< Is a Bitcoin bubble hiding in the mining infrastructure?

‟As my skepticism on Bitcoin increases, as does my optimism on crypto in general. #blockchain
– via Twitter

Caveat: This is in the Bitcoin failure mode series. I own a (very) modest amount of Bitcoin, Ethereum, and other tokens. Far from steering people away, I'm curious to explore their dynamics more.

With that caveat in place, on to this failure mode. One area I wanted to explore were the threats to the Bitcoin mining infrastructure. In this article, I'm going to consider some of the leverage threats.

One primary question is if Bitcoin is a store of value versus a payment system. Fred Wilson weighed in favor of store of value on his AVC blog. Many others have weighed in on various sides. But the popular stance appears to be as a store.

For the moment, we're going to park that question as it's worth unpacking standalone. For the discussion here I'm going to jump to "store of value."

With Segwit2x halting their fork today1, the nature of this store is more relevant than ever.

It's difficult to argue the chain itself is a store of value2. A significant amount of computation has gone into the existing Bitcoin blockchain. But, the chain itself is abundant. Near-infinite copies or forks can exist with near-zero cost.

A more interesting economic driver is at the top of the chain. And the dynamic "top" of the chain is the mining infrastructure.

Mining bitcoin is expensive. Both in infrastructure and energy. Sources attribute rising costs of GPUs due to their use in cryptocurrency mining. Sophisticated miners are now moving to bespoke ASIC systems, which I'll come back to later.

The cost of mining is proportional to the amount of miners and infrastructure in the network. By design. The more mining infrastructure there is in place, the more competitive it is. But, that is offset by increases in the price of Bitcoin. Economically, one would expect mining infrastructure to expand to meet the current price. While that's an oversimplification, this dynamic suggests an equilibrium. A higher price drives up the infrastructure and vice-versa.

And indeed, it seems that with every Bitcoin increase, mining operations expand. In something that echoes of Jevon's Paradox, efficiencies also extend mining. If electricity and compute power was half the price, you'd expect infrastructure to increase to meet the price-point.

The striking thing about the now-defunct Segwit2x was miners drove the fork (or not in the end). The chain experiencing the majority of mining was the one that was likely to win out. This is curious because it suggests a power-balance in favor of the miners over other parties.

This suggests the store of value with Bitcoin is the mining network itself. This opinion is not unique, although people like Fred Wilson tend to disagree. In Wilson's blog, the comparison is gold and gold infrastructure. Oil may be a better one. The price of oil isn't the oil infrastructure. But infrastructure holders have a unique ability to manipulate the price.

A softer view is that the mining infrastructure at least tracks the Bitcoin value. However, there is another dynamic in that Bitcoin miners are also Bitcoin holders. Like oil, the nature of their participation has a significant impact.

This creates an interesting dynamic. The miners are by definition actively engaged in the pricing of the market. How does this work? Within "normal" trading volume, the cost of mining a Bitcoin is the last price3 (ish). The Bitcoin you mined in the past was cheaper to produce than the Bitcoin you mined today4. As miners re-invest their returns in Bitcoin infrastructure, this becomes somewhat self-fulfilling.

An obvious maximization strategy for a miner is to hold Bitcoin for as long as possible. Holding Bitcoin in most scenarios has the net effect of pushing up the price. The longer you wait, the better the return. In the meantime, the miner ramps up infrastructure to meet the new price. This infrastructure both tracks and puts upward pressure on the Bitcoin price.

Even if you don't directly associate Bitcoin value with the mining network, this is a driving dynamic. Once a miner gets big enough, they can exert more and more control of this process. But it doesn't need to be a single party. Even without coordination, miners are likely to gravitate to this shared strategy.

That strategy implies the more highly-leveraged miners get the most significant gains. That is, you need to hold your mined coins for as long as possible. This is great for other Bitcoin holders. In the happy path, everyone gains. But a miner also needs to add infrastructure to keep fueling growth.

For a miner looking for the best leverage, you turn to more elastic means. My first stop would be fiat. Borrowing money to start mining. Although I'm sure there are more sophisticated hedges out there. If anybody knows of large-scale miners using Bitcoin as collateral for infrastructure, I'd love to hear it.

Bitcoin itself resists leverage5, but the fundamental mining infrastructure does not. This thesis introduces some failure modes that are worth exploring.

The obviously worrying scenario is where a "meaningful" number of (leveraged) miners are forced to liquidate Bitcoin.

In this scenario, leveraged miners will be in a lot of trouble. It's effectively a call on their Bitcoin. Ironically the use of ASIC-style mining makes this worse. These can't be readily sold or repurposed for other tasks, unlike GPUs. In the case of a falling Bitcoin, this specialized hardware will fall very hard indeed. The miner hurts on both the virtual coin and the physical infrastructure.

Due to the difficulty algorithm, the Bitcoin chain should survive. As miners leave the network the cost of mining drops. Mining would continue. But the price correction would be substantial. The question is how much and at what stage is such a drop unrecoverable.

The triggers for this type of failure mode I will cover down the line. But, structural shakes seem the most likely. Off the cuff, a significant regulatory change might be one. Or a change in traditional markets. Or a more left-field shift. Such as a change in ML/AL markets that make other computational assets more valuable.

As with all failure modes, there is an opportunity.

Miners liquidate and fail out of the network. Presumably, mining infrastructure gets sold off at a significant discount. One mitigation would be to pick up this discounted infrastructure and start mining. If the discounts are deep enough, doing this early will be an advantage. The question is the floor. Plus if and how quickly confidence can bounce back.

Thoughts?

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Filed under Blockchain.

Footnotes

  1. Specifically, November 8th 2017. 

  2. I'm going to simplify here, as usual. This is a topic worth digging in to even more. But for the purposes of this article it's somewhere to start. 

  3. Again, simplifying. Volatility is high, but you can smooth it out over some reasonable period of time. 

  4. This was less true in the earlier days, but recent history is more consistent. 

  5. Also see my previous article: What happens to loans in a Bitcoin economy?

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