“Mining 2.0”: Capital investors are not limited to cutting leeks

After the BCH war, the price of Bitcoin plummeted and has already approached the psychological barrier of its 200-week average. As a result, the good days of miners are over. A video on Weibo about "mining machines being sold by kilogram" even became a hot search, causing panic in the market.

On the other side of the Pacific, American miners are also wailing. According to The Paper, Giga Watt, once the world's largest single mine, filed for bankruptcy protection on the 18th. The mine's residual value is less than $50,000, but its debt is as high as $10-50 million.

The miners who were originally used to maintain the stability of the blockchain network are powerless against the fluctuations in the price of the currency. If a blockchain network cannot even guarantee the stability of its own services, how can it expect thousands of ordinary people to rely on it for their lives?

A brief review of the construction of global Internet submarine cables shows that a prosperous Internet economy can only develop if the infrastructure is well built.

In 1990, there were only four submarine cables connecting the European continent to the surrounding islands; today, the number of submarine cables in the world has exceeded 400, and the number of routing nodes has exceeded 520,000. It is the neural network composed of them that drives the global Internet economy to continuously create new economic miracles, especially the submarine optical cables that were mostly built after the bursting of the Internet bubble in 2001.

In contrast, the number of nodes of Bitcoin, which wants to become the "first global currency", is fluctuating at any time. Although the Bitcoin network currently has 9,298 nodes, we don't know how many miners will survive this wave of bankruptcies.

The endless cutting of leeks may eventually completely destroy the blockchain technology.

It is particularly important to point out that the Bitcoin network is currently the most stable blockchain network. When Satoshi Nakamoto launched Bitcoin, he did not pre-sell any Bitcoin, and no VC had any privileges. Anyone who wanted to participate could deploy their own Bitcoin node and obtain Bitcoin through "mining". Therefore, when the price fluctuates greatly, those who invested in advance will not flee in a rush; but the decline of Bitcoin will indeed cause those miners who faithfully maintain the nodes to go out of business, or even go bankrupt.

According to Metcalfe's Law, when miners go bankrupt and the number of network users decreases on a large scale, the value of the network to users will decline exponentially, which may cause the price of the currency to fall further, thus forming a vicious cycle.

In response to this problem, a trend of generalizing the concept of "mining" has gradually surfaced. "Generalized Mining" was first proposed by CoinFund for the role of investors, mainly to restrict them from investing money and reaping the benefits without caring about the life and death of the project. They must actively participate in the construction of blockchain projects: mining, verifying transactions, operating nodes, resolving disputes... Only when everyone contributes value can the value of the entire network be maximized.

Later, the concept of "generalized mining" was further expanded in the practice of the blockchain project Livepeer, and gradually formed the concept of "mining 2.0".

Recently, Cambrial Capital sorted out the logic of these concepts and published them as a special topic in the "Token Economy" column of Medium. Blockchain Base Camp reorganized them as follows:

With the rise of more complex “n-sided-marketplace” blockchain networks such as Augur, Filecoin, Livepeer, Orchid, and Kleros, “third party economies” have gradually come into our sight and brought many very attractive speculative opportunities.

However, in the face of this emerging thing, we are still feeling our way forward, and it is not clear how to properly participate in its development as an investor. In order to better analyze the opportunities, we can start with the analysis methods of traditional fund investment strategies and analyze them step by step.

The task of miners and validators in the blockchain network is to spend some resources (or freeze some equity as a deposit) to participate in the competition or election of block generators according to the consensus protocol of the network. After successfully generating a block, they will receive some monetary rewards in the form of the network token, such as the transaction fee and block reward in the block. Of course, mining can also be used to combat the impact of inflation. These expenses can be regarded as necessary costs to ensure the security of the blockchain network.

Other participants in the blockchain network, such as transcoders in Livepeer and miners in Filecoin, are tasked with providing some required services to the network to earn fees. Unlike other networks, these fees are usually not in the form of the network token. The service fees in these networks are usually denominated in some other network tokens (such as some stablecoins). Blockchain networks of the "Work token" type belong to this category.

Finally, these blockchain networks often provide opportunities for third parties to profit, and sometimes this is intentional, such as guardians in the Maker network, payment channels in the Lightning Network, but sometimes it is not (such as front-running bots in the Steem network). CoinFund calls these profit opportunities "third-party economy", which is a very general term because it includes a basket of things, such as some are direct arbitrage, some are liquidity provision, bond market making, front running, "guards" (such as fishermen in the Polkadot network), or just some user interface or programmable interface layer that people will pay for.

Mining and Validation

Generally speaking, the ultimate winners in mining and validation services will be infrastructure companies and large trustees.

Because the underlying services need to be stable and efficient. Miners who conduct underlying mining and verification can be separated from the application layer of the blockchain economy, just like telecom operators who collect monthly rents, and accept the constraints of "network neutrality" or similar principles. Ultimately, the fundamental goal should be to provide users with stable and efficient blockchain network services.

Based on the economics behind Proof of Work (PoW) mining, we believe that in the future everyone will buy the same mining chips from 1-3 major manufacturers to compete on chip utilization and hourly electricity cost.

At first glance, you may think I'm talking nonsense, but I'll explain.

“Everyone will buy the same mining chips”

Chip production is a business with high research costs and high fixed costs. The reasons come from many aspects. From a technical perspective, chip design is extremely difficult, and from a commercial perspective, the production, promotion and distribution of chips require a lot of financial support, so much so that some people call the chip business a "bottomless pit" that burns money.

We think it is very difficult to prevent ASIC (Application Specific Integrated Circuits) mining on the valuable network of blockchain. What miners need to do in proof of work is to compete to perform a specific type of calculation, usually hash value calculation. If you can calculate faster than others, you win the right to generate a block. Each calculation is clear and specific, which means you can customize it at the chip level, and customization often means performance optimization. Take the first generation of mining equipment CPU: CPU is a very general processor that can be used to run operating systems, process strings, process images, etc. In contrast, the second generation of mining equipment GPU has more specific constraints. In most cases, it is slower than CPU, but GPU is much faster in vector operations, so it is used for image processing. The ASIC that dominates the mining industry implements logical reasoning through a single constraint. For example, you can design an ASIC "specially for Bitcoin SHA256 calculation mining". You don't even need to design this chip to be programmable. You can write the algorithm directly into the chip.

Therefore, as long as the blockchain network still uses the proof-of-work model to perform specific types of calculations, these manufacturers will be driven by economic interests to continuously optimize the computing power of chips. These chips are difficult and expensive to produce, so the production of chips will gradually become centralized. At that time, there should be only 1-3 manufacturers left in the market, so people will buy the same mining chips.

“Compete on chip utilization and hourly electricity cost”

When the chips are all the same, the only factor that affects the profit equation is the cost of electricity consumption. It is not difficult to imagine that the location of Bitcoin super mines is chosen in places with low electricity prices, such as Sichuan and Inner Mongolia. However, this is not the best. The ideal situation is that the cost of electricity consumption is "less than zero", that is, if you use electricity, the power supply bureau will give you money, which is not a fantasy. Because some types of electricity production are basically unadjustable, such as nuclear power generation and fixed solar photovoltaic power generation. In most cases, the power supply bureau will use nuclear energy as the main force of power output, and then use adjustable thermal power stations to meet the remaining power demand. However, sometimes the power supply bureau will mispredict future power demand, which may result in excess power supply. Electricity is not like other resources that can be discarded at will. In this case, the power supply bureau must deal with it, and it is very difficult to deal with gigawatts of electricity. The power supply bureau can only choose to spend money to deal with it. Therefore, there are places in the world where you can get paid just to run ASIC mining machines.

So in our view, proof-of-work mining is a game of general infrastructure, and the winner is more likely to be infrastructure companies. Mining is a traditional, high-fixed-cost industry that has little to do with high-tech companies.

Next, let’s talk about proof of stake and its variants.

In proof of stake and delegated proof of stake (dPoS), miners need to freeze some tokens as a deposit to vote on blocks. If the entire network reaches a consensus on the block, the miners will be rewarded. If the entire network disagrees with the block, the miners will be subject to some economic penalties (affected by inflation, etc.). From an economic perspective, proof of stake looks a bit like a fixed-income product, and mining is like buying a financial product that may suffer huge unexpected losses, but there is usually no risk.

Like Proof of Work, Proof of Stake is a pretty nifty two-way game: you either stake or you don’t. All tokens are equal in terms of profitability, you can’t risk a small bet on a large one, in other words, there is no gross margin leverage in the network. There is some operational leverage in the sense that Proof of Stake requires basic infrastructure (i.e. high fixed costs), but not a lot. The real leverage is in Delegated Proof of Stake. Given that Proof of Stake is a zero marginal cost business (as opposed to a business like car production that requires components and some assembly costs to produce a marginal unit), the large mining pools that manage delegated stake will receive outsized returns.

From the perspective of the stake delegator, delegating stake looks a lot like depositing cash into a bank account. You wouldn’t give your life savings to a bank that you know is unreliable. You’d put it in a bank that you know and trust (usually no more than two, according to cognitive load theory). People generally want to delegate their stake to mining pools that will eventually become the ICBC of the crypto world. We’re not sure which mining pool will win the hearts and minds in the end, but we think branding is important here. The mining pools that win the trust of the masses will win the competition. Like deposits, this won’t be a particularly profitable business (because it doesn’t involve a monopoly and competition will be fierce), but it’s a winner-takes-all business.

Basic Services

Provisioning services is a widely used term in blockchain networks. In this article, we refer to provisioning services as the basic services provided to end users through blockchain networks. They include:

Transcoder in Livepeer → End users want to watch live content on the network, and transcoders provide services to end users by providing computing power and bandwidth to the network.

Miners in Filecoin → End users want to store files, miners provide storage space to the network and periodically submit proof that the data is stored correctly.

Relayers in the decentralized anonymous proxy network Orchid → End users want to browse the Internet anonymously, and relayers act as routing nodes for this Internet content, ensuring that end users can hide their identities.

Fundamentally, most blockchain networks are multi-party markets where the number of participants is greater than 2. The blockchain networks mentioned above all confirm this view. Even Bitcoin can be seen as a market: users want a secure ledger to transfer funds, and miners provide this service in exchange for transaction fees and block rewards.

The most common situation is that a group of people need a certain service, and another group of people can provide it. The blockchain protocol as a platform helps them connect and enforce the rules, just like Didi Dache helps match passengers and car owners.

With the rapid development of blockchain networks, the services that the platform can provide have become more diverse, giving rise to the gig economy (an economic field composed of freelancers with a small workload) in the crypto world.

Take the decentralized arbitration platform Kleros, for example. In this platform, both parties can submit disputes to the decentralized network, and the arbitrators randomly selected by the network (or sometimes manually designated) will review and adjudicate the disputes. The arbitrator who successfully resolves the dispute will receive the arbitration fees paid by both parties. This is a legitimate business opportunity, but it is difficult for people to accept it in the short term. For example, it is still abrupt to see a hedge fund company hire a large number of lawyers and let them arbitrate disputes on the Kleros platform.

“Third-party economy”

As the name implies, a healthy blockchain ecosystem drives the prosperity of surrounding economic activities. We believe that both transactions and venture capital in the new economic system are investment opportunities.

For example:

• Act as a Guardian in the Maker Network → Collateralised Debt Position (CDP) arbitrage.

• Track trends in the Steem network and front-run transactions → Predict which content will become popular and bet behind it.

• Make markets in the Augur network (and arbitrage between markets).

In all of these examples, you are:

• Interact directly with blockchain protocols

• A certain amount of deposit has been frozen

• To trade

• Aims to make a profit

From this perspective, these investment activities are not much different from those of quantitative investment funds such as Renaissance Technologies, Two Sigma, and Jane Street. The only difference is that the investment takes place in different locations, one is a blockchain network and the other is the New York Stock Exchange, while the investment strategies are basically the same (such as market making, arbitrage, short-term price prediction, high-frequency trading, etc.)

From the perspective of the blockchain network, these investment activities are usually welcome and even essential for the normal operation of the network in most cases. For example, guardians are an integral part of the Maker network: active arbitrage guardians in the network help ensure that the DAI token is properly collateralized, while adding liquidity to the market maker guardians. In order to allow more people to participate, the Maker team has developed and open-sourced libraries to simplify the participation process, which means that they actively encourage the existence of guardians in the network.

In fact, if the vision of Decentralised Finance (DeFi) becomes a reality, we will need a large number of such participants to make these markets efficient. Our team member Edward has in-depth research on decentralized finance, specifically interest rates, spreads and yield curves in blockchain networks. We need more participants and liquidity to improve these indicators so that the market operates more efficiently.

Capital is not just about profiteering

There has always been a debate in our team: can capital parties achieve value growth by actively supporting and nurturing blockchain networks? As far as we know, those profitable early investors usually provide material support to blockchain networks at the stage of "from scratch".

But are investors really suited to play the role of operators in blockchain networks? Who should pay for the hardware costs of securing the network and the costs of engineers building these networks? Should investors provide advice and help build connections, or should they play the role of an outsourced growth consulting firm?

The best answer may be that the capital party provides the start-up capital for the blockchain network and gives financial support to the generalized miners in the network, and such support means hardly requires any hardware expenditure. For the capital party, the main goal is to participate in and support the project party's blockchain mainnet within a few months after the release. Especially for blockchain networks like Livepeer and Orchid, in these networks, due to latency issues, their number of nodes, transcoders, and repeaters are not enough to support the normal operation of the entire network. It is obviously valuable to provide timely assistance to the network at this stage.

Furthermore, supporting these blockchain networks from the earliest stages can also be a profitable activity. New blockchain networks compete with existing ones not only for users, but also for financial support. Miners in existing blockchain networks often already have configured software, mining strategies, and security strategies. If there is no attractive reward, why would they migrate to this new blockchain network with no program library, no ecosystem, and no liquidity? Venture capital funds that have invested in blockchain projects naturally have an information advantage in understanding (and influencing) token dynamics and how to best support blockchain networks, so they can obtain returns far exceeding the industry in the early stages of blockchain networks when competition is not fierce.

How to solve the most fatal pain points of founders without interfering in the management of the company? This is a question that the top capitals in the industry will think deeply about. For example, the Figment team deliberately split the business into Figment Capital and Figment Networks operating companies, of which Figment Network is the core holding company of Figment Capital. Although such tax payment efficiency is relatively low, it helps to solve the potential "tax safe harbor" problem. Figment believes that actively participating in the project will help them better understand the project and better guide project decisions from the perspective of capital.

Finally, Cambrial Capital wrote that as more investors participate in blockchain projects like they do in the New York Stock Exchange, they will endow blockchain networks with the efficiency and influence of traditional investments, helping blockchain transform from a capital experiment to a true global public infrastructure.