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Original source: "What is the essence of cryptocurrency?"
By Chris Dannen, Leo Zhang and Martín Beauchamp, all of Iterative Capital
Compiled by: Katt Gu
This article is excerpted from the report “What is the Nature of the Cryptocurrency Phenomenon?” written by Iterative Capital, a cryptocurrency management company. Iterative Capital is an investment management company focused on mining and operates i2 Trading, a North American cryptocurrency OTC trading platform.
Cryptocurrency Essence Series:
1. The Historical Background of Cryptocurrency from 0 to 1
2. The Birth and Development of Hacker and Cypherpunk Culture
3. What is the halving theory?
Compared to token issuance, venture capital, or volatility trading, mining is less marketed in the capital markets, making it the most predictable cryptocurrency investment activity. The profitability of mining is affected by the semiconductor cycle, energy costs, and the overall performance of the cryptocurrency market. Although mining investment is essentially a long-term investment, as long as miners can optimize their overhead and purchase machines at fair market prices, they can reduce the cost of mining. A miner's decision to purchase hardware or support a specific network is far less influenced by short-term market trends than by the characteristics of the network protocol and the technical life cycle of the purchased hardware. Basic factors that miners consider include but are not limited to the following:
Select a viable network.
Buy hardware from the right hardware manufacturer at a reasonable price.
Adjust purchase timing according to hardware cycles.
Energy costs and other overheads for hosting facilities.
Security and staffing of hosting facilities.
Fluid reward management.
Local regulations and taxes.
There are two main factors driving the mining market dynamics: hash rate growth and price fluctuations. Fundamentally, these two factors are closely related. A higher hash rate enhances the security of the blockchain, making the network more valuable; in turn, as the price of the associated currency grows, the demand for mining equipment will also increase, which means that competition between mining hardware suppliers will intensify to capture that demand.
Despite the dramatic decline in Bitcoin spot prices so far, the Bitcoin network’s hash rate has been growing at an astonishing rate. Since January 2018, Bitcoin miners and traders have been living in completely separate worlds: miners continue to reinvest in hardware and facilities in anticipation that engineering progress at the core protocol level will bring about the next round of price increases. Because miners control liquidity, this is almost a self-fulfilling prophecy. (An appendix discussing popular notions about price trends is given at the end of this article.) Figure 11: Despite the decline in Bitcoin prices, the hash rate continues to grow. (Source: bitinfocharts.com)
The mismatch between hash rate growth and price fluctuations is the result of the hardware market and capital market being out of sync. Under normal circumstances, mining difficulty can be predicted by wafer shipments from semiconductor producer TSMC, which accounts for 90% of Bitcoin ASIC production. Foundry lead times (typically three months) are longer than Bitcoin price cycles, meaning that wafers that have already been put into production during Bitcoin price declines will result in excess capacity.
Figure 12: Demand for TSMC wafers may decline due to unsustainable mining profits. (Source: Morgan Stanley Research)
On the other hand, due to the cumulative nature of proof of work, higher hashrates flowing into the network will make the system more secure and reliable. Higher finality means that the system will be more stable when processing transactions and more convenient for third-party developers to develop on the system.
Cryptocurrencies that use proof of work closely link capital markets and distributed networks by design. As the price of Bitcoin has continued to rise over the past decade, the mining industry has developed into a huge industry. In the first half of 2018, Bitmain, the largest cryptocurrency ASIC manufacturer, reported $2.5 billion in revenue and $1.1 billion in profits.
Figure 13: Bitcoin miners’ income in recent years. (Source: Frost & Sullivan)
The rise of specialized hardware
Over the years, cryptocurrency mining tools have evolved from CPUs to GPUs to specialized hardware like FPGAs (field programmable gate arrays) and ASICs. Due to the competitive nature of the industry, miners are incentivized to purchase more efficient hardware, even if it means paying a higher upfront cost for those machines. As some hardware manufacturers upgrade to faster, more efficient machines, others are forced to upgrade as well, and a race for equipment is born. Today, for the more prominent networks, mining is primarily performed with ASICs. Bitcoin’s sha256d is a relatively simple calculation; the job of a Bitcoin ASIC is to perform trillions of SHA256d hash function calculations per second, something no other type of semiconductor can do.
First introduced to the market in the 1980s, ASICs have transformed the chip industry. In the cryptocurrency world, ASIC manufacturers such as Bitmain design chip structures based on a specific hashing algorithm for a given network. After many iterations and tests, the circuit photomask designs are sent to foundries such as TSMC and Intel as part of a process called "tapeout." The actual performance of the chip is not known until the chip returns from the foundry. At this point, ASIC manufacturers need to optimize the thermal design and chip alignment on the hash board before the product is ready for production use.
The rise of application-specific hardware is inevitable and a necessary trend in the computing hardware cycle. Similar to how gold mining and oil drilling technology have evolved as the value of the underlying commodity has continued to increase, application-specific hardware for cryptocurrencies is also improving rapidly as cryptocurrencies become more important. While short-term price behavior is primarily driven by speculation and has been observed to be uncorrelated with hash rate, in the long run these two factors form a virtuous feedback loop.
Figure 14: Market size of the global blockchain hardware market, by revenue and growth rate, 2012-2020. (Source: Frost & Sullivan) Figure 15: China's blockchain hardware market size from 2013 to 2020, divided by revenue and growth rate. (Source: Frost & Sullivan) ASIC Manufacturing: Past, Present, and Future
Cryptocurrency miners are a type of heterogeneous computing system, that is, a system that uses more than one type of processor. Heterogeneous computing is becoming more common as Moore's Law slows down. Gordon Moore, the creator of the eponymous law, predicted that transistor density in semiconductor manufacturing would produce continuous and predictable hardware improvements, but that these improvements would only have 10-20 years before reaching fundamental physical limits.
The first generation of Bitcoin ASICs included China's BakedCat, Sweden's KNC, and the United States' Butterfly Labsh and Cointerra. Application-specific hardware soon showed their promise. The first Avalon miners became available in February 2013. By May, about a third of the network was supported by their unparalleled computing power.
The key to integrated circuit competition lies in how quickly a company can iterate its products and achieve economies of scale. Without sufficient hardware manufacturing experience, Baked Cat quickly lost market share due to delays and a series of key technical errors.
Around the same time in 2013, Jihan Wu and Zhan Ketuan founded Bitmain. In the early days of Bitcoin ASICs, simply improving the density (i.e., technology node) of the previous generation of chips provided an immediate and effective upgrade. It was always expensive to obtain advanced technology nodes from foundries, so the challenge was not in superior technical design but in the ability to raise funds. Shortly after Bitmain was founded, the company launched the Antminer S1 using TSMC's 55nm chips.
In 2014, the cryptocurrency market entered a long bear market, with the price of Bitcoin falling by nearly 90%. By the time the market recovered in 2015, the Antminer S5 (Bitmain's latest machine at the time) was the only one still in production. Bitmain quickly established its dominance. Subsequently, engineers from Baked Cat joined Bitmain to develop the S7 and S9. These two machines later became the most successful cryptocurrency ASIC products sold to date.
The semiconductor industry is developing rapidly. Increased competition, production innovations, and economies of scale mean that chip prices will continue to fall. For large ASIC mining companies to maintain their profit margins, they must relentlessly seek more design improvements.
Changes in the hardware industry
In the past, producing faster chips simply required placing transistors closer together on the chip substrate. The distance between transistors is measured in nanometers. As chip designers begin to use cutting-edge technology nodes with transistor distances as low as 10nm or 7nm, the increase in chip performance may not be proportional to the reduction in the distance between transistors. As of March 2018, Bitmain reportedly attempted to tape out new Bitcoin ASIC chips at 16nm, 12nm, and 10nm. All of these chips allegedly had problems with tapeout, causing the company to lose nearly $500 million.
After the 2017 bull run, many new original equipment manufacturers (OEMs) are entering the Bitcoin ASIC space. While Bitmain remains the absolute leader in terms of scale and product sales, the company is clearly lagging behind in terms of the performance of its core products. InnoSilicon, Canaan, Whatsminer, Bitfury, and others are catching up quickly, squeezing the profits of all players in the market.
As the rate of technology node improvements slows, ASIC performance becomes increasingly dependent on a company's architectural design capabilities. Therefore, having an experienced team to implement fully customized chip designs is critical to the future success of ASIC manufacturers. In the long run, ASIC designs will become more open source and more accessible, leading to commoditization.
Figure 16: Mining hardware and mining difficulty (Source: "The evolution of bitcoin hardware")
Bitcoin mining started out as an activity for hobbyists, done with laptops. From the chart above, we can see the acceleration of industrial mining. Today, industrial mining groups, cloud mining providers, and hardware manufacturers no longer run mining equipment in garages or basements, but instead build or refurbish data centers specifically for cryptocurrency mining. In places with abundant electricity, such as Sichuan, Inner Mongolia, Quebec, Canada, and Washington State, USA, large facilities with thousands of machines operate 24/7, 365 days a year.
In the cutthroat game of mining, constant infrastructure upgrades require operators to make deployment decisions quickly. Industrial miners work directly with mining machine manufacturers on overclocking, maintenance, and replacement. The facilities where they host mining machines are optimized to run the machines at full capacity with the maximum possible uptime. At the same time, large miners sign long-term contracts with some power plants to obtain cheap electricity. It's a win-win situation; miners can get a lot of electricity at a near-zero price, and power plants can get a stable demand for grid electricity.
Over time, cryptocurrency networks will behave like evolving organisms, continually searching for cheap and underutilized energy sources and increasing the utility of distant facilities that exist outside of existing industrial centers. Cryptocurrencies that use proof-of-work rely on adding new blocks to the blockchain to maintain consensus.
Over the years, many have expressed concerns about the large amount of energy consumed in the production of Bitcoin. Satoshi Nakamoto himself responded to this concern in 2010, saying:
“It’s the same story with gold and gold mining. The marginal cost of gold mining tends to be close to the price of gold. Mining gold is a waste, but that waste is far less than the utility of using gold as a medium of exchange. I imagine the same is true for Bitcoin. The utility of the transactions that Bitcoin enables greatly exceeds the cost of electricity. Therefore, not having Bitcoin would be a net waste.”
The "delicate balance of terror" when miners rule
In non-permissioned cryptocurrency systems such as Bitcoin, large miners are also potential attackers. Their cooperation with the network is based on profit; if the attack becomes profitable, then large miners are likely to try to attack. Those who have followed the development of Bitcoin in recent years know that the topic of miner monopoly is controversial.
Some participants believe that ASICs can undermine the health of the network in various ways. In the case of hash rate concentration, the community fears that miners will unite to launch a so-called 51% attack, where miners with a majority of the hash rate can use this computing power to rewrite transactions and spend the same funds twice. This attack is common in smaller networks, where it is cheaper to achieve 51% of the hash rate.
Any mining pool (or coalition of mining pools) with more than 51% of the hash rate has a “nuclear weapon” in the network. This is essentially holding the community hostage using hash rate. This scenario is reminiscent of Cold War nuclear strategist Albert Wohlsetter’s ideas about the delicate balance of terror:
“Balance does not occur automatically. First, because thermonuclear weapons offer an enormous advantage to an aggressor, it takes great wisdom and realism to engineer a stable balance at any given level of nuclear technology. Second, the technology itself is changing at an alarming rate. Deterrence requires urgent and sustained effort.”
While large miners could theoretically launch an attack to reverse consensus history in their favor, they could also push the market in a way that is not favorable to them, causing a sudden crash in token prices. Such a price crash would render miners’ hardware investments and long-term holdings worthless. In situations where high concentration is created, secret 51% attacks would be easier to pull off.
Figure 17: Miner concentration in mining pools (Source: blockchain.com)
Over the past few years, Bitmain has dominated the market in the form of hash rate concentration and manufacturing concentration. At the time of writing, analysts at Sanford C. Bernstein & Co. estimate that Bitmain controls 85% of the cryptocurrency mining chip market.
The tyranny of structurelessness under the rule of core developers
While malicious miners pose a constant threat to permissionless cryptocurrency systems, the dominance of core software developers can be equally detrimental to the integrity of the system. In a network controlled by a small number of elite technical people, miners and full node operators who run the code may not be able to easily detect spurious changes to the code.
Communities have taken various approaches to combat the outsized influence of miners. The Siacoin team decided to produce their own ASICs after learning about Bitmain’s Sia miners. Communities like Zcash have cautiously welcomed ASICs. New projects like GRIN have designed their hashing algorithms to be RAM (random access memory) intensive, making ASICs more expensive to manufacture. Some projects like Monero have taken even tougher measures, changing their hashing algorithms just to disable one manufacturer’s ASIC machines. The fundamental disagreement here is not about “decentralization” but about which faction controls the way the coinbase rewards are generated that the market values; it’s a fight for control of the “golden goose.”
Due to the highly dynamic nature of decentralized networks, taking swift action against the concentration of power around miners can lead to the opposite extreme: the concentration of power around top developers. Both concentrations of power are dangerous. The latter extreme can lead to a tyranny of the structureless, where the community worships the top committers in a cult of personality without the false premise of a formal hierarchy of power. The term comes from social theorist Jo Freeman, who wrote in 1972:
“As long as the structure of the group is informal, the rules for how decisions are made are known only to a few, and the perception of power is limited to those who know the rules. Those who do not know the rules, and who have not been chosen as initiates, must remain confused or fall into paranoid delusions that something is going on that they do not quite understand.”
The lack of a formal structure can act as an invisible barrier to new contributors. In the context of cryptocurrency, this means that the open-distribution governance systems we discussed in the previous section can go awry despite the incentive to bring more developer talent to the team (thereby speeding up the project and increasing the value of the network).
The dominance of miners or developers can lead to changes in the development roadmap, which can undermine the entire system. One example is the bad decisions made by those "big block parties". The Bitcoin network split in two on August 1, 2017 due to the will of some miners to support larger block sizes, which led to increased costs for full node operators. For blockchains that use proof of work, these operators play a vital role in enforcing its rules. Higher costs may mean that there will be fewer full node operators on the network, which in turn makes it easier for miners to upset the balance of power for their own benefit.
Another example of imbalance is the Ethereum Foundation. While Ethereum has a strong community of DAPP (decentralized application) developers, the core protocol is determined by only a small group of project leaders. In preparation for Ethereum's Constantinople hard fork, developers decided to reduce mining rewards by 33% without consulting miners. Over time, alienating miners can cause the network to lose support from a major stakeholder group (the miners themselves) and create new incentives for miners to attack the network for profit or revenge.
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