On May 2020, Bitcoin (BTC) will witness two significant events. Coming up is Bitcoin Pizza Day which occurred back in May 22, 2010, when BTC was first used to make a commercial order payable for pizzas. The more important event is called the halving, and it is a part of the Bitcoin protocol’s incentive system. The ETA is that around May 11–15, 2020, the halving will occur. This will lead to a block subsidy reduction or in simpler terms a reduction in Bitcoin rewards to miners. The current block reward is 12.5 BTC for every block a miner validates, so that means when the halving occurs the block reward will be cut in half to 6.25 BTC. That affects the community of miners significantly and it seems the impact will be on the profitability of mining Bitcoin.
Mining Explained
The purpose of the halving is to reduce the inflation of Bitcoin by limiting the amount that goes into the circulating supply. It seems this was done by the design of its creator Satoshi Nakamoto to provide a deflationary model that values the scarcity of the digital asset. This is according to the same concept as mining gold. Bitcoin as a digital asset can be similar in features to a physical asset like gold. Like gold, Bitcoin requires a process called mining. Bitcoin mining is a totally digital and electronic process, but the idea is that it must be created from the work of miners. The miners, in the case of Bitcoin, are nodes or computers on the network.
When gold is mined, their miners expend resources that require extracting the precious metal from the Earth. Gold mining operations can be as simple as panning along streams or using heavy machinery to cut into rocks. Bitcoin miners use computer processing power and expending electricity as their resources for mining. The process of extracting gold and mining Bitcoin are part of the costs in giving those assets value. In Bitcoin, the incentive given to miners are new coins as a reward for the contribution of their compute resources.
The Bitcoin blockchain is open to anyone who wants to be a miner, but they must contribute their computing resources to what is called the Nakamoto Consensus or Proof-of-Work (PoW) consensus mechanism. In mining BTC, miners must compete with each other to solve a cryptographic puzzle. The miners must use specialized mining devices which are specified in hash rate. These devices can compute trillions of hashes per second (TH/sec). The higher the hash rate, the better. The hashes refer to a one way cryptographic hash function using the SHA256 algorithm.
Miners must first take the transactions from the node mempool and hash them into a block. They must then add a random hexadecimal number with the block and hash it again. The result or solution must be less than or equal to a value called the difficulty target. Using a probabilistic consensus, the first miner that discovers the solution to the puzzle called the nonce becomes the block’s validator. The miner who validates adds the block to the blockchain and collects BTC as their reward. On average, block propagation time on the Bitcoin blockchain is every 10 minutes. Miners also collect a transaction fee as another form of incentive when they verify transactions during consensus.
The whole process is part of the PoW consensus mechanism which provides an agreement on the validity of transactions on the blockchain and also protects the network from attacks. This is because once the block has been validated, a bad actor or hacker cannot reverse or modify a transaction unless they have the majority of hash power on the network. That can be very expensive to the point where it is much better to mine than to attack. All transactions in the block are immutable, so consensus also provides security for the blockchain.
Impact Of Halving
There have been plenty of views from around the cryptocurrency community about what the overall impact will be on miners. A reduction in the incentives is not exactly what miners want, but that is part of the Bitcoin source code. The halving occurs on the Bitcoin blockchain after every 210,000 blocks, which is approximately every 4 years. This is identified in the Bitcoin source code as:
“Consensus.nSubsidyHalvingInterval = 210,000”
Cutting the rewards for miners will be less incentive, so the effects on profitability remain the question. Established mining pools will be faced with finding the balance of operating costs and mining rewards.
Another thing to consider is the difficulty target. This can increase if the hash rate is high (meaning there are more miners on the network) or decrease if the hash rate is low (meaning there are less miners on the network). If the halving leads to an exit of miners, it will bring the difficulty target down. That can be an opportunity for new miners to enter the network, so it is somewhat like a reset button. Established mining pools can split up to smaller mining pools to maximize on rewards. The larger mining firms, who have the highest hash rates may reconfigure their systems to cut costs by retiring older mining devices and prioritizing newer investments in resources.
There are fixed costs for all miners. This is mainly the cost of the mining devices and electricity. If it was the same for everyone, it is fair to say that when the halving occurs all profitability gets cut in half. For miners who have higher hash rates it is a different story because they also have the highest operating expenses. To achieve higher hash rates would require having more devices, so that is why they would have to retire some of them in order to cut down on operating expenses. The block rewards in the past allowed these miners to offset operating costs, but with the halving they will have to scale back.
This is the opportunity for new miners to enter since the scaling back will mean a decrease in the difficulty target. That makes it easier to become a miner during the start of the halving, but eventually the difficulty target increases as more miners enter the network. This is also a time for miners with inefficient mining rigs to begin retiring their older devices and invest in more advanced ASIC rigs that give higher hash rates.
Cutting the costs of electricity is another measure miners could take to maximize profitability after the halving. Miners will also want to consider their sources of electricity. It has become more ideal to setup mining operations not just in places where electricity is cheap, but where the climate is cold for most of the year. Locations like northern Canada and Iceland have become ideal due to the colder temperatures which favors controlling overheating of mining devices and the cheap cost of electricity due to renewable sources like geothermal energy in Iceland.
Examining The Costs
Post-halving, for miners to get the same amount of BTC rewards, they will have to run twice the number of computations, along with an increase in electrical costs. If the costs of having too many mining devices is not above or at a break even point, they will have to be retired. As a miner, it is about maximizing profits and cutting costs or keeping them low. The devices themselves quickly lose value once put into production in terms of accounting i.e. depreciation of assets. If you are only going to make half of what you used to make as a miner, reconsidering the current mining configuration becomes important.
I am going to give an example of a theoretical miner’s operation. We will have to consider 4 factors involved in mining, namely:
- Hash Rate (TH/sec)
- Bitcoin Price (Market Value in $USD)
- Electrical Power Consumption (W)
- Cost Of Electricity (KWh)
Let’s assume the miner is using an Antminer S17 which has a hash rate of 70 TH/sec and maximum power consumption of 3,313 W. The price of Bitcoin is $7,158.00 per 1 BTC. The cost of electricity is $0.12 per KWh. Your daily cost to operate the miner at full power is $9.54. In one month that is (using 30 days) $286.24 and in one year of continuous non-stop operation it is $3,434.92. That is quite a lot of money for electricity, so the miner must be able to offset that with BTC rewards. Right now we are just starting with 1 mining device for simplicity’s sake.
Assuming the current incentive is 12.5 BTC valued at $7,158.00 per BTC, the miner will make $89,475.00 by validating just one Bitcoin block. Now that is in theory, if there is only one miner without any competition. We have to remember that this is a probabilistic consensus in which there are more than one participant.
The truth is there will be more miners competing so the hash rate will increase, making the 70 TH/sec hash rate less capable compared to a 1400 TH/sec ASIC miner. Based on an online mining calculator, with the specifications used above the miner will actually be at a loss. This means your typical miner must have more than 70 TH/sec to break even. Based on this calculator, that would be around (with no changes to cost of electricity) 182 TH/sec and nothing lower. Miners can use these calculations to figure out what costs they can cut. The current total hash rate on the Bitcoin network (as of 4/18/20 17:00:00 GMT) is 113.4030 EH/sec (Exahash per second).
When the halving comes, there could be a big exit of miners who will need to remove some mining devices from production to cut their costs. This should bring the hash rate down and therefore also decrease the difficulty target. Miners can start mining at a lower hash rate until the hash rate increases again with the return of more miners.
Other miners may just capitulate if they cannot maintain the costs of their current systems with half the rewards. This miner could have accumulated ASIC mining devices to increase their hash rate while the incentives were still profitable. Now the additional hash power just adds more to operational costs rather than validating blocks so it becomes necessary to retire unproductive resources. That is just a part of the business. The advantage will be the miners who have the best and most efficient ASIC mining devices.
Scarcity & Appreciation
What gives gold and Bitcoin their value is their scarcity. You don’t produce gold or BTC out of thin air, otherwise everyone can have it and becomes less valuable. It requires labor to extract gold and work to process Bitcoin. It becomes even more valuable when the supply is not infinite, but finite in the case of Bitcoin. There will only be 21 million BTC in total, and this is distributed every 10 minutes on the Bitcoin blockchain. The point of halving is to control the amount or supply of BTC being distributed so as not to quickly deplete the total supply of BTC. When an asset’s supply is scarce, it becomes more valuable due to the demand. So long as there is a demand for BTC, that is the driving force that increases price value in the open market.
The appreciation of Bitcoin value as a digital asset has also been a primary motivation among miners. If the price value is high, it certainly doesn’t matter if there is a reduction in the rewards if it is more than the previous. This has made BTC the strongest cryptocurrency in the market because of its store of value. At least that is what it has come to be. Though the intention of Satoshi Nakamoto was for BTC to be used as a digital medium of exchange in a P2P electronic payment system, investors are instead treating it like digital gold. You are less likely to see BTC being used to buy items like a cup of coffee or even a donut. There are those who believe it is not ideal for micropayments and has more significance as a GPT (General Purpose Technology) for storing value. That is very much the same with gold, since you cannot use a nugget or speck of gold to purchase snacks at a gas station.
Will Mining Be More Centralized?
Another talking point is that the halving could centralize mining. This is because when you have less block rewards, miners could consolidate into one larger mining pool to increase hash power and maximize profits. Unfortunately for smaller mining pools, these larger pools possess more hashing power that could prevent other miners from validating blocks. This mismatch is rather expected though because you certainly will not be able to validate a block using a desktop computer when you are up against ASIC devices. Your best shot would be to join a mining pool to contribute your share of compute resources and get a reward if a block is validated proportional to your contribution.
What could also end up happening is a more decentralized mining community. With the halving of rewards and not immediate price action, miners may split from their pools to try to maximize their profits. Larger pools could split into smaller pools while new miners enter as others exit the network. Larger pools may also remove inefficient miners and prioritize those with the latest ASIC devices. This would make sense since older mining devices are just no match to the newer products available. At this point it is fair to say that some pools could disintegrate due to inefficiency while others could consolidate to put their resources together.
A more serious concern should the majority of hashing power fall under a single miner is the “51% Attack”. The good thing about Bitcoin’s theoretical design is that it has checks and balances. If you own the majority hashing power on the network (e.g. 51% of hashing power) you can control the transactions from that point forward, but not reverse transactions in the entire blockchain. The larger the blockchain, the more secure it should be to attack and the harder for anyone to try to reverse what are called historical blocks. It also requires plenty of compute resources and hashing power that it makes attacks more expensive, and will financially ruin the attacker. Thus it discourages attacks because the costs are greater than just mining. Nodes on the network can also do another thing to put an end to such attack and that is activate a hard fork, which is an entirely different blockchain. That would split the blockchain and leave the attacker behind as the miners move to a separate network.
Mining Continues
The market signals after previous Bitcoin halvings indicate an increase in price value. Therefore it is not likely to lead to what some reports consider a death spiral for miners due to the reduction in rewards. As long as there is an incentive on the network, there will be miners validating blocks on the blockchain. When the last halving occurred on July 16, 2016 the price originally dipped to $610 and then shot back up. That can also happen with any halving event. What happens to price value can also be influenced by what the miners do that can affect the network’s hash rate.
Block rewards to miners remains an important part of the Bitcoin blockchain. As long as it is incentivized, then it should continue to work. It can be viewed as a Zero-Sum Game theory among the miners as they compete to validate blocks. As long as there are blocks to process, there will be miners. It is actually good with less competition for the chance to validate more blocks and collect greater rewards. The main problem with lower hash rates is slower transaction processing times, so it is a scaling issue. Since the network is decentralized, it is open to any node that wants to join as a miner so the hash rate can shoot back up. As for predicting the price value of BTC after the halving, Bitcoin guru Andreas Antonopoulos best explains it like “astrology or reading tea leaves.” It will eventually be the market that determines the prices.
