Cryptocurrency Mining: The Basic Economics

Crypto 101

Cryptocurrency Mining: The Basic Economics

Crypto investors generally consider several factors before putting their money into an asset. The economics of cryptocurrency mining is arguably one of the most important.  

Just as the Federal Reserve controls the levers of an economy by adjusting fiat money supply, cryptocurrency-issuing companies can also regulate prices and value of a coin by altering its supply through mining.

But generating digital coins is not as straightforward a process as simply printing money. It is a complicated exercise that depends on several factors and is subject to the push-and-pull of errant market dynamics.

Bitcoin, for instance, has a fixed cap of 21 million coins. Slightly more than 17 million have already been mined and the last bitcoin is expected to be mined around 2040. The coins are distributed as rewards to participants in its network as reward for solving complex cryptographic puzzles. But those rewards are halved every four years, meaning that bitcoin numbers follow the law of diminishing returns. It’s no surprise, then, that each such event has been accompanied by a bump in bitcoin’s price.

But, there are also cryptocurrency forks which can split a blockchain — as the name suggests — and temporarily disrupt supply. In some instances, the newly created coin may suffer from supply constraints or may not have enough miners backing its production process. This will inevitably end up affecting the price of the cryptocurrency. For traders and investors, this is valuable information that could end up affecting their entire portfolio.

How Does Cryptocurrency Mining Work?

Cryptocurrency mining consists of a network of computers running an algorithm. Each computer in the network is referred to as a “node.” While it is not necessary for all nodes to be situated in physical proximity with each other, doing so can significantly reduce a cryptocurrency network’s latency, or the time it takes to nodes to connect with each other. Co-location of mining equipment can also increase the probability of earning rewards in the form of coins for cryptocurrencies that use the Proof of Work (PoW) algorithm.

When it was first introduced to the world ten years ago, Bitcoin was largely mined by individuals. That activity has been taken over by mining farms run by large companies after the cryptocurrency’s popularity skyrocketed. As with any production process that benefits from economies of scale, crypto-mining pools make it cheaper to mine cryptocurrencies by deploying mining equipment farms to the task.

There are two advantages to this practice. First, it eliminates the uncertain expense of electricity costs. In the U.S., states charge more to supply electricity to individual miners. Mining companies generally sign agreements with guaranteed custom rates.

Beijing-based Bitmain is the world’s biggest cryptocurrency mining company and is said to account for as much as 51% of bitcoin’s hashrate or number of systems deployed to the task. Mining for the world’s second-most valuable cryptocurrency, Ethereum, is also centralized and controlled by select miners.

Through their mining processes that make coins for various cryptocurrencies available to the market, mining firms essentially control the supply of important coins in the market. Unsurprisingly, mining companies profited off skyrocketing prices in cryptocurrency markets throughout 2017 and 2018.  Conversely, crashing prices can negatively affect their bottom line.

In this most recent crypto winter, during which prices crashed by more than 80 percent, miners resorted to cost-cutting measures to maintain profits. Bitmain, which mined profits of close to one billion dollars during the crypto boom, laid off some of its staff last year. Another report claimed that 600 miners shut down their operations in response to the price decline in November 2018.

Coin prices are also dependent on the presence or absence of cryptocurrency mining companies in their ecosystem. The price for Siacoin, a token for decentralized cloud storage, fell by as much as nine percent in a single day after it resisted attempts by Bitmain to begin mining its coin by developing custom ASICs (Application Specific Integrated Circuits) to mine it.     

Factors That Influence Cryptocurrency Mining  

Algorithms

The two most popular algorithms used to mine cryptocurrencies are Proof of Work (PoW) and Proof of Stake (PoS). In a PoW system, nodes compete with each other to solve cryptographic puzzles and earn coins. The PoS system distributes coins to stakeholders in proportion to their stakes or holdings in the cryptocurrency.

Other popular algorithms within the cryptocurrency ecosystem are variants of these two. Scrypt, the algorithm used by Litecoin, is a more simple version of Bitcoin’s algorithm. The X11 hashing algorithm used by Dash incorporates a combination of 11 scientific hashing algorithms for a PoW system.

These algorithms are important within the context of price because the choice of algorithm can determine costs for a cryptocurrency mining setup. PoW algorithms are mined using costly ASIC miners and use up more electricity. They are also generally considered more complex as compared to PoS algorithms.

Electricity costs

Electricity is said to account for as much as 90% of overall mining costs. By some estimates, the process for Bitcoin mining consumes as much electricity as the country of Ireland. It’s worth noting that some economists have questioned those estimates, but most economists agree that Bitcoin mining is an energy-intensive affair.

Most of that electricity consumption can be accounted for by high-end systems that run 24/7 in order to solve complex puzzles for cryptocurrencies that use PoW algorithms. Cryptocurrencies that use PoS are not much better because they require expensive GPU cards, which also consume vast amounts of energy.

Electricity rates are an important factor in calculating production costs for cryptocurrencies and determining profitability. As prices increase and electricity rates become cheaper, miners step up production to maximize gains from rising prices. Mining outfits involved in the production of multiple cryptocurrencies also switch between production of different coins to maximize profitability. On the flip side, when electricity rates go up, they bear down on production costs and decrease margins, making it hard for miners to eke out profits.

To cope with rising electric rates, miners have spread their operations all over the world in search of cheap energy. Locations with cheap and plentiful hydropower or other forms of renewable energy — like the Sichuan province — have become especially popular with cryptocurrency mining companies.

Algorithm Difficulty Levels

The difficulty of PoW puzzles is constantly being re-calibrated. As the number of systems involved in mining for a particular cryptocurrency increases, the difficulty level for its algorithm also increases.

An average of ten minutes is currently required to create a block in Bitcoin. SHA-256, the PoW algorithm used for mining the cryptocurrency, adjusts the difficulty level of its puzzles every 2,016 blocks. The adjustment level is based on past statistics regarding the amount of time required to generate a block on its chain. Thus, the algorithm will reduce difficulty levels if the time required to generate a block earlier was high.

The time required to solve cryptographic puzzles has an indirect bearing on the price of coins because more time equals more electricity and fewer coins in the long run. Bitcoin Cash (BCH), which is an offshoot of bitcoin and uses a PoW algorithm, adjusts its difficulty levels every 144 blocks.

Rewards    

In conventional economics, supply and demand determines the price of an asset. For example, the price of a currency decreases when its money supply increases. This mechanism is implemented in cryptocurrencies through rewards.

Rewards are disbursed to miners after they have solved puzzles, but the schedule and amount of rewards varies. In Bitcoin’s early days, miners earned 50 Bitcoin as a reward for solving puzzles. In other words, 50 new Bitcoin were supplied to the market every 10 minutes. That figure has obviously decreased over time.

Halving

Specifically, rewards available to miners are halved every four years. The first reward halving in Bitcoin’s history occurred in 2012. The event resulted in 25 new Bitcoin being created every 10 minutes. The second halving occurred in 2016, when the number of Bitcoin rewards was reduced to 12.5. Each halving event has corresponded with inflation and a bull run in the original cryptocurrency’s price.

Analysts and cryptocurrency experts are predicting a similar bull run for Bitcoin in 2020, when the number of bitcoin rewards will be halved to 6.25. “Cryptocurrency markets are often very event-driven, and as we get closer to the next halving, Bitcoin’s price will receive a boost from those anticipating a forthcoming reduction in new supply,” explained Garrick Hilleman, co-founder of Mosaic.io, and Cambridge University researcher.

Forks

Forks are another mechanism to adjust cryptocurrency supply in the market. As the name suggests, a fork is when a cryptocurrency’s blockchain is split into two. A fork produces another cryptocurrency but with different characteristics, such as a changed mining schedules and reward systems. Given that the number of cryptocurrency mining resources available is limited, miners play an important role in forks. Their support can ensure there is a supply of new coins to create a new market for trading.

Bitcoin Cash’s split from Bitcoin is a textbook case of the critical role that cryptocurrency mining can play in pricing a new coin. During the Bitcoin Cash fork, Bitmain supported Bitcoin Cash, thus ensuring that there would be enough supply to meet demand for trading in it. The supply of a cryptocurrency can also help determine winners between two competing cryptocurrencies — in the split between Bitcoin Cash and Bitcoin Cash SV (Satoshi’s Vision), miners supported the original chain, resulting in a price jump for $BCH immediately following the fork.

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