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Cryptocurrency Mining Explained

The most recent research released by CoinShares shows that the large mining farms are mining bitcoin where the costs of production are above $5,600. With Bitcoin prices over $10,000, that’s a highly profitable business because it brings over a $5,000 profit per coin. We asked John Lee Quigley, a founder of Adaptive Analysis, to tell us more about cryptocurrency mining. On this episode of Blockchain Beyond Hype, he talks about mining farms and pools, and renewable energy powering them. He also argues why Proof of Work is by far the most secure consensus mechanism and why bitcoin mining is still sustainable despite the massive energy costs.

How would you explain what blockchain is to a grandfather?

My grandfather used to own a store. So I would tell him – imagine you don’t own a store, imagine you own a franchise. In every franchise, there is a copy of the ledger and an auditor looking at the ledger 24/7. Essentially, this is what we have in the Bitcoin mining industry. We have people making sure that the Bitcoin ledger is secure and that every bitcoin is in the place it should be. These computers are also responsible for processing transactions. So when I send money through a bank, the bank processes it. Bitcoin is a decentralized network, so we have computers in the network processing the transactions. These are the miners, and they have an incentive to process this transaction in the form of a block reward.

How would you explain what bitcoin mining farm is?

At the start of the bitcoin mining, people used their personal computer to mine bitcoin. But this quickly evolved as people started using more advanced hardware to mine bitcoin. It evolved from the pure personal CPU to GPU to FPGAs to ASICs. Today the industry has become so competitive that people have huge factories full of ASIC hardware. The only way that they can remain competitive is to mine at a large scale. These days, the only real people who can mine at a small scale are people who have cheap, really cheap, or free electricity because it’s become so competitive that the businesses have to operate on huge economies of scale.

Where are the farms located, and why? 

Today most of the farms are located in China because there is access to very cheap electricity in the Sichuan region. They have a cold rainy season over there where there is an excess of hydropower. So the cryptocurrency miners can access it at very low energy rates. It’s very characteristic of the industry now. A lot of the business concentrates in the areas where people can access the lowest rates because it’s the natural evolution. It becomes more and more competitive, so the miners need to operate at larger scales and are highly incentivized to access lower electricity rates.

Is bitcoin mining actually profitable? 

It comes down to having to operate at a large scale. The most recent research released by CoinShares shows that the large farms are mining bitcoin where the costs of production are above $5,600. With Bitcoin prices over $10,000, that’s highly profitable. It’s making over a $5,000 profit per coin. CoinShares estimates that some of the farms with access to the lowest electricity rates have the cost of production as low as $3,500. But for the small scale miner, it won’t make sense.

How about the statement that mining is “free money”?

The concept of mining being “free money” is extremely flawed. These miners make huge investments in hardware and electricity cost. The idea of them just creating money out of thin air is entirely wrong. The idea that the difficulty adjustment rate which adjusts every two weeks being a flaw, I would argue it’s one of the most smartly designed elements of the Bitcoin protocol because the role of miners is to secure the Bitcoin network. If we have a drop-off in miners because they can’t meet their costs, that means the hash rate drops. That means the network is less secure because a hash rate is the measure of the computing power. If there is less hash rate, that means another entity can get this computer power to attack the network potentially. But with difficulty adjustment every two weeks, it means if we have a drop-off in the amount of miners mining on the network, the difficulty mining will reduce, and it will incentivize new miners to come in. So it’s a very smartly designed element, and it’s always designed to keep the network secure.

Is bitcoin mining actually sustainable?

A lot of people argue that Proof of Work is unsustainable because it consumes a lot of energy. Yes, indeed, it does consume a lot of energy. But the Bitcoin network will only consume what miners are willing to give because miners are expending energy to produce cryptocurrencies. So if it doesn’t make sense for them to do that, they won’t do it. The idea that the Bitcoin network consumes a lot of electricity, which it does, doesn’t necessarily mean that’s not sustainable. It’s more like a feature of Bitcoin than anything because it’s a very inefficient process for miners. They have to expend this energy in order to produce bitcoin. If it were an easy thing to do, then Bitcoin wouldn’t be very good money because everybody would be able to create it.

Could you explain what a mining pool is?

At the start, you could mine Bitcoin from a CPU. After a couple of years, you could mine it from a GPU. The way it works is you can expect the payout in proportion to how much computing power you’re contributing to the network. So if I’m contributing 10% of the computing power of the entire network, I can expect 10% of the payouts. But because the computing powers securing the network have continued to increase and get larger and larger, and we have more and more powerful hardware, we have a thing called mining pools and farming. The role of mining pools is to reduce the variance in payouts.

What does it mean for the mining farmers?

If I’m a miner and I have a small farm, maybe a factory full of ASICs, I can join a mining farm. They will pay me out based on the amount I’m contributing to their mining pool. So I’m getting more of a steady dividend as opposed to waiting for the payout of every hundred years, which might be what I would expect if I was just mining on my own.

Is renewable energy a solution to massive electricity usage?

The good thing about bitcoin mining is that it incentivizes the miners to source cheap electricity, and often that’s in the form of renewables. The argument against Proof of Work and mining is often that it consumes a lot of electricity. But in fact, the latest research estimates that 74% of the energy consumed on the Bitcoin network is sourced from renewable energy. 

Could you give us any real example? 

There are also some things which may show positive benefits towards the model. Let’s say I have a natural gas farm. A lot of natural gas producers can’t sell their natural gas to the grid because the grid cuts them off in case it gets overloaded. So they leak this gas straight into the ecosystem. But recently we have a new product that natural gas producers use. They set up a mini-bitcoin mining farm on their site, and instead of releasing the excess gas straight into the atmosphere, they use it to power their mining. So they’re actually making a net positive impact.

Is mining a source of passive income which even less tech-savvy people should look into?

I would say absolutely not. Mining is a very serious profession. If somebody was looking to get into mining from an educational point where they’re willing to invest money just to learn about how it works, and get their hands dirty in the learning process, then I believe it will be quite a good investment. But in terms of making another source of passive income which is going to look after itself – not at all. Because prices are the most significant factor that plays into miner’s profitability and we have no certainty about what altcoin prices are going to be.

Do you think the Proof of Work mechanism will survive, or it will be pushed out by other mechanisms?

I believe Proof of Work is by far the most secure consensus mechanism. I believe that all the other ones which have been proposed have a lot of flaws. Proof of Stake is the biggest competitor to Proof of Work at the moment. But if you break down the Proof of Stake model, it doesn’t make a lot of sense. In the Proof of Work model, there are huge capital expenditures by the miners in terms of their ASIC equipment. So their balance sheet is extremely tight about the value of bitcoin under ASIC hardware. Because if they can’t mine bitcoin with that, it goes in the bin. So they’re always incentivized to act in the operating health of the network. In the Proof of Stake model, we don’t have this incentive. We have people with the most capital running nodes and validating blocks. They get paid a dividend to validate blocks, so they’re incentivized to hoard their coins, and they get rewarded for doing so. So the people who are actually using the cryptocurrency on a lower level, who aren’t running nodes, are just getting their supply increasingly diluted.  And it’s going to be worth less and less money as it goes forward.

How do you envision blockchain changing the world?

I believe blockchain technology, as the blockchain that underlies the Bitcoin network is already changing the world. For citizens that are in countries like Venezuela and Argentina, where their central banks have inflated their currency way too much, it gives them another option. It gives them the option to be self-sovereign. It gives them the option to invest in a cryptocurrency that they know the inflation schedule. Even though the price of Bitcoin was dropping throughout 2018, it still maintained better value than the Venezuelan bolívar.

How do you think the market for the blockchain-based solutions will evolve?

If we look at the historical trends of markets and technology, it typically converges to the point of ‘winner takes it all.’ That’s why we have one Google operating as the dominant search engine, and why Facebook is by far the most dominant within social media. I believe blockchain will converge in a similar manner. We will have a decentralized protocol that has all the key features in it, and then all the developers and all the business people will focus on building upon that. Because if you think about it, any real innovation on smaller blockchains can’t be incorporated into the bigger ones. So I believe a handful of players will capture the majority of the market.

 

BBH Guest: John Lee Quigley, Founder of Adaptive Analysis
First heard of bitcoin in 2015. After the initial skepticism, a bit of further research resulted in him falling down the rabbit hole. With a background in finance, he has been pursuing a career in the crypto industry since 2018, when he started his cryptocurrency content strategy and research agency Adaptive Analysis.

Blockchain Beyond Hype is a series of interviews with blockchain experts and technology professionals from all across the globe about blockchain projects, challenges, innovations and the future of blockchain within the blockchain jungle!

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