examining the basic transactional structure and the importance of outputs. This installment will focus on Bitcoin’s hashrate and the implications associated with its centralization or decentralization.
Generally speaking, the hashrate of a Proof-of-Work(PoW) network is a basic indicator of that network’s health. This is because miners on PoW networks compete with each other to produce a block hash that is beneath a specified threshold; the more miners that are competing, the more hashes produced. The more hashes produced, the harder it is for malicious entities to undermine the integrity of a PoW network’s rules.
Therefore, the higher a PoW network’s hashrate, the more secure that network is — and ultimately, the funds that live on that network are more secure.
As these concepts are important in gaining an understanding of the bitcoin blockchain, this piece will seek to proceed in an intentionally deliberate manner, so as to build upon concepts previously discussed.
This piece will:
- Review ‘hashing’ and ‘hashrates’, then expand upon the processes involved in mining bitcoin.
- Introduce the concepts of mining targets, difficulty adjustments — and how those factors influence the blockchain.
- Emphasize the importance of a robust, and increasing hashrate in a PoW network.
- Explore current trends in the global hashrate, complications, and potential solutions.
Let’s dive in!
Setting the Foundation
Let’s circle back to earlier installments and refresh the concepts of hash and hashrate. Hash is a fixed-length, alphanumeric code used to represent words, messages, and data of any length. Think of hashing as a sort of data compression mechanism. The bitcoin network uses the SHA-256 (secure hashing algorithm — 256 bits), specifically. Hashrate refers to the number of hashes that a network — or individual mining operation — can make on a per-second basis. For example, if a network has a hashrate of 10 Th/s — this means that 10 trillion calculations can be made every second.
Now that we’ve established some understanding of what hashing and hashrates are, we will expand on the bitcoin network’s mining process as previously described in Bitcoin: Answering the “What” and “Why”?
Recall that miners on the bitcoin blockchain compete with each other to create the next block in order to earn a reward comprised of new bitcoin and transaction fees. As previously mentioned, these miners utilize specialized hardware devices — the reason being that these devices are specifically designed to produce as many hashes as possible. Nearly all miners use these devices today, and as a result, the bitcoin network’s overall hashrate has been steadily increasing since its inception. Consistent, positive growth in hashrate is vitally important to the security of the network: the more miners’ machines produce hashes, the harder (more expensive) it is for malicious actors to attempt to undermine the network.
At this point, some readers may be asking themselves: “But if there are more miners producing an increasing rate of hashes per second, why is a new block produced in 10-minute intervals? Shouldn’t blocks be produced more quickly with an increasing hashrate?”
Fantastic question, let’s dive deeper into the process of mining blocks on the Bitcoin network.
The bitcoin blockchain was designed to prioritize the security and stability of the core functionality of the protocol: to produce new blocks of transactions, roughly every 10 minutes. Over the years, there have been efforts to increase the network’s throughput — the number of transactions able to be processed — by increasing the frequency that new blocks are added to the chain. Increasing network throughput may seem like a good idea initially, but it can lead to the unintended consequence of miners building competing chains, composed of different blocks, and therefore wasting resources and hashrate.
The inventor(s) of the network, Satoshi Nakamoto, possessed an astounding level of forethought. Bitcoin’s Proof-of-Work consensus model is supported by a dynamic block hash mining target, which represents the alphanumeric threshold that a miner (or mining pool’s) potential block must be beneath to be added to the chain. One can think of the block hash as a reference number for a block in the blockchain. The target is adjusted every 2016 block (~2 weeks) in a process known as the difficulty adjustment.
“To compensate for increasing hardware speed and varying interest in running nodes over time, the proof-of-work difficulty is determined by a moving average targeting an average number of blocks per hour. If they’re generated too fast, the difficulty increases.” — Satoshi Nakamoto
The initial target value is hard-coded into the source code of every node; it was likely the best guess by Satoshi as to what difficulty level would produce blocks in ~10-minute intervals. Today, each node calculates its own target by simply dividing the actual time between blocks by the expected time between blocks, both within a 2016 block period. For example, say that the total time between blocks was 21,160 minutes — each node would divide that by the expected value of 20,160 minutes and end up with a difficulty adjustment value of 1.04.
In the above example, blocks were being produced less frequently than every 10 minutes on average, therefore the difficulty adjustment is upward to make it easier for miners to get below the target during the next period of 2016 blocks. Conversely, if new blocks are being produced more frequently than roughly every 10 minutes, the difficulty adjustment would move the target downward and make it harder to mine new blocks. Again, miners’ specialized devices are producing a staggering amount of hashes per second in an effort to be underneath the period’s mining target threshold.
A Rising Tide
These systems are in place to ensure that the amount of time between blocks is about 10 minutes, on average. To reiterate, this length of time was intentionally chosen by the creator(s) of bitcoin in order to maintain a consistent interval between blocks; and this consistency has two main advantages.
First, as previously mentioned, 10 minutes gives blocks enough time to be propagated across the network, thereby minimizing the risk of miners building competing chains and wasting hash power. Second, the consistent time between blocks equates to a consistent issuance of new bitcoin — via the block reward paid to the miner (or mining pool) responsible for constructing the latest block.
A relatively fixed rate of new bitcoin issuance adds stability to the network — which is especially important for a monetary good. 10 minutes has so far stood the test of time, sufficiently balancing a new block’s propagation along with not having users wait too long for a new transaction to be added to the chain. Bitcoin, like all blockchains, is a dynamic and complex system. The creator(s) understood that as the system grew in popularity, miners would likely become more sophisticated and grow in number. These two factors directly equate to an “up-and-to-the-right” trend in the network’s hashrate.
On the one hand, a consistently increasing hashrate is positive, as this better secures the network — making it far more expensive for malicious entities to execute a 51% attack. But it also poses an ongoing challenge to a system that is designed to be predictable.
“If broadcasts turn out to be slower in practice than expected, the target time between blocks may have to be increased to avoid wasting resources. We want blocks to usually propagate in much less time than it takes to generate them, otherwise nodes would spend too much time working on obsolete blocks.” — Satoshi Nakamoto
Ultimately, through the mining processes of block hash targets and periodic mining difficulty adjustments, a balance in trade-offs has been sustained for the entirety of bitcoin’s existence. Thus far, the bitcoin blockchain has been demonstrably anti-fragile. But bitcoin is a living process that constantly evolves; new challenges arise that threaten the network’s security and demand action from stakeholders.
In the next section, we will examine current trends in the mining industry and extrapolate on the implications of “hashrate centralization”
Is this “Decentralized?”
Up until the Chinese government’s 2021 actions to restrict and outright ban bitcoin mining in certain regions, China was a massive contributor to the global hashrate. According to University of Cambridge Bitcoin Electricity Consumption Index data, as of April 2020, mainland China accounted for approximately 65% of the network’s global hashrate — with the Xinjiang and Sichuan provinces accounting for about 30%, globally. In the month that followed the Chinese government’s decision, bitcoin experienced a nearly 50% decline in global hashrate, as reported by The Block. The network hashrate quickly recovered due to countries like the United States and Kazakhstan producing more hash, but the events of 2021 illustrate a legitimate threat to the ongoing success of bitcoin: hashrate centralization.
Bitcoin’s global hashrate has experienced a dramatic increase since 2019, due in large part to the rise in popularity and profitability of enterprise-scale mining operations. As previously discussed, a rising hashrate is a net benefit for the network, as users’ transactions and funds are more secure. However, if this increase in hashrate is concentrated in the operations of a handful of large players — the network’s security is at risk via a handful of points of failure. A blog post from Lumerin Protocol (built by Titan Mining) lays out distinct centralization vectors that could be damaging to the bitcoin network if not adequately addressed.
The most prevalent form of hashrate centralization in the mining industry today is the concentration of hashrate in specific geographic locations. The Lumerin team asserts that this is common, due to miners’ preferences in optimizing the balance between cheap electricity, stable infrastructure, and favorable regulatory environments. For example, roughly 50% of hashrate produced by the United States is concentrated in three states: Georgia, Texas, and Kentucky. All three of these states have the appropriate infrastructure, entrepreneur-friendly regulatory climates, and most importantly — cheap electricity, all paying between 11–12 cents per kilowatt hour. However, as evidenced by the Chinese government’s 2021 actions, the geographic concentration of miners is inherently risky, as a regulatory environment can change faster than miners can move their physical infrastructure, generally speaking.
A similar sort of centralization risk is that of power source dependencies. The risk is tangential to geographic centralization, as it is likely that those in the same physical location would be accessing the same power grid. Generally, power grids themselves are centralizing factors; the transmission of electricity necessitates investments in infrastructure, which are at risk of being disrupted by single players — generation plants or grid operators. Certain mining operations — particularly in the United States — have recognized this potential threat, and are seeking to innovate solutions by harnessing “stranded” energy products, like flared natural gas, to power their processes.
Miners are ultimately concerned with the profitability of their operation, they are effectively “short” their local currency (via electricity costs) and “long” bitcoin. While a sense of network-based altruism may be present, most miners are acting in their best interests. The majority of miners today direct their hashrate at a mining pool for enhanced profitability and stable payouts. The top three mining pools account for roughly 50% of the global hashrate, while the top 10 pools produce more than 98%. Unfortunately, the price paid for this pooling of hash resources is a dramatically centralized block construction process. Miners who point their hash at a pool do not construct the new blocks; the operator of the pool alone has that privilege. Even under the assumption that the pool operator is acting in good faith, there is still a risk of coercion, forced or otherwise, by malicious entities.
The bitcoin blockchain was thoughtfully and intentionally designed to reflect the dynamic world that it inhabits. Processes that maintain the stability of a payments network with settlement every 10 minutes, on average, continue to work as intended. The seamlessness with which the network moves forward can be attributed in part to the periodic mining difficulty adjustments made to the block hash target. The protocol was always meant to be anti-fragile; adaptable to ever-changing conditions across several surfaces.
But the risk of hashrate centralization should not be overlooked as it poses an ongoing threat to the security of the network. Synergistic operations, such as those miners utilizing stranded energy resources (flare gas), will need to be continually developed in order to sustain the consistent growth of global hashrate. Thus far, the bitcoin protocol has correctly aligned the incentives of users, miners, and developers to at once work for their own interests and the interests of the system as a whole. But complacency kills — as the saying goes. The work is just getting started.
At VegaX, we believe in the power and security of a truly decentralized monetary protocol. We will continue to develop products that best provide our clients with an appropriate balance of exposure and risk. We very much hope that you have found the content in this Bitcoin Educational Series valuable, and would welcome any feedback.
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