Understanding the Miners’ Behavior Game in Bitcoin Halving

This article comes from ChainNews

No matter how the price of Bitcoin changes, miners survive and the strong win. In order to survive and develop, miners must gain greater comparative advantages than their peers.

Written by Matt D'Souza, Sam Chwarzynski, Mason Jappa and George Adams, all of whom work at cryptocurrency mining service provider Blockware Solutions

Compiled by: Zhan Juan

Many analysts believe that there is a price floor for Bitcoin because there is a break-even point in the production costs of Bitcoin miners. This is not accurate.

In fact, as the price of Bitcoin gets closer to the cost of production for miners, Bitcoin selling tends to accelerate. Bitcoin prices have been facing selling pressure from miners. The support for the price actually comes from miner capitulation and a net reduction in hash power on the Bitcoin network - that is, a favorable difficulty adjustment. It is critical to understand how to analyze miner behavior with game theory.

The cost of a miner producing Bitcoin is determined by their electricity bill, because 95% of the operating expenses for miners are electricity. Bitcoin needs to reach a certain price before the Bitcoin income earned by miners can exceed the electricity bill. Miners who can get the lowest electricity price have a significant comparative advantage.

We will analyze it in the following steps:

1. Bitcoin Network:

   Who are the market participants and how do they influence the price of Bitcoin?

   Dissecting the various layers of the mining network

2. How the next generation of mining machines will level the playing field – allowing miners with high electricity prices to still stay in the game.

3. Break the myth that "the break-even point for miners is the lower limit of Bitcoin's price."

4. The impact of the 2020 halving on the Bitcoin industry - a three-game winning streak.

5. Mining Difficulty: Satoshi Nakamoto’s ingenious network stabilization mechanism — understanding its gravitational pull.

6. How miner capitulation accelerated Bitcoin's price bottoming out.

There are three main types of participants in the Bitcoin market:

1. Investment funds: Hedge funds, venture capital funds, family offices and other institutional investors. They almost exclusively adopt a "long only" strategy and rarely go short. They usually have a long-term bullish bias, but if their beliefs are tested, they have the ability to withdraw their positions at any time and walk away.

2. Hodlers: Long-term accumulators who seek to maximize their Bitcoin holdings. Hodlers have a long-term bullish bias and are less sensitive to price fluctuations than investment funds. However, like investment funds, Hodlers can withdraw their entire position at any time and leave.

3. Miners: The backbone of the Bitcoin network. Miners have a higher conviction in Bitcoin than investment funds and hoarders. They have a long-term investment horizon. They invest in assets with long life cycles that can neither be used for other purposes nor quickly cashed out at fair market value. For example, ASIC mining machines have a life cycle of more than 3 years and can only be used to mine coins with the Sha-256 protocol (almost only Bitcoin). Bitcoin mining facilities have a life cycle of more than 5 years and are usually renovated warehouses designed specifically to cool mining machines. On average, it takes miners 18 months to break even after investing money in mining machines, facility construction, and electricity expenses. Miners are the main driving force of selling pressure on the Bitcoin network. All newly issued Bitcoins are harvested by them, and they must sell Bitcoins to fund the capital expenditures and operating expenses of their mining operations.

Selling pressure from miners

About 54,000 new Bitcoins are mined each month. Assuming Bitcoin is trading at $10,000, that's $540 million in new Bitcoin supply released to miners each month. Of those 54,000 Bitcoins, miners must sell a large portion to pay for electricity. Miners with higher electricity costs must sell a larger portion of their Bitcoins to pay for electricity. So a large portion of the capital outflow on the Bitcoin network is driven by miners.

New Bitcoins released, i.e. potential selling pressure

Dissecting the layers of the mining network. The right picture shows the distribution of miners' electricity costs and the percentage of hash power controlled by miners at each layer. The percentage of hash power is derived from the percentage of Bitcoin mining rewards received by each layer.

How do next-generation mining machines level the playing field?

The dynamic has changed significantly over the past eight months due to the release of new generation miners. Bitmain’s S17 Pro 50T consumes 50% more energy than the S9 13.5T but produces 300% more hashing power. Deploying one S17 Pro 50T is equivalent to the hashing power of four S9 13.5T miners.

Tier 1 and 2 miners, who once accounted for a larger share of the network hashrate, have less incentive to upgrade to the next generation of miners due to their lower electricity prices. The older generation S9 13.5T uses 16nm chips, while the S17 Pro 50T uses 7nm chips. Innovations in chips have made electricity less important because each terahash consumes less power. The next generation of miners mitigates the financial impact of high electricity prices.

In contrast, inefficient older generation miners do not have much of a relative disadvantage at low electricity prices. From the perspective of Tier 1 and Tier 2 miners, the opportunity cost in Bitcoin/balance sheet depletion of upgrading mining equipment to achieve lower production costs is not worthwhile, given the percentage of older miners that are still on the network. As long as miners in other layers are still using older miners, Tier 1 and Tier 2 can still be competitive even with older miners.

Mining depends on survivability and being more competitive than your peers. As miners from layers 3-8 switch to new generation mining machines, when the hash they control approaches 100% in the future, layers 1-2 will be forced to upgrade. Bitcoin halving is likely to be the trigger for this event.

As long as electricity prices rise, it immediately becomes worthwhile to consume Bitcoin reserves/balance sheet to obtain funds to purchase the next generation of mining machines in terms of opportunity cost.

As early as May 2019, forward-thinking miners began predicting that S9s would be at risk of shutdowns due to the 2020 halving. As a result, over the past 8 months, tier 3-8 miners have actively entered a hardware upgrade cycle and moved to next-generation mining machines, while tier 1 and tier 2 miners are still running their older generation S9s.
Next-generation mining upgrades have increased the network hash rate by 80% and increased the proportion of the network hash rate represented by layers 3-8 — diluting the share of layer 1 and layer 2 in the overall network hash rate.

As a result, environmentalists’ predictions about the Bitcoin network have been thwarted. Many predicted that as the Bitcoin network exceeded a certain hash rate, it would cause excessive energy consumption. However, because mining machines are becoming more efficient, the energy consumption rate of the network hash has actually dropped significantly.

Understanding Bitcoin Miner Behavior

The following analysis will explain how miners operating under different electricity prices will cause selling pressure on the market when their profits are squeezed, and how selling pressure is relieved after unprofitable miners shut down (the impact of difficulty).

We simulated the behavior and decision-making of miners in different scenarios based on game theory. These scenarios do not propose a target price for Bitcoin, but rather illustrate how the mining network will be affected when Bitcoin is at various price levels before and after the halving.

For ease of simulation, we used a single average kWh rate for all miners in the same "mining layer". Only with this simplification can we confirm the number of miners that are "shut down" at each Bitcoin break-even price threshold. This also causes a waterfall to form when miners shut down, because it amplifies the magnitude of subsequent network difficulty adjustments and also amplifies the profits of remaining miners.

Because of these assumptions, the model creates a “step diagram” that helps conceptualize reality, but the real world is supposed to be a smoother, more linear progression.

To maintain consistency, this analysis makes the following assumptions:

• Bitmain's S17 represents the next generation of mining machines, while Bitmain's S9 represents the previous generation of mining machines. The percentage of the next generation and previous generation in the total network hash rate is currently 61.38% and 38.63%.

• Within each layer, the electricity price for all miners is uniform and based on the average kWh rate of all miners in that layer. Therefore, in this analysis, all miners in each layer have the same break-even production cost, and when the Bitcoin price falls below this point, all miners will shut down.

• During the analysis period, no new miners joined the network.

• The proportion of S17 and S9 mining machines in each layer varies, according to the distribution in the following table:

We have full confidence in these settings for the following reasons:

• Blockware Solutions, LLC is one of the largest distributors of Bitcoin mining machines in North America. Our customers and partners mine in the following countries and regions: United States, Canada, Mexico, Venezuela, Paraguay, South Africa, Iceland, Sweden, Norway, British Columbia, Germany, Eastern Europe, Kazakhstan, Russia, UAE, Iran, Mongolia, China, Japan and Australia. Our business scope is extensive: customer base, strategic partners, business partners and network, accounting for more than 20% of the total network hash rate.

• We conduct working meetings and peer reviews with the top mining pools and the largest ASIC manufacturers to gain a deep understanding of the distribution of hashrate, electricity prices and mining machine models in each region.

• We have visited a 30+ MW mine in Chengdu, China, as well as operations in hydropower-rich regions of upstate New York and the Pacific Northwest.

• Customers and partners in Sichuan Province, China, Venezuela, Kazakhstan, West Texas, Upstate New York, and the Pacific Northwest all have electricity costs below 3 cents per kWh, but most are using the previous generation of mining machines exclusively. They have little incentive to upgrade to the next generation of mining machines because the electricity prices are low and the benefits of using more efficient mining machines are not high, so there is little reason to upgrade to the next generation of mining machines because the cost is huge.

Bitcoin at $10K: Healthy profit margins for miners on every tier

When Bitcoin was trading at $10,000, every miner tier enjoyed healthy profit margins, especially S17 miners. However, for Tier 8 miners, S9 miners are close to the shutdown price point. Even at a high price of $10,000, Tier 8 S9 miners need to sell 96.3% of the Bitcoin they produce to cover their electricity costs.

Based on the above scenario, all miners must sell at least 39.12% of their Bitcoin (equivalent to $211,225,815) per month to cover their electricity costs. This means that new funds deployed by investment funds and coin hoarders must reach $211,225,815 per month to keep up with the fiat currency expenditures required by miners for their operations. The selling pressure from miners is continuous, while the new funds raised by investment funds and coin holders are driven by market sentiment and vary according to different stages of the market cycle.

When Bitcoin Price is $7,500: The Myth of “Miners’ Breakeven Point is Price Floor” Debunked

As the price of Bitcoin falls, miners’ profit margins are squeezed. As a result, they are forced to sell a larger percentage of their mining rewards to cover electricity costs (revenue is decreasing while expenses remain the same).

Let's look at miners operating S9s on layers 6, 7, and 8: As the price of Bitcoin approaches and breaks through the miners' breakeven price, miners are now operating at a loss. They must sell all the Bitcoin they mine, in addition to selling their previous Bitcoin reserves to pay for electricity. This creates selling pressure on the market in addition to the newly mined coins - the exact opposite of price support.

Understand the difference between actual operational results and theoretical ideas

Many people believe that when the price of Bitcoin reaches the breakeven point, miners can simply shut down and that they will not operate at a loss. This is a grossly misunderstood concept. Contractual obligations and poor financial management often cause miners to continue operating at a loss. This also forces miners to sell more coins than they mine; depleting Bitcoin reserves and creating additional selling pressure on the market:

1. Miners have negotiated lower electricity rates with power companies, but these prices are subject to meeting minimum electricity usage thresholds. Therefore, some miners may find that even if mining is unprofitable during a period, they still have to continue mining in order to meet the minimum usage requirements, otherwise they will not be able to enjoy the predetermined long-term electricity prices. (When it is unprofitable) They can't simply shut down for a week or a month and wait for Bitcoin to rebound.

2. Many miners send their mining machines to hosting facilities. These hosting contracts lock miners into a fixed rate for 1-2 years, charging a fixed monthly fee (determined by the price of electricity) per mining machine. If a miner defaults on a monthly payment, the hosting facility can seize the mining machine. As a result, many miners will mine for several months even if they are losing money, so as not to default and risk losing their expensive mining machines.

3. Miners turn into speculators. Miners are human, and therefore subject to emotional fluctuations. Many miners may try to adopt a strategy to time the sale of a certain amount of Bitcoin. Some miners may sell as soon as they receive a block reward, while others may choose to sell weekly, monthly, or only sell enough Bitcoin to cover their electricity bills. Unfortunately, when Bitcoin rises, miners often turn into speculators, hoping to catch a bull run. We shared some thoughts with one of the largest OTC desks in the crypto space. In September 2019, we discussed why some of the OTC desk’s mining customers deviated from their cash-out plans and chose to hold rather than sell their mined Bitcoin in July and August—because they believed that Bitcoin would continue to rise. However, Bitcoin peaked in late June, and these miners were forced to sell Bitcoin in September and October at much lower prices. This situation accelerated the sell-off of Bitcoin because the cashing out of Bitcoin reserves in addition to the newly mined Bitcoin created additional selling pressure.

Bottom line: When the Bitcoin price is $10,000, only 39.12% of the total Bitcoin mined per month needs to be sold to cover electricity costs. Once Bitcoin drops to $7,500, all miners’ profit margins will drop, and the Tier 6, 7, and 8 S9 miners will have to operate at a loss. As a result, 53.18% of the total Bitcoin mined per month needs to be sold to cover electricity costs.

Miner surrender roadmap

The explanation of the above picture is as follows:

1. Bitcoin is close to the break-even price of a certain miner. The miner's profit margin is squeezed, so he has to sell most of the mined Bitcoins. This creates greater selling pressure in the market.

2. Bitcoin fell below a miner's break-even price, leaving him operating at a loss.

3. The miner must sell all the bitcoins he has mined and his own bitcoin reserves to cover his electricity bills, which creates selling pressure on the market in addition to the newly mined coins.

4. This additional selling pressure accelerates the sell-off of Bitcoin, which continues until miners operating at a loss finally capitulate, wiping out their entire balance sheet and going bankrupt (which could take months).

5. After bankruptcy/capitulation, these miners shut down their machines, which also caused a reduction in the network's hash rate. This led to a favorable difficulty adjustment.

6. This difficulty adjustment transfers newly mined Bitcoins from inefficient miners to surviving miners. Surviving miners have healthier profit margins, which reduces selling pressure on Bitcoin prices and provides a healthier environment for Bitcoin's rise.

When Bitcoin was at $7,500 — before the halving

There are many inefficient, older generation miners still mining Bitcoin (layers 3-8 miners running S9). These miners cause the most selling pressure on Bitcoin, as they have to sell most of the coins they mine to cover their electricity costs. Layers 3-8 miners running S9 also have the highest breakeven Bitcoin price. They represent the pressure point in the current mining network that is putting downward pressure on Bitcoin price.

Bitcoin at $5,000 — before the halving

In the event that Bitcoin continues to fall to $5,000, the S9 miners on tiers 6, 7, and 8 will be forced to shut down. This results in a favorable difficulty adjustment that will also improve the breakeven price for all remaining miners.

However, despite the benefits of the difficulty adjustment, miners operating S9s on Tier 4 and Tier 5 are still operating at a loss at Bitcoin’s $5,000. Tier 4 and Tier 5 S9 miners represent a new pressure point in the mining network, making Bitcoin’s price very vulnerable. These S9s will follow the miner capitulation roadmap described above: they will begin to empty their Bitcoin reserves to pay for electricity costs until they go bankrupt and are forced to shut down — increasing the selling pressure on Bitcoin before shutting down.

Bitcoin at $5,000 — after inefficient miners shut down

After operating at a loss for a long time, the 4th and 5th layer S9s were also shut down. As a result, the remaining miners finally saw the difficulty adjustment in their favor. The 4th and 5th layer S9s that were shut down accounted for 14.5% of the total network hash rate. This means that after the shutdown, the new coins previously mined by the 4th and 5th layer S9s, that is, 14.5% of the new coins, will be redistributed to the remaining miners.

This redistribution will improve the breakeven price for the remaining miners and reduce the selling pressure on Bitcoin as the profit margins of the remaining miners will improve. Newly mined Bitcoin is now accumulating in the hands of strong hands (more efficient miners). The minimum selling pressure from miners has dropped from 69.60% to 51.49%.

When Bitcoin is at $5,000 — after the halving

At $5,000 after the halving, the network will have undergone a healthy cleanup and Bitcoin will be in a prime position to reach new highs again (even $8,000 would bring a substantial cleanup).

The May 2020 halving event will reduce miners’ rewards by 50%. Mining revenue denominated in Bitcoin will be reduced by 50%. In order to stabilize mining profit margins, the mining revenue denominated in USD can only remain the same if the Bitcoin price rises. This is critical because only in this way can miners finance their electricity expenses. All miners running S9s with electricity costs exceeding 2.5 cents per kWh (Tiers 2-8) and S17s with electricity costs exceeding 6.5 cents per kWh (Tiers 7 and 8) are operating at a loss, and extreme cases of miner capitulation will occur when they are forced to shut down.

When Bitcoin was at $5,000 — after the halving — and after inefficient miners shut down

Satoshi Nakamoto’s ingenious network stabilization mechanism: understanding the gravitational pull of mining difficulty on miners’ profit margins.

If the price of Bitcoin remains low for 2-4 months after the halving, many loss-making miners will be forced to shut down. After all loss-making miners shut down, the surviving miners will experience a huge release of profit margins. We will see a short-term network chaos, and once the inefficient miners shut down, the difficulty adjustment will restore stability to the world.

Difficulty: The Bitcoin protocol has a self-correcting mechanism that stabilizes the profit margins of the mining network to ensure that miners are sufficiently incentivized to continue to secure the network. Miners are the backbone and security layer of the Bitcoin blockchain. The difficulty mechanism ensures that efficient miners are incentivized to fulfill their role. This is one of the most underestimated and least understood phenomena in Bitcoin mining. If the mining network is experiencing profit margin compression, the least efficient miners will be eliminated layer by layer.

As inefficient miners shut down, there are fewer hashes on the network to produce timely blocks, so it takes longer for the network to mine a block. If the network does not produce a block within 10 minutes, a favorable difficulty adjustment will occur. The rewards that would have been earned by the miners who shut down are now distributed to the miners who remain on the network. This is considered a favorable difficulty adjustment. This process will continue until profit margins return to normal and even very attractive for the remaining/most efficient miners. Mining is a fight for survival. Difficulty adjustments will mitigate the impact of Bitcoin price corrections on miners that are operating efficiently.

The shock before the breakthrough - a three-game winning streak

• Halving — Improvement in supply-side economics

Many market participants are speculating about the future of Bitcoin. What is certain is that by mid-May, the potential selling pressure on Bitcoin will be reduced by 50% as the newly issued mining rewards are halved. A 50% reduction in supply-side issuance will reduce the supply of Bitcoin. This supply has been slowly decreasing as per the Bitcoin protocol code. This is a positive catalyst for the price of Bitcoin.

• The halving also improves the demand-side economy, triggering positive sentiment

Some economists may say that Bitcoin is worthless because it is currently too unstable to be an effective means of storing value and too slow to be an effective payment platform. Bitcoin maximalists say that Bitcoin is digital gold because it is scarce. Ultimately, it is the market that determines the price of Bitcoin.

Historically, Bitcoin has experienced sustained upside/bull cycles (with multiple severe price corrections along the way) as it heads toward the halving event. This historical trend is well understood by most market participants. Some have asserted that the halving is already priced into the Bitcoin price, but this cannot be proven unless you can confirm that most market participants have mobilized their cash positions and reached their target price. Market participants disagree, but most hold some amount of cash positions. Everyone knows the halving date, which will create positive sentiment on the demand side.

This psychological positivity will have market participants anticipating and preparing to mobilize cash positions for upward momentum. Everyone knows about previous Bitcoin halvings, and everyone has missed a big Bitcoin rally at some point — which is why Bitcoin has more “hoarders” than any other asset. Hoarders don’t want to get hit again and miss out on a big rally. This is a market, and markets are driven by human psychology. The psychology of Bitcoin market participants, before the halving, is biased toward bullishness. This creates positive sentiment on the demand side of Bitcoin.

• An opportunistic environment: capitalization due to available debt

After the Bitcoin network experiences significant or sustained favorable difficulty adjustments, the likelihood of a Bitcoin price bottom increases (https://bitcoin.blockwarepool.com/mining-data) . This is because newly mined Bitcoins are now distributed to and accumulated by the most efficient and financially healthy miners. The amount of Bitcoins received by the remaining miners is proportional to the amount of Bitcoins received by the shut-down miners. This rare opportunity to earn money allows the surviving miners to accumulate a large amount of Bitcoin.

Many market participants are quickly gaining access to a new stimulus. Through centralized lenders and decentralized lending platforms, miners can use their mined Bitcoin as collateral in exchange for cash or stablecoins to obtain debt. Now, miners can also hold Bitcoin instead of selling it, of course, they still have to bear the expenses of electricity, hosting contracts, purchasing more mining machines or further expanding infrastructure, etc. In short, this change reduces the selling pressure from the network, which we believe will be an important catalyst for the rise in Bitcoin prices.

When more Bitcoin is accumulated by strong hands, it may be hoarded for a long time, which is equivalent to removing a certain amount of supply from the network. These experienced miners have witnessed miner capitulation before and have a strong amount of Bitcoin on their balance sheets. Many people choose to hold Bitcoin when they feel the price is low. For miners holding a large amount of Bitcoin, obtaining debt on the market will be another tool for them to hold Bitcoin during price corrections, which will reduce selling pressure and accelerate the bottoming out during corrections. Of course, this may also be another stimulus for the network, and its results deserve careful observation, because debt often ends in tragedy when accompanied by excessive speculation.

Combining the above three forces, we can expect a strong multiplier effect as the economics of both the supply and demand sides of Bitcoin prices improve dramatically. This is why the halving is bullish for Bitcoin prices.

As Bitcoin rallies to $7,500 — post-halving — how miner capitulation could accelerate the bottom

After a miner shuts down (capitulates), newly mined Bitcoin is distributed to the most efficient miners, which minimizes selling pressure on the Bitcoin market because these miners are well above their breakeven point. There is some friction in selling Bitcoin when miners shut down, and there is also some friction for miners to restart their machines when Bitcoin rises. Many miners may be months in arrears on electricity, hosting fees, or land leases, and cannot restart without paying the funds owed for multiple months. This makes it easier for the price of Bitcoin to rise, as the price rises, only a small portion of the newly mined Bitcoin needs to be sold to cover the cost of electricity (cost remains the same) because the surviving miners have healthy profit margins.

Miners who have shut down their machines cannot start up their machines in sync with the rise in Bitcoin price. There is a similar friction when miners operating at a loss cannot shut down their machines immediately when the price falls. When Bitcoin price rebounds after a major difficulty adjustment, it creates a favorable environment for efficient miners who do not need to shut down their machines, and they will also receive a larger part of the pie.

As Bitcoin bounces to $10,000 — post-halving — how miner capitulation could accelerate price bottoming

Friction prevents inefficient miners from restoring their machines in time. As a result, all newly mined Bitcoin rewards are obtained by efficient miners, so the minimum selling pressure from newly mined Bitcoin continues to decrease. When the Bitcoin price reaches $10,000, the minimum proportion of selling pressure from miners drops to 23.33%.

The following comparison nicely illustrates how healthy cleanup can be by removing inefficient miners and reducing potential sell pressure on the network:

The cycle repeats itself: Bitcoin rises to $10k – after the halving – and then rises after the difficulty adjustment

After the price of Bitcoin has been rising for a long enough period of time, inefficient miners are finally able to turn their machines back on. This results in an unfavorable difficulty adjustment as more miners compete for the same amount of Bitcoin. This causes the minimum percentage of selling pressure from miners to increase from 23.33% to 51.49%.

This is a good example of the gravitational pull of mining difficulty, and of course, what we see is an unfavorable difficulty adjustment due to miners joining the network, which leads to a compression of profit margins. Difficulty adjustments keep the mining network stable and also provide sufficient incentives to maintain Bitcoin's security layer.

Over time, determined and efficient miners will have ample margins to remain profitable regardless of Bitcoin price fluctuations. Eventually, mining difficulty will eliminate miners that are inefficient, but when Bitcoin prices rise sharply in the short term, even inefficient miners can enjoy healthy profit margins.

Many people fear the halving. But if you understand the psychology of miners, and how game theory drives people's behavior, before and after the halving, then the efficient miners should welcome the halving. Miners with the most efficient mining machines (with electricity costs less than 6.3 cents per kWh) will experience pain, but will survive.

Bitcoin will naturally face selling pressure from miners, which will drive down the price of Bitcoin. After the halving, less fiat will be needed to offset the miners' selling pressure. As a result, by injecting enough new fiat into the system, investment funds and coin hoarders will be more able to stabilize the downward pressure and achieve a long-term increase in the price of Bitcoin.