The three-body problem of Bitcoin mining: What is the "dark forest law" of mining that has grown wildly for ten years?

This article was published on June 8, 2020, by ChainNews, authored by Leo Zhang, founder of Anicca Research.

The more transparent something is, the more mysterious it becomes. The universe itself is transparent; as far as the eye can see, you can look as far as you want, but the more you look, the more mysterious it becomes.

------ Liu Cixin, "The Three-Body Problem"

Bitcoin mining presents a situation that combines multiple factors such as hardware and software, energy and financial markets. Invisible rules affect every aspect of mining. The efficiency of each miner's operations depends on various external factors, most of which are difficult to quantify and almost impossible to outline and predict.

From a macro perspective, we can identify three main internal factors driving the development of the entire cryptocurrency mining industry: supply mechanism, climate cycles, and hardware iteration, each of which impacts different parts of the miner profit calculation formula:

Mining Profit = Mining Revenue - Mining Costs = (Block Reward + Transaction Fees) * Bitcoin Price * Miner Hashrate / Total Network Hashrate - (Electricity Costs + Hardware Depreciation)

• The token supply mechanism affects block rewards (revenue);
• Climate cycles indirectly affect average electricity costs in the industry (operating costs);
• Hardware iteration affects miner hashrate, efficiency ratio, and hardware depreciation (capital expenditure).

When Bitcoin first halved in 2012, most people were using home computers and GPUs for mining, with the total network hashrate distributed around the world. At that time, the dominant force in the market was merely the halving of Bitcoin block rewards. As mining output ratios decreased, the total network hashrate plummeted and temporarily shifted to the more profitable Litecoin. By the second halving in 2016, commercial ASIC mining machines and industrialized cryptocurrency mining farms had begun to be deployed.

Before the third halving of Bitcoin in May this year, analysts in the cryptocurrency market engaged in heated debates about potential outcomes. Some analysts speculated that, due to supply and demand dynamics, Bitcoin prices would double. Others predicted that the total network hashrate would decrease by 20-30%. At the same time, the timing of this halving, the transition of climate cycles to the wet season, and the upgrade of mining machine chips from 16nm to 8 and 7nm coincided, with these three factors interacting to collectively impact mining revenues.

1. Token Supply Mechanism

Bitcoin is a product of hashrate, and the foundation of the mining industry lies in the continuous incentive for miners to invest in hardware and consume energy to strengthen Bitcoin's network's ability to guarantee transaction settlements. In the absence of an active block space market, block rewards are the main source of income for miners. Over the years, due to the rise in Bitcoin prices, mining revenues have also significantly increased, which in turn has shaped mining into a multi-billion dollar industry.

Unlike most tangible goods, Bitcoin's contracts explicitly stipulate a halving schedule every four years. A varying proportion of newly minted Bitcoin tokens re-enter the Bitcoin economic network each day. Since miners are the only natural suppliers in the Bitcoin ecosystem and the largest, most stable group of sellers, the profit margins from mining are a key factor determining the supply side of Bitcoin.

*Estimated returns from June to December 2020, based on each block *6.25BTC* and prices from January to May, source: blockchain.info

It is evident that the halving of Bitcoin block rewards will directly reduce miners' output ratios. Some older machines may fail to start due to reduced power. During these periods, buying and integrating mining machines often occurs, with miners who have access to cheap electricity resources purchasing older generation machines in bulk at low prices, while the secondary market for mining machines becomes more active.

Mining machines are dual-variable call options in the physical form of Bitcoin. The complexity of pricing mining machines and the difficulties in transportation make the second-hand mining machine market very opaque, characterized by poor liquidity and high dependence on industry insiders. However, poor price discovery sometimes provides significant arbitrage opportunities for some miners. For example, at the end of 2018, Bitcoin prices plummeted to around $3,000, leading to a significant drop in a large proportion of hashrate, triggering numerous headlines discussing the "Bitcoin Mining Death Spiral." Some miners seized this opportunity to find large quantities of Antminer S9s being sold at low prices. Within just four months, Bitcoin prices entered a frenzied bull market. These buyers not only made substantial profits from the Bitcoin they mined but also saw the resale prices of these mining machines triple. This indicates that even non-operational mining hardware still possesses the nature and value of options.

*Source: *Jinping Gou*

The buying and integrating activities of mining machines have changed the structure of the mining hardware market. The structure of the hardware market can tell us how much energy the entire mining activity consumes. Although many people attempt to calculate miners' "shutdown prices" in a relatively simple way, each miner's entry time, capital amount, cost basis, and risk tolerance vary. Therefore, the cost basis across the entire industry is actually a wide range, and the act of selling Bitcoin occurs at various price levels.

To assess the pressure on miners to sell Bitcoin in the Bitcoin network, we need to understand the components of mining machines. Since no party in the industry can grasp the entire buying and selling information of the mining machine market and its electricity costs, collecting this data is very challenging. The Blockware Team recently conducted this research by categorizing different types of mining machines and factors such as electricity costs. In a report released in March, the team estimated the components of part of the network as shown in the figure below:

After this year's Bitcoin halving, the total network hashrate dropped from about 109EH/s in March to about 94EH/s. Assuming all shut-down hardware is represented by Antminer S9, we can update the component chart mentioned above: (adding daily operating costs and daily depreciation information)

* Antminer S9i specifications ( 13.5TH/s *, * 1,310W *, unit price *21* USD), Antminer S17+ specifications ( 70TH/s *, * 2,800W *, unit price *1,232* USD); **S9i average lifespan over 18 *months, * S17+ average lifespan over 36 months

Based on the above data, we can calculate the approximate daily Bitcoin sales by miners as a proportion of daily Bitcoin output at various price levels, as well as the proportion of daily Bitcoin sales by miners to global daily trading volume:

Due to the significant variation in global trading volume with price changes, the price range is relatively narrow. * *Each block *6.25BTC. Excluding transaction fees. ** *Global trading volume *$1.14 billion, source: Bitwise

Please note that the data in this analysis is only used to illustrate conclusions. The above data is based on very rough assumptions: all old mining machines are represented by Antminer S9, and the new generation of mining machines is represented by Antminer S17. It goes without saying that miners purchase machines from multiple manufacturers, and the same generation of mining machines from different manufacturers also has different specifications. In reality, the differences in market composition factors are much greater. Additionally, this analysis is based on a static time point, and the composition of mining hardware is very unstable, actively changing as the market seeks a new balance after the halving. The upcoming wet season will also have a significant impact on the electricity costs for most miners. Furthermore, as more miners use financial tools such as loans, futures, and even hashrate markets, the selling pressure on miners in the Bitcoin network will be partially alleviated or delayed.

By observing the changes in the components of the mining industry over time, one conclusion that can be drawn is that the generation of hashrate is " asymmetrical." In other words, due to the constant changes in the components, each unit of Bitcoin hashrate is unique.

2. Climate Cycles

Climate cycles are one of the reasons why the mining industry is geographically concentrated. Over the years, Bitcoin mining has inadvertently benefited from massive, even excessive investments in hydropower in southwestern China. The remaining cheap electricity, massive power generation capacity, low labor costs, and proximity to mining machine manufacturers make southwestern China an ideal location for Bitcoin mining. It is estimated that over 65% of global hashrate is concentrated in the following provinces.

Approximately May to October is the wet season in southwestern China, which is also the "festival" of the cryptocurrency mining industry, where a large surplus of hydropower supply significantly reduces miners' operating costs. For small and medium-sized miners, the wet season can reduce costs by up to 40%. For large miners with dedicated facilities, electricity costs during the wet season can even be negligible. During the wet season, over 80% of miners from provinces like Inner Mongolia and Xinjiang will migrate in groups to Sichuan, Yunnan, and Guizhou for wet season mining, and these miners may return or sell their mining machines after the dry season arrives in November.

Bitcoin mining map, source: Cambridge Centre for Alternative Finance

The booming cryptocurrency mining industry has brought benefits to local power plants, with many building or transforming their facilities into hashrate centers.

Gradually, the cryptocurrency mining industry has adjusted its structure around these climate patterns. Like some ancient ritual, every year before the arrival of the wet season, the mining industry holds large-scale cryptocurrency mining summits in Chengdu, Sichuan Province. We also see phenomena such as: some facilities only open to external customers during the wet season; mining machine manufacturers planning new product releases before transporting products; miners competing to purchase the latest and best mining machines.

Growth of Bitcoin hashrate during the wet season:

*Source: *coinmetrics.io*

At the beginning of this year, due to macroeconomic uncertainties, investors and miners returned to a more cautious investment approach. Due to the impact of the COVID-19 pandemic on the supply chain, the production of new mining machines was also temporarily halted. After the Bitcoin halving, more mining machines shut down, leading to a situation where mining machine hosting supply exceeds demand. Many factories in regions like Sichuan and Yunnan found it difficult to find customers, which continued to lower coin prices. Compared to last year's electricity costs of 0.24-0.26 yuan/kWh, the average cost expected at the beginning of this year could drop to 0.10-0.20 yuan / kWh.

Lower electricity costs will partially offset the impact of the halving of Bitcoin block rewards, and many mining farms must sign contracts with power plants, committing to a minimum level of electricity usage. To attract business, some companies offer " joint mining" plans, where miners pay a minimum monthly fee and allocate part of their mining revenues to hosting service providers, effectively transferring some market risks to the hosting providers.

However, such measures do not guarantee a reduction in operating costs. Although hydropower facilities are cheaper during the wet season, these mining farms are often located in more remote areas, where power supply and internet connectivity may be unstable, and there is sometimes a risk of losses due to mountain floods.

Another risk is the policy risk from local governments. Before 2018, most local officials were unaware of what mining was, and cryptocurrency mining facilities were often reported to the government under the guise of big data or cloud computing project data centers. In 2018, China's Internet Finance Rectification Office classified cryptocurrency mining as "pseudo-innovation," arguing that crypto mining is extremely resource-intensive, and regulators required local enterprises to orderly exit the mining business. Some mining farms indeed closed operations under this pressure. However, in the second half of 2019, the National Development and Reform Commission removed " virtual currency mining" from the list of "eliminated industries." It is worth noting that the National Development and Reform Commission is responsible for supervising the energy industry. The massive waste of hydropower resources during the wet season has been a long-standing issue, and officials may have begun to realize that Bitcoin mining is an effective way to convert excess local resources into global digital goods.

A few months ago, Sichuan announced the first batch of " hydropower consumption demonstration enterprises," which included several Bitcoin mining companies. The bad news is that despite more cryptocurrency mining facilities starting operations, this year's rainfall has not been as great as expected. As this article is being written, with the arrival of the summer heat, the electricity from hydropower plants is primarily used to ensure the power supply for residents in Sichuan.

However, recently, a region in Sichuan called Muli County issued a notice on May 21 regarding the reporting of virtual currency "mining" activities. Although many local individuals do not wish to enforce this order, it also indicates the complexity of the energy situation during the wet season, and the expectation that the wet season will reduce miners' electricity costs is not a guaranteed remedy.

In this phase of cryptocurrency mining, climate cycles are a rather unique phenomenon. If in the future mining operations migrate to more diverse locations instead of being concentrated in a single power supply, the factors of climate cycles will no longer play such an important role.

3. Iteration of Mining Hardware

Mining machine manufacturers are constantly competing to produce leading products in the market. For a long time, Bitmain's Antminer S9 dominated the market. According to the IPO documents submitted by Bitmain in 2018, its mining machines accounted for approximately 74.5% of all ASIC mining machines in the market. However, in the past two years, competitors such as Bitmain's Shenma mining machines and Canaan Creative's Avalon mining machines have rapidly eroded Bitmain's market share.

In 2017, Shenma mining machines sold 90,000 units, accounting for 7.2% of the total network hashrate at the end of the year. In 2018, the new machine hashrate from Shenma accounted for 9% of the total network hashrate at the end of the year, and in 2019, the new machine hashrate from the company accounted for 35% of the total network hashrate.

Mining machine products are a commodity, and although specific factors can help mining machine manufacturers stand out, such as customer service, delivery times, and supply chain management, competition forces manufacturers to relentlessly focus on two key metrics: price and energy efficiency ratio.

The energy efficiency ratio of mining machines is measured by the power consumption per unit hashrate; the lower this metric, the less electricity is consumed for mining. Each generation of mining hardware defines new products by improving the energy efficiency ratio of mining machines.

* As of May 31, 2020; ** Based on 6.25BTC *block reward, * 15,138,043,247,082 *mining difficulty, * 9,500BTC price

Improvements in the energy efficiency ratio of mining machines have a significant impact on profitability. Using the current Bitcoin difficulty and the average price of second-hand Antminer S9i (each machine costing $21, with an energy efficiency ratio of 97.0J/TH), we can calculate the payback days at various price levels:

Below is the latest calculation of the payback days for the Antminer S19 Pro (each machine costs $2,407, with an energy efficiency ratio of 29.5J/TH):

Currently, in most cases, the Antminer S9 is not profitable; however, miners with access to extremely low-priced electricity resources can still make a profit. Comparing the two tables above, we can see that at prices below $0.04/kWh, miners using S9 for mining have a faster payback period. Thanks to cheap power, when new generation mining machine products hit the market, previous generation products do not necessarily exit the market immediately. The CoinMetrics team aggregated the expected usage of Antminer S7 and S9 over a period based on random number distribution. As we can see, with the popularity of S9, the usage rate of Antminer S7 does not merely show a downward trend:

*Source: *CoinMetrics Issue 51 State of the Network

As mentioned in the previous section on the "Token Supply Mechanism," miners with cheap electricity resources will purchase some older generation mining machines in bulk at low prices to earn higher profits. This arbitrage opportunity typically arises when hashrate is relatively high and Bitcoin prices are relatively low. Although the value of hashrate largely depends on the price of Bitcoin, there is a discrepancy between hashrate and price due to the lag in the hardware market's response to financial market trends. Custom chip manufacturing incurs one-time engineering costs, and mining machine manufacturers and their supply chain partners need to amortize these one-time costs based on the number of chips produced. Unless the mining machine manufacturer is a long-term partner with large orders, in most cases, foundries will require full payment for reserved wafer orders.

The production cycle for wafer orders typically lasts 12 to 13 weeks, making it more challenging for manufacturers to develop forward-looking business plans. At the end of 2017, many manufacturers did not have enough inventory during the bull market to sell products to the market, thus misjudging the duration of the bull market. Manufacturers, including Nvidia, overestimated order volumes in 2018 and had to gradually sell off their inventory at a loss in the second half of the year.

*Source: *BitInfoCharts*

Once the mining market completes the upgrade from 16nm chips to 7nm chips, the competition for backend product technology will cease for a long time. The average lifespan of new mining machines will extend from the previous 2 years to 3 to 4 years, and the failure rate of mining equipment will become a more important factor. In fact, failure rates, along with price and energy efficiency ratio, are considered key metrics for evaluating mining machines.

Frequent failures of mining machines can reduce their hashrate and rapidly increase maintenance costs after the warranty period ends. Severe failures mean that maintenance will incur a loss of some revenue. For example, due to defects in heat dissipation design, the failure rate of the Antminer S17 series is as high as 20%-30%. The cause of the failure is that loose or misaligned heat sinks lead to short circuits on the hashrate boards, and the cost of repairing this failure is very high—despite the Antminer S17 series being based on advanced manufacturing processes, the product does not perform well.

More advanced mining hardware means higher upfront capital expenditures, which in turn drives further industrialization of cryptocurrency mining. Soon, more data centers will define their infrastructure to meet specific mining needs. Surplus natural gas energy mining, immersive liquid cooling, and internal monitoring solutions will begin to emerge.

Additionally, should we be concerned that " industrialization" will further centralize cryptocurrency mining?

Hardware manufacturing is a reproduction process that can actively eliminate the need for genetic mutations. In the current state, hardware manufacturing benefits from standardization and centralized management. The industrialization of cryptocurrency mining is unstoppable, and decentralized mining should focus on downstream hashrate voting rights, such as the decentralized mining protocol Stratum V2, which supports the " work negotiation" model. (ChainNews Note: Stratum V2 is the next generation of mining pool protocols that will improve the efficiency and security of mining data transmission and reduce the hardware facilities required for mining. It also introduces three new sub-protocols, allowing miners to choose their own set of transactions through a negotiation process with the mining pool, enabling miners to decide which transactions to include in blocks rather than the mining pool.)

After a decade of barbaric growth, cryptocurrency mining stands at a crossroads of development. The entanglement of supply mechanisms, climate cycles, and hardware iteration produces unpredictable short-term changes. However, in the long term, as Bitcoin increasingly integrates with other parts of the crypto economy, cryptocurrency mining will become more competitive and tend toward a resource-intensive industry. In the past, miners only needed to keep operating costs as low as possible. Looking ahead, the continuously declining mining profit margins will force miners to become more aware of the importance of cash flow and risk management, and the future of cryptocurrency mining will trend more towards " industrialization" and " financialization."