The Economics of The Bitcoin Hash Rate

The bitcoin network first came into existence on the first week of January 2009 by one Satoshi Nakamoto. It was not the first cryptocurrency but it certainly has risen to be at the forefront of the industry. Bitcoin is an intriguing computing paradigm that utilizes dedicated hardware to abstract out communications, storage, and computing. Without any type of centralized coordination, this format is able to replicate and create safe, independent transactions due to it offering transparent, stored transactions. It is an incredible design that has led to it being so widely used, with over twenty major companies allowing users to pay for goods and services via bitcoin.

However, while this system has key benefits, there are also some trade-offs. In order to be fully transparent, Bitcoin is designed to give every participant access to a full and complete copy of the database and the transactions stored therein. This makes it possible for one to trace back a bitcoin transaction in order to ensure it is a legit transaction, but it also creates redundancy and the requirement of excessive storage amount. The set-up of Bitcoin also can make it cumbersome and in some ways largely inefficient.

Because of these characteristics of being inefficient, cumbersome, redundant, and fully transparent, many newcomers to bitcoin and the economies of hashrate are initially confused on why prioritize such a system. The following is a look at that answer as well as a broader investigation into the economies of Bitcoin hashrate.

The Difference Between a Traditional Distributed System and Bitcoin

In any traditional distributed system, in any traditional system at all, there is a central institution or company that controls everything. This central institution is what provides the data storage, it’s what provides and defines access services, and it’s what provides the rules of coordination and distribution. For example, the US Federal Reserve is the institution that controls the money supply for the US dollar. They are the ones who create the money, they lend the money out, they facility control of open market operations, they are charged with drafting and imposing regulations, and more.

Bitcoin takes the system and turns it on its head. While there is an established consensus with transitional rules that must and are obeyed, they are done so from various points around the world — without the confines of traditional financial distribution systems like the US Federal Reserve. Here, transactions can be initiated at any time, in any span of time, from anywhere in the world, and via any type of network speeds. You do not need to be on the same network or connected with the same distribution standard in order to send or receive bitcoin.

Due to their being no single set time and no single entity to coordinate bitcoin transactions, there is no way to determine at what exact time any transaction took place. But, again, that doesn’t mean it’s not recorded. Bitcoin takes out the necessity of needing an exact timestamp by instead offering a proof-of-work mechanism. This proof-of-work mechanism shows that a determined amount of computation resources were used for a determined amount of time and the storage of this computation provides a data record.

This is incredibly important because any ledger, every ledger, must have order. You cannot spend money that you never actually received, nor can you spend a sum of money that you actually already spent. A ledger ensures that you have what you say you have and receive what someone else has sent you. In the US dollar world we know, all ledgers are organized by time. A company sends you money and there is a stamped time of them sending and you receiving it. Bitcoin had to find a solution around that and it does so by creating its own notion of time, the proof-of-work mechanism.

Defining Hash Rate & Block Chain

To understand the proof-of-work mechanism for Bitcoin, one must first understand that a “hash” is an algorithm that takes an arbitrarily large amount of data (set input of encrypted letters and numbers) and sets it into a fixed-length. The hash rate is a measuring unit of a Bitcoin network’s processing power. This measurement is displayed or conveyed as Th/s or tera hash per second. Therefore, when a Bitcoin network is said to reach a hash rate of 10 Th/s that means it is making or has the ability to make 10 trillion calculations per second.

Hash and hash rate are first two key terms to understanding proof-of-work, the second two terms are block and block chains. Instead of precise time stamping, Bitcoin records transactions via “blocks” which are records that contain and confirm waiting transactions. About every ten minutes, one block will end and a new block will be happened to a block chain via mining. A block chain is the public record of all Bitcoin transactions listed out in chronological order. This block chain can be easily shared between each and every Bitcoin user and it is the primary way in which one will verify the veracity of a Bitcoin transaction to prevent aforementioned issues like double spending.

The reason why it is called proof-of-work is because while you cannot pinpoint the exact time an amount of bitcoin was sent, what you can do is find where in the block chain and what block it is in, and that the value of that block is the work rather than the time that is implied it took to insert itself within the block chain. There is no gap or any type of time between blocks; each new block moves forward one block at a time with ten minutes being the smallest amount of time.

How it All Comes Together

One of the most important aspects of ordering ‘time’ or transactions via the blockchain method is that it makes the financial transactions extremely resistant to tampering. The blockchain will continually propagate as hashpower continues to accrue so that each block becomes more settled or have a greater economic weight’. This prevents it from being the target of attack and, due to its public availability, prevents it from being erased. The hash acts also allow a p2p network to efficiently coordinate and do so via a sort of transactional ledger. This results in a strong assurance from the sender and the receiver that the bitcoin is properly transacted. This assurance is also known as settlement assurance.

Settlement assurance is the necessary foundation of any distribution system, but most especially a distribution system that does not have a centralized authority. Also sometimes as referred to as economic finality, buyers and sellers are most confident in the settlement assurance when there is proof that their transactions are unable or highly resistant to tampering by outside forces. As noted above, because of how the blockchain system builds block after block and remains stored, there is heavy economic weight to the blockchain system that makes tampering highly improbable.

How does all this compare to traditional banking systems? Well, some strong proponents of Bicoin make the case that it is in fact stronger than traditional systems. This is because the nearly impossible ability for anyone to tamper with blockchains combined with their free and open data sourcing makes the Bitcoin system more verifiable and therefy more resistant to counterparty risks. The system also ends up being a lot cheaper due to the their being no centralized party. This point is going to be discussed more in the next section, but it is important to note here that in Bitcoin, any individual can contribute to ongoing computations and thereby become a part of the sustaining system. Participating earns the participant a share in the economic value and in doing so secures the full economic value of the Bitcoin system or network.

Understanding the Hashpower Asset Class

An asset class is a collection of financial instruments that both feature similar financial characteristic and behave comparably in the market place. In the Bitcoin network, there is what is known as the hashpower asset class and that class is defined as including all assets that create hashpower in exchange for cyrptocurrency and mining returns. The following is a look at various hashpohwer assets and how they integrate with Bitcoin.

Bitcoing Mining

First, the hashpower asset class revolves around Bitcoing mining so to understand the hashpower asset class, first understand Bitcoin mining. Mining is the process of adding each of the aforementioned transactional records to a block that will be then added to the blockchain — that public ledger. Anyone can be a miner so long as they are properly equipped and they add to the greater Bitcoin community by confirming each transaction is legitimate. The incentive for Bitcoin mining is that every time an individual seals off a finalized Block, they get a financial reward.

As of October 2020, Bitcoin miners receive 6.25 bitcoin for every block mined. Due to how miners receive currency for each block created, the term ‘mining’ was chosen as the process appears similar to the mining of gold from the ground.

The Mining Machine Markets

While anyone can technically mine bitcoin, it involves some significant effort and know-how — and it takes the right equipment. Mining Bitcoins is complex and thus requires a specialized type of hardware. The primary parameter to consider is the desired hash rate a piece of hardware can perform as the higher the hash rate, the greater the chances of the equipment solving the data sequence and thereby sealing off the block chain and allowing the user to collect the mining reward. Despite the mining reward having gone down in recent years, this remains a highly competitive field and thus it is integral for a Bitcoin miner to choose hardware, or mining machines, with the highest hash rates possible.

In choosing mining machines to set up a mining operation, one must consider the key factors that would increase the hash rate or hashpower; factors that include chips design, energy source, tape-out, and maintenance. New mining machines and hardware products designed specifically to improve a user’s hashpower are released annually and quite frequently will sell out. This is a high demand, low supply market that, in following the mining analogy, is not unlike how U.S. mineral contracts and mining permits are doled out. There are large-scale miners who get priority access to each year’s new release machines and then a small secondary amount is made available to the public at large. Once they sell out, the market is depleted until the following year.

As of 2018, this type of inventory control has become increasingly more rigid by the few manufactures that assemble and distribute mining machines. Today, Bitcoin miners, especially larger operations, will need to pre-order and then, and only then, will the manufactures will only begin assembling and later distributing, releasing a select few to the general public and often with a higher premium.

In addition to this market of new mining machines there is a secondary market for used machines as many individuals are interested in Bitcoin mining but perhaps do not have the capital or other recources to get in the list of annual mining machine releases. This secondary market is typically done as a peer-to-peer purchase with machines that are past their warranty and underperform at the desired or listed hashrate. Buyers in the secondary used market should also be aware that there is a fair amount of scamming going on and that it is a very much ‘buyer beware’ market. The primary reason that this market exists is to fulfil the higher demand for mining machines that cannot be fulfilled by the primary manufacturers.

How Hashpower is Valued

Mining machines are one part of the hashpower asset class but they exist and their prices exist and depend upon the value of hashpower and the value of hashpower depends upon several variables. Just as the going price of Bitcoin variates, soo too does the value of hashpower. The network hashpower and the hashrate are good starting indicators of where mining machines will be on the price scale for any given year, but they aren’t the only ones.

The price of mining machines are set by manufactures and they frequently determine how much they will list their machines on factors that are in flux every year. These factors include the how many days of bitcoin mining one must do in order to break even on their machine, the hashrate that the machine can produce (or that a certain specific piece of machine can contribute to producing), the all-in electric cost to operate the machine, and the most recent average transaction fee per block. These are not the only factors that determine mining machine cost but they are some of the most common ones and ones to consider for anyone looking to purchase a used mining machine in the secondary market.

Obtaining Access to Mining

Once a price has been agreed upon for a mining machine and has been purchased the next, and arguably most daunting task, is to get mining exposure. Remember, bitcoin mining is akin to current real-world mining and this can make it hard for one to join and be successful in the industry. One manner that can ease one’s access into bitcoin mining is via cloud mining contracts.

Cloud mining is a type of hashpower that separates future production from current location and tends to be the best choice for individuals who do not have larger mining operations. This is because cloud mining utilizes rented cloud computing power, allowing the miner to open an account and participate remoltey in the mining of bitcoin without having to directly install and run the necessary hardware and software. This format also helps reduces the costs associated with energy/electricity and equipment maintenance.

Note, however, that cloud mining is viewed as a type of secondary market and, like purchasing secondary used mining machines, should be approached warily as scams abound. This is because you are leasing the equipment from a thid-party cloud provider and relying on them to pay out a fair pro-rata share of the profits they will directly receive for their hardware and software completing the bitcoin mining.

On the other side of things, a user with a more sophisticated bitcoin mining operation can utilize their own equipment as well as offer out cloud sharing contracts to remote individuals in order to build a sort of diverse portfolio of bitcoin mining operations. This type of mining operation can also join what’s known as a mining pool in which they join a group of bitcoin miners and a distribution of coins produced by that pool is distributed based on hashpower.

Hashpower as an Investment Vehicle

It is not easy to invest in bitcoin mining on one’s own, nor is it something you can do readily on-the-side as you might with stocks or other types of investment portfolio. This is because to really make money off of hashpower like an investment venture requires significant bandwidth, expertise, and knowledge of the industry. Instead, someone who wants to invest in hashpower but not do the work will likey go through another large mining company and attempt to build up their position within. This because most traditional investors don’t have the manpower or expertise to operate machines, they must instead buy up the manpower and machines, pooling together a significant start-up capital in order to fun and entire mining operation. You might also gather from this why finding authentic, trustworthy cloud mining opportunities can be scarce.

In general, most investors of mining companies evolved from an already large Bitcoin operation — one in which large bulks of coins are generated every day. Going too fast too quickly into bitcoin mining has resulted in some colossal failures. Take for example the company Gigawatt which, due to lacking proper equipment and expertise, had only $50,000 in assets when filing for bankruptcy and yet had an estimated liability within the range of $20 to $50 million.

In order to properly invest in hashpower and be profitable, one must make a plan that includes several key factors. First one must make that significant investment in both mining machines and personnel and then keep in mind the linearly deprication of the machines themselves as, in order to stay competitive, one will want to buy new mining machines every couple of years or even annually. Power consumption, total hashpower, and maintenance costs will also have to be considered.

The Cycles of Bitcoin Mining

As with traditional markets, bitcoin mining has boom and bust cycles in which a user has chances to make better returns, worse returns, and sometimes no returns at all. The hashpower dyamics, the economics of the Bitcoin hash rate, is driven by a mish-mash of factors that include trending prices, hash power reflexivity,fees, hardware reaction time, and more. Each variable can be unpredictable and thereby makes entering the market challenging. The following is look at four key cycles to keep in mind:

• The Rising Bull. Bitcoin and other cryptocurrency mining will always be most profitable whenever difficulty drops behind the price rally. So once you see a long period of volatile prices, you can generally expect to see the price to then start to rise, gaining momentum. But this cycle isn’t just about rising price. A rising bull phases occurs only when at the same time that price rises, the global hash rate falters. Situations in which this might occur include natural disasters in one region that allows miners in another region to take advantage.
• Mining Gold Rush. Here, both the rate of hash power growth and the price growth go high. Typically, this will occur after the rising bull phase as once some people are making significant cash mining, others will try and take advantage. At first, they will succeed. This is the second-best time to be Bitcoin mining.
• Inventory Flush. After the mining gold rush, too many people will have entered the field until it becomes overcrowded. During this phase, the hashpower rate is still going high as there are many mining machines activated and running blockchains, but the profitability and thereby the price drops. This tends to be a good period for newcomers to get more expertise, but generally you do want to bow out before you hit the next phase.
• The Shakeout. The inevitable end of this cycle when left to go into the extreme (sometimes prices and hashrate will even out for awhile, fluctuating but no going into extreme lows or highs together). Once the price drops too much, when the revenue of mining dips so low that miners are no longer being profitable, then the phfase enters what is called the shakeout or shut-off time.

Finding Your Place in the Bitcoin Economy

Understanding the aforementioned four phases of the Bitcoin economy are important but if you are just getting into it, generally the advice is to do what you can when you can as you gain expertise. Bitcoin mining can be incredibly profitable but only when you have the right equipment and the right understanding of the economy to take advantage and remain profitable amidst all of the cycles.