An Introduction to the Economics of Mining within Cryptocurrency — Part 1

bitcoin Mining Farm in China — Rows of Asics

Cryptocurrency Miners are an integral part of the blockchain ecosystem, with the other components being the “users” (or consumers) and “founding core developers.” Miners essentially ensure, or “validate”, the transactions within each block to guarantee the blockchain’s integrity and are subsequently compensated through block rewards as well as transaction fees. They are the engines of the blockchain, with block rewards and fees being the “gas” (not to be confused with Ethereum’s “gas” which powers smart-contracts) that compensates and fuels their work. The founding core development team of any tokenized network thus must guarantee the incentive structures of the miners are properly aligned within the overall ecosystem.

Miners validate transactions by solving number-crunching intensive computer problems — known as algorithms — using various ranges of computing power (also known as “hash power”) that is dependent on the level of difficulty of these algorithms. The core developing team is responsible for establishing the specific algorithm difficulty within the protocol through the “hash rate.” This hash rate is generally automatically readjusted depending on how quickly the founding development team wish for the blocks to be validated and thus created — known as the “block creation time.” If there are more miners within the network that are competing to validate blocks, the hash rate will readjust to ensure that blocks are created every 3 seconds, 3 minutes, or 10 minutes on average, depending on what the founders ultimately decide is the ideal block creation time for their respective tokenized network.

The amount of computing power necessary to solve these algorithms is a critical factor in determining whether the miners will decide to even mine on a blockchain. Miners are strictly profit-motivated; thus they will only expend capital resources if it makes financial sense to do so. The core development team thus must decide their ultimate protocol’s hash rate difficulty wisely.

A significant number of users on the network will ensure a constant stream of transactions to be validated, thus incentivizing miners to remain within the ecosystem and keep the blockchain running smoothly. Hence the developers must also guarantee that its blockchain solution (i.e. “tokenized network”) will provide something truly unique in whatever its intended use case may be (P2P payments, utility token, etc.) so that the users will be active within the network.

An obvious question that arises is, why simply don’t the developers establish a very simple hash rate with the most minimal block creation time possible in order to ensure that users will be able to conduct transactions quickly and cheaply and that the miners will be incentivized to remain within the network to validate transactions?

The answer is that blockchain transaction speed and block creation time as well as low fees may come at the cost of security and privacy (in reference to the well-known “triad” of blockchain technology), in addition to inflating the supply too quickly (covered below).

Thus a more difficult hash rate will result in a higher block emission reward as well as fees for the miners, but slower transaction speeds within the network. This increased difficulty may in part be due to the enhanced privacy and security features of the respective blockchain (i.e. Zcash — ZEC, and Monero — XMR).

Yet another complexity of mining incentive structures within the blockchain is the supply schedule, or inflation rate. Though shorter block creation times offer faster transaction speeds, this directly impacts block emission rewards, and thus the token supply may be liquidated at a high rate which dampens the overall price of the token. Thus, a higher level of difficulty and subsequent longer block creation time applies a brake on the token supply rate, at the expense of transaction speed.

The protocol by which miners go about validating transactions are known as “Consensus Mechanisms” — the most popular one being “Proof of Work” in which miners compete using highly capital-intensive computing equipment that have been built and designed specifically for cryptocurrency mining, known as ASICs (Application Specific Integrated Circuits). ASIC mining machines are what currently power the Bitcoin network, with the dominant mining farms located in China (as electricity there is cheap and reliable). ASIC’s evolved from CPUs (computer processing units) and then GPUs (graphic processing units). CPU/GPU mining is the least expensive (but quite energy inefficient) and can be generally accomplished using home computer equipment (see Litecoin example below).

Proof of Work (PoW) as an incentive structure is arguably the most simple solution to ensure blockchain operability, yet two issues have arisen as the popularity of the blockchain and cryptocurrency industry has surged in the past year — the first being the cost of the electricity consumed to mine bitcoin (roughly $3 Million per day — source, and the second being the fear of increased reliability of miner control through collusion, which defeats the entire decentralization mantra of blockchain technology.

Charlie Lee’s Litecoin (LTC) was a fork off the Bitcoin network created in 2011, in which Lee created and instituted a particular ASIC-resistant hash algorithm that prevented LTC from being mined by specialized and highly expensive computer hardware. Anyone with a desktop or home computer could essentially be a miner. Litecoin thus can be mined more easily and its block creation times are significantly lower. Additionally it offers faster transactions than BTC as well as lower fees. The tradeoff is that Litecoin’s supply rate is vastly higher than BTC’s, which can instill more downward pressure on price.

Proof of Stake is the other main incentive structure utilized within the crypto asset realm. Proof-of-Stake mining require that miners hold a certain percentage of tokens before validating transactions. It ensures that miners thus have a vested interest within the network, and will not quickly sell their block rewards and flood the market (as is generally the case with PoW), thus also instilling a brake on the supply inflation rate. The trade off with PoS is that the top holders of the token essentially control the network — severely limiting the decentralization feature. A spinoff to PoS is Delegated Proof of Stake or DPoS. DPoS is similar to PoS in that the miners must have a vested interest and will not sell their holdings, and additionally there is a voting process where miners are “delegated” or voted on to validate blocks. This ensures a more equitable as well as vested incentive structure in which the top token holders are not the ones in sole control of validating transactions and provides opportunities for those with smaller “stakes” of tokens.

In Part 2 of the Economics of Mining, I will go into how incredibly influential miners are in instituting forks and new currencies. We will cover their specific roles within the current Bitcoin network soap opera.