Understanding Bitcoin by Franco Pedro

Understanding Bitcoin by Franco Pedro

Author:Franco, Pedro [Franco, Pedro]
Language: eng
Format: epub
Published: 0101-01-01T00:00:00+00:00


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UNDERSTANDING BITCOIN

FIGURE 9.1 Bitcoins in circulation. Data from blockchain.info

Bitcoin is a peer-to-peer network; anyone can connect to it and start mining right away. New entrants do not have to ask for permission or adhere to a set of rules or regulations before they enter the mining market. Nor can incumbents collude to prevent new participants from entering. Thus new investment will enter the contest to capture the block reward, lowering the reward of all miners already in the network. Thus, in an scenario of increasing bitcoin price (or increasing technological advancement), miners have to keep increasing their hashing rate in order to obtain the same reward, in a process similar to the Red Queen Effect3. This process will continue until the marginal cost of the last miner to enter equals her expected reward. At this point the network has reached an equilibrium, which can only be perturbed by some external factor, such as a further increase in bitcoin prices.

There are, however, some factors that could confer a sustainable advantage to some participants, allowing them to enjoy higher profits:

Technological advantage. This technological advantage could either stem from an innovation in the implementation of the proof-of-work algorithm (SHA256^2) in

silicon hardware4 or it could stem from a miner controlling a better chip manufacturing process, such as a big chip manufacturer entering the mining business.

3 The Red Queen Effect refers to situations where competitors must constantly evolve, not to gain an advantage but merely to survive in a highly competitive environment. It gets its name from Lewis Carroll’s Red Queen character when she explained to Alice that it took all the running she could do just to keep in the same place.

4 At the time of writing, an SHA256 hash function takes approximately 20,000 gates to build. A technological breakthrough that reduces that number significantly could spark a new episode in the ASICs arms race.

Mining

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Hedging Bitcoin volatility. A miner could get an advantage if she were able to hedge the Bitcoin price volatility more effectively than her competitors. Any miner could in principle hedge the Bitcoin price volatility using Bitcoin futures5 but, as of the time of writing, this market is almost non-existent. This advantage could be specially important during periods where the price of Bitcoin is depressed and competitors could be forced to shut down6. Furthermore, a miner who is able to hedge the volatility of her income would require a lower rate of return for her investment.

Lower electricity prices. Miners who are able to secure low electricity prices have a cost advantage. Bitcoin mining would likely migrate to places with cheap and abun-dant electricity, such as Iceland. This might even decrease the environmental impact of Bitcoin mining, as places with cheap electricity are usually able to generate it from environmental-friendly sources, such as hydro-electrical plants.

In summary, barriers to entry to the mining business are generally low, as there is no way for the incumbents to collude and prevent new competition from entering the network.

Therefore the network hash rate will probably stabilize at a rate where the mining reward just covers the marginal costs of running the mining equipment.



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