From American Affairs Journal, May 2018:
Bitcoin and the other altcoins now have more “experts” than perhaps
any other market. I am no such “expert”: I am neither a cryptographer
nor a computer programmer. I am a currency and commodity trader of
thirty-plus years, and I approach the cryptocurrency market from that
perspective.
The cryptocurrency market cannot easily be dismissed, despite the
fact that several high-profile people and institutions have called it a
fraud, a Ponzi scheme, and a scam. The altcoin market surpassed $700
billion in market capitalization in late 2017, even though it is about
half that now. This extraordinary volatility is caused by the immaturity
of the market along with other factors that will be analyzed below.
Most discussions of cryptocurrencies revolve around two core
questions: whether the trading values of Bitcoin and other
cryptocurrencies are justified, and whether cryptocurrencies’ underlying
blockchain technology will live up to its disruptive billing.
Such
discussions, however, too often end up as abstract, irresolvable debates
between blockchain optimists and pessimists. In contrast to these
typical approaches, I will focus mainly on the quantifiable elements of
the Bitcoin mining process, not only to suggest a reasonable range of
values, but also to explore the larger economic and political issues
surrounding cryptocurrencies and blockchain technology. While most
commentators tend to emphasize the differences between virtual
currencies and physical commodities, I will focus on the similarities.
Indeed, it is the similarities to conventional mining that are likely to
determine cryptocurrencies’ future trajectory more than their virtual
aspects. As is the case with commodity mining (over the long term),
Bitcoin mining will continue to increase in capital intensity; for
Bitcoin, such a trend is effectively built into the system.
As a result,
the shift toward corporate centralization, which has already begun,
will likely accelerate. Although cryptocurrencies began under the guise
of a libertarian ethos, market and mining conditions will steadily lead
them back toward corporate cartelization and state involvement.
Bitcoin and the Blockchain
First, a bit of background on the origins of Bitcoin as well as the
distinguishing features of blockchains. Bitcoin (BTC) was created by the
person or persons using the pseudonym of Satoshi Nakamoto, who released
a white paper on the concept right after the collapse of Lehman
Brothers in 2008. The key component of Bitcoin, like those of the other
altcoins, is the blockchain. The blockchain is a decentralized
ledger. In contrast to many other tech applications—social networks,
mobile phone ecosystems, and the like—the Bitcoin network is not
administered by or dependent upon a corporate (quasi-)monopoly. In
theory, it is the antithesis of one. No central authority is in charge,
and its protocols are subject to change with the user base consensus.
This is the main promise offered by cryptocurrencies, and, if nothing
else, BTC so far has offered solid evidence that a peer-to-peer system
can create a secure database: there have been no hacks of the system to
date (although participants have been hacked). This fact in itself
demonstrates that the blockchain has some value.
In a blockchain ledger, each transaction is recorded by a population
of “nodes.” These nodes are the miners, which are required to solve
computational puzzles before anyone else in order to receive
compensation for their efforts. The miners are the backbone of any
crypto system. It is the miners that have to validate every transaction
on the blockchain. To do so, they need to build and store all the blocks
on the blockchain and then reach a consensus on which blocks make it
into the blockchain.
This network of distributed nodes replaces the trust and
centralization needed in a hierarchical system. In fact, the Bitcoin
network is the most powerful computer network in the world, and this is
the true source of its value. The price of Bitcoin is directly
correlated with the revenue opportunity for securing the Bitcoin
network.
The first thing to ask about any market is whether it can become
sufficiently liquid. BTC has achieved this, and the binary risk of its
going to zero is for now alleviated: BTC is mainstream. To understand
the underlying value of Bitcoin and its blockchain more precisely,
however, it is necessary to understand the incentive structure that
supports the blockchain. Without appropriate incentives, a decentralized
system cannot sustain itself. Although the “decentralized” character of
the blockchain has attracted the most attention, the incentive
structure for mining Bitcoins is gradually adding crucial “centralized”
elements to the cryptocurrency market’s overall character.
Unlike fiat currency systems, under which a central bank or other
central authority determines the supply of money, in BTC the total
supply is determined by supporting the blockchain, which occurs through
the activity known as mining. Mining is governed by an algorithm:
everyone knows when each supply of BTC is produced as well as the
maximum total quantity, which is 21 million Bitcoins. For BTC, the
mining algorithm initially offered a reward of fifty Bitcoins per block
until the first 210,000 blocks were mined, and then the reward per block
halved. The current reward is 12.5 Bitcoins.
Reaching 210,000 blocks
requires about four years of mining, given that each block has been
structured to be mined in about ten minutes. The ten-minute block
average is maintained by a difficulty adjuster. This difficulty adjuster
is changed every 2,016 blocks, or about every two weeks, based on how
fast miners were able to mine the previous 2,016 blocks. This block
reward system should end around 2140. There are also rewards through
transaction fees, which have become a major component of compensation
for the miners (though not without creating other controversies).1
Since Bitcoins are produced only by mining, understanding the costs
and difficulty of mining is key to understanding the supply side of the
equation. A major cost of mining is the computer hardware. Leading-edge
chips are needed to compete effectively for blocks. The many
similarities to the physical mining business make it quite appropriate
that nodes are called miners. At block 512,500 in the blockchain, for
example, mining computations become quite difficult and require a
significant investment in hardware before one can even become a player
in the field. Much like in physical exploration, there are no guarantees
that the miner will get a return on this up-front investment. The most
important pieces of hardware for BTC miners are ASIC
(application-specific integrated circuit) chips, and only the latest,
most expensive chips are sufficient for effective competition. Moreover,
the lead times on the production of these chips are long and costs are
prepaid to the vendors.
Finding the right location for mining operations is also crucially
important. A mining location needs three major attributes—a cold
climate, cheap and widely available electricity, and good internet
speeds. Given the magnitude of computing power involved, mining uses an
enormous amount of electricity and produces a lot of heat. To be
competitive in the mining sector, costs of electricity typically cannot
exceed five cents per kilowatt hour (kWh), and a miner will need a
reliable electrical network capable of delivering megawatts of
electricity per hour.
Although results can be highly variable, miners can use a Poisson
distribution to predict the expected blocks to be mined. The Poisson
distribution is used for modeling the number of times an event occurs
within an interval of time. A mining operation can calculate the
probability of finding blocks over the life of its chips in order to
decide whether the operation is likely to be of value. The block
probability is directly affected by the global hash rate (the speed at
which an operation in the Bitcoin code is completed) versus the amount
of hash power the miner has. Usually miners have a set capacity of hash
power until additional investments are made in new chips. Miners can
thus expect their probability of successfully mining blocks to decay
over time.
To reduce block volatility, many miners have joined mining pools.
Herein lies a major risk, at least in theory. The top twelve mining
pools currently control 13,225 petahashes per second (at the time of
writing), while the total network speed is about 20,000 petahashes per
second. The top three mining pools control almost 40 percent of the
power of the whole network, and the top six control a majority of
network power. That is a lot of power in the control of a few top
miners. Remember that cryptocurrencies are supposed to be decentralized
systems. Even though each pool represents many miners, there is a real
risk that decentralization could be undermined, should the top six
mining pools initiate a 51 percent attack on the system. The main point
here, however, is simply that the power of the system is controlled by a
few, given the complexity and cost of mining. Another potential
challenge to maintaining BTC’s decentralization is that only two
companies dominate the market for the hardware underpinning
cryptocurrencies: Bitmain Technologies Ltd., a closely held company in
China, and Bitfury, a Georgian company. Bitmain, moreover, is believed
to be much larger than Bitfury.
Such growing concentration and cartelization is relevant because
everything in the Bitcoin world is done by consensus. When consensus
breaks down and some miners want to follow a different set of rules, a
fork is created in the blockchain. How much support (via mining power)
each fork gets will determine the success of that fork.
Although the miners are the key players in the Bitcoin ecosystem,
there are other important members, including the core developers and the
buyers of BTC itself. Other components of the Bitcoin ecosystem include
those who use Bitcoin for transactions, such as merchants and their
respective customers, along with any intermediaries and payment
services.
Bitcoin Valuation:
The Limits of Demand-Based Calculations
Since the buyers of or investors in BTC represent the demand side of
the equation, we need to understand how they value BTC. As we shall see,
these methods cast some light on BTC’s possible valuation, but their
predictive value is limited. Some investors in BTC and other altcoins
use exponential models to project prices for cryptocurrencies. These
models use variants of Metcalfe’s law and Zipf’s law. Metcalfe’s law
looks at the change in nodes and squares them (n2). Zipf’s law takes a less aggressive approach, using logarithms and multiplying the nodes by the log of the nodes or (n log (n)).
For example, let us assume a network of 100,000 members that generates
$1 million. In this example, if the network doubles its membership to
200,000, Metcalfe’s Law says its value grows by (200,000/100,000)²
times, quadrupling to $4 million, whereas Zipf’s law says its value
grows by 200,000 multiplied by log(200,000) divided by 100,000
multiplied by log(100,000), or to only $2.12 million. Applying the two
models to the node growth from last year and looking at the price of
BTC/USD, we see the two models imply the following price: One year ago
there were 5,625 nodes and today there are 11,714. So using Metcalfe’s
Law, the BTC price should have increased by (11,714/5,625)² times or
4.34 times. Last year, BTC was $920. So using Metcalfe’s Law, BTC should
be $4,000. Under Zipf’s law, BTC should be (11,714 ×
log(11,714))/(5,625 × log(5,625)) or 2.26 times $920—about $2,100.
Needless to say, these methodologies have not proven especially useful
in predicting prices and constitute little more than applying basic
formulas to the major unknown variable—network size.
Clearly, expanding the network is extremely important to the success
of a peer-to-peer system. Attempting to quantify this, other investors
seek to value BTC based on relative values. One such approach to BTC
valuation includes comparing the market capitalization of BTC to the
narrow money supplies of the major economies of the world.
When BTC hit
$20,000, the total BTC market capitalization was about $340 billion. If
one BTC equals $10,000, the market capitalization for BTC is about $170
billion. For perspective, the M1 “narrow” money supply of the United
States is $3.6 trillion. This puts BTC at 5 percent of the narrow supply
of money of the United States.2
The comparison is probably a poor one, however, given that the
cryptocurrencies are not really transactional currencies, even though
the amount of entities accepting BTC is increasing daily. In addition,
the multiplier effect for cryptos is probably close to one as there is
no real lending market to date, unlike for fiat currencies....
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