The Bitcoin network has experienced a significant decline in hashing power over the last two months. Bitcoin hashing power showed sustained increases until October 2018, in contrast to Bitcoin’s price, which has been in a year-long downtrend.
The sudden decline in resources that secure the blockchain has worried several investors about the sustainability of the network’s integrity. These concerns have seen the "Bitcoin mining death spiral" concept resurface from the archives of 2011. Bitcoin mining revenue has decreased from $13M per day to less than half that (around $5-6M per day) over the last month, and this has made the death spiral subject extremely topical. Here’s an analysis of the legitimacy of this threat to the proof-of-work mining industry.
The "Bitcoin mining death spiral" is akin to the snowball effect, and is caused by a massive price drop within a short period of time. Its main premise is that a Bitcoin price reduction causes miners to leave the Bitcoin network. In turn, when miners turn off their equipment, the network becomes slower until the difficulty adjusts accordingly. The network slowdown caused by the decrease in miners would then result in a further price decline, which would then again result in a further exodus of miners. This cycle is repeated until the network becomes worthless, and the remaining miners are forced out of the system due to a lack of profitability.
Bitmain mining server. Reuters.
The argument certainly has some merit, but it is built on several static assumptions that might have been plausible in the earliest eras of an ASIC-driven Bitcoin network. The actual thesis is very theoretical and is often characterized as an attack vector by critics of proof-of-work blockchains. In my opinion, the thesis fails to incorporate several considerations of the current mining industry.
For us to judge this theory, we have to understand the basic operational structure of the highly opaque mining industry, as well as the relationship between hashrate and difficulty.
All miners have different operational expenses, mainly comprised of electricity, hardware, and rent. The general view is that when mining profits drop below expenses, the affected miners turn off their equipment to avoid losses.
The difficulty of the network is defined as the automatically adjusted complexity of the "puzzle" that is being solved by the miners. The fewer miners, the easier the puzzle, which always calibrates to 10-minute block times. The network automatically adjusts the difficulty approximately every two weeks so that the network maintains a 10-minute block time average.
The recent Bitcoin Cash hard fork has been an extremely contentious one. Despite the fork being removed from the larger Bitcoin community, we have to take into account that several highly influential and powerful entities are fighting for the success of their respective projects. The split chains have both utilized hashrate from the Bitcoin Core blockchain to attack each other due to the fact that replay protection was not enabled until a later stage. The leaders of Bitcoin Cash ABC are, of course, Roger Ver and Jihan Wu, who is a co-founder of Bitmain, a mining pool and the leading mining equipment manufacturer in the world. On the other side, we have the infamous billionaire Craig Wright. The war has mostly come to an end, and we could possibly see a return of hash power to the Bitcoin blockchain.
BitMEX Research has recently reported that both of sides of the split have mined their respective chains at a loss. The incentive is clearly toward control rather than financial gain.
Another important consideration is the complexity of institutional-sized cryptocurrency miners. Their operational expenses are not nearly as simple as their retail counterparts. It is common for these large groups of miners to enter into long-term contracts for the purposes of mining inputs (hardware, electricity, and facilities), which typically means they would be forced to keep the equipment online even at a loss. It is worth noting that some miners are often integrated within the hardware manufacturers themselves, which would greatly reduce hardware expenses. Hardware should be viewed to some degree as a one-off operational expense, rather than a capitalized asset, due to the fact that equipment is constantly upgraded. Mining equipment becomes obsolete faster than one would expect.
The decentralized nature of mining allows for remote mining facilities. Some of these remote regions have infrastructure that produces excess electricity, which is subsidized and creates a cost advantage for these miners. This is highly prevalent in western China and parts of Mongolia. It is estimated that more than half of all Bitcoin mining is powered by means of subsidized electricity.
These considerations often allow for large miners to operate with extremely low expenses. The complexity of subsidized utilities and vertically integrated hardware could potentially offer a near zero-cost operating environment for certain miners.
A large part of the "death spiral" thesis is built on the concept that the decline in price and hashrate would spiral down a lot faster than the rate at which the difficulty could adjust to allow for reasonable mining conditions. This school of thought does not take into account that the difficulty could be manually changed by means of a hard fork, and miners would not likely oppose such a fork, as it would instantly increase their profitability.
One final consideration is the fact that mining profits are made up of block rewards as well as transaction fees. Transaction fees could also easily increase to accommodate a reduced block reward.
Taking the above factors into consideration, I find it highly implausible that a death spiral could occur. It is even less plausible than when the topic first appeared years ago. While the ride hasn’t been smooth toward the back end of 2018, the effect is similar to how price fluctuates through market cycles.
Lastly, we have to consider that the whole blockchain sector has evolved to greater complexity over the last few years, and the mining industry is no different.
The author is an investment analyst at Invictus Capital.