Go to the profile of  leyi
leyi
Leyi is an intern at CoinHako for Summer 2016. She is passionate about FinTech and thinks that blockchain is pretty cool.
11 min read

Economics of Bitcoin Mining

Tracing the source

Just like your phone and your computer, the production of Bitcoins is driven by economics. This article aims to break down the various factors so you understand Bitcoin better.

Like many things you own, most of the bitcoin in your wallet was probably made in China.

In fact, more than half of the world’s hashing power is concentrated in China, held by the biggest mining pools in the world, such as F2pool, Antpool, BTCC and BW.

Bitcoin mining hash rate share

Mining share on 5 Aug hash rate, source

We usually attribute Chinese manufacturing success to their cheap, skilled labour. However, unlike most manufacturing jobs, production of Bitcoin is done by computers. So why is China still the top Bitcoin miner? Which other factors affect the production of Bitcoins?

This blog post is all about the economic forces which drive mining pools to create these bitcoins that end up in your wallet.

This article assumes you understand the basics about mining. If you are a complete newbie, we recommend that you learn more about mining by reading up about the evolution of bitcoin mining,  bitcoin block reward halving or the Bitcoin Wiki.


How do miners make money?

Miners make money as long as they can earn more from selling bitcoin than spending on hardware and electricity costs incurred to create the bitcoins.

Their source of funds includes block reward and transaction fees, a dynamic fee paid by users of the network. Both of which are awarded when a new block is mined. A miner can choose to include transactions based on transaction fees to optimize his fee earnings.

Block Reward

The block reward is the reward they get for successfully mining a block. This reward is currently 12.5 bitcoins per block. However, this block reward will halve every 4 years or so. The last halving occurred on 9 July 2016, and reduced the block reward from 25 to 12.5. Learn more about block halving on our blog post about block reward halving.

Transaction fees

In addition to block reward, a transaction fee is paid every time a transaction is made. This is an additional fee to incentivize miners to provide the service of confirming blocks to bitcoin users.

This price has been on the rise, because of the congestion of the network due to the block size limit and the concentration of mining power as the arms war continues to escalate. Hence, the block size can be seen as a quota, and mining centralization is the strengthening of monopoly pricing power.

Block size limit has been seen to be an issue since 2015, as the increasing congestion of the 1mb block limit led to concerns about the functionality of Bitcoin as a payment network. There has been a lot of discussion about this. Read more about this on our blog post:


Organization – mining pools

Given the difficulty of bitcoin mining nowadays, coupled with the fact that successfully mining a bitcoin depends on chance, few people mine bitcoins by themselves. Instead, they spread out their earnings by joining mining pools, aggregations of bitcoin miners which connect to the same bitcoin node. This allows them to work on the same problem at the same time, greatly increasing the chances that the pool will solve the block. If a miner in a pool mines a block, the rewards are shared according to hashing contribution. There various methods used to calculate earning distribution. Each mining pool has a slightly different distribution model.

This kind of reward sharing allows miners earn a steady income over time. Instead of earning 12.5 bitcoin with a very low probability very infrequently, miners in mining pools can get a steady stream of a fraction of the block reward by participating in the pool, when some another miner manages to mine a block, by pure chance.

However, the formation of a pool also causes centralization of mining power. It is more likely for a new miner today to join an existing big mining pool than to go on his/her own. Hence, the mining pools have an oversized influence over decision on the Bitcoin blockchain. This centralization has resulted in a reduction in mining nodes over time.

Furthermore, this creates a problem of trust. When mining nodes are fewer and mining is more centralized, it is more likely that these nodes can have greater market power over transaction fees. They will also have greater voting power over hard forks.

Financial contracts

Bitcoin prices can fluctuate unpredictably, and miners have come up with ways to ensure that they continue to profit and can find funds to expand their mining operations.

Bitcoin miners may use futures contracts with some big exchanges in order to lock down the prices to sell bitcoin at in the near future. Doing this can provide certainty of prices of bitcoin when they sell in the future, so that they can ensure that they can cover their operational costs regardless of the volatility in Bitcoin prices.

Bitcoin miners also go crowdfunding for loans to raise funds to increase their hashing capacity. Platforms such as Bitbank offer bitcoin loans that are paid back in BTC, especially for these loans to finance mining operations.

There are also cloud mining contracts, which allow investors to mine for bitcoin without having to deal with hardware at all. Buying a cloud mining contract, this is analogous to owning equity in a mining operation. The investor puts in funds to a cloud mining company, which uses the funds to buy mining equipment, rent space, pay salaries etc. Any bitcoins mined will go towards paying the expenses, and if there are additional bitcoins left over, it will go to the investor.

** **

Block size debate

Block size refers to the maximum size of a block as measured in megabytes. Today, the block size stands at 1Mb. This can process a maximum of around 3000 transactions per block on the network. This translates to around 5 transactions per second. However, as compared to the volumes processed by transaction settlement networks such as major credit card companies, this is just a fraction of what would be required to create a global settlement network.

As the bitcoin community grows, the number of transactions on the network has been increasing. This means that a larger percentage of the block size limit has been filled in recent months. This has resulted in congestion, and increasing transaction fees as users have to pay more to get their transactions confirmed earlier.

As the block size limit is coded into the bitcoin protocol, a hard fork by the miners is required to apply a change in the block size. These changes are proposed in several proposals. Read our post on the block size debate to learn more


Technologies

The age when bitcoins can be mined with your laptop CPU and GPU are long gone. Bitcoins are mined today with state-of-the-art Application specific integrated chips (ASICs), whose sole purpose of existence is to mine bitcoins.

Since mining is a competitive process, and the mining difficulty keeps on increasing, there is a constant arms race to produce faster and more energy efficient miners.

Although many miners find cheap electricity, not everyone does. Hence miners are always looking to upgrade their hardware. According to Jihan Wu, CEO of BitMain, 80% of hashing power today comes from 28mm and 16mm chips, which are miners that are less than 2 years old.

The market for older mining rigs is still liquid, because there are miners with various factors of production which could mean that mining with old rigs is still profitable.

The latest generation ASIC miner (as of August 2016) is the Antminer S9. Learn more about how mining technology has evolved.


Factors for profitable bitcoin mining

Cheap electricity

Electricity is a major input to ASICs, so reducing electricity bills is vital for a mining operation to stay profitable.

China, with her size, has plenty of natural resources. Coal is the major source of electricity generation in China, contributing to over 78% of China’s total energy production. This has been driven by falling coal prices. China has also been building these coal-powered power plants to drive local job creation, even though this is not cost effective.

This has led to overproduction of electricity in China. Due to the additional plants, the surplus was over 20%. This may be bad news for electricity producers, but for bitcoin miners and other electricity users, this means electricity costs will be lower.

Some miners are able to get electricity from private generators away from the grid. These generators include small-scale hydroelectricity generators, who find it difficult to sell their power to the grid, especially in Summer. If this excess electricity is not used, it is usually wasted. Hence some miners are able to put this electricity to use at a cheaply and still support these small generators.

Iceland is another popular location for bitcoin miners. Mining companies such as Bitfury and Genesis mining have taken advantage of their cheap hydroelectric and geothermal electricity for mining. Electricity prices in Iceland are around USD0.05/kWh, which is much lower than USD 0.1427/kWh in Singapore or in Malaysia. At the scale these mining firms are operating, their cost savings are significant in Iceland.

However, even if electricity costs were not an issue, newer mining setups have advantages such as faster hashing per unit (less labour costs to maintain) and reduced need for cooling, which is why electricity consumption is still a concern for Bitcoin miners

Cheap labour

In spite of all the hype about how machines will replace humans, people play an indispensable role in maintaining the upkeep of mining operations. These workers are in charge of ensuring that ASICs work to their full capacity around the clock.

Some of their responsibilities include fixing ASICs, upgrading them to more energy efficient models, and ensuring they keep cool to optimize their efficiency.

China has low labour costs and low costs of living, but this is rapidly changing as workers are more skilled and have been demanding more pay from their employees.

Cheap Chips

China is also the producer of some of these chips. One of the biggest mining ASIC producers is BitMain, which produces Antminers. As it is shipped out from China, Chinese miners have the advantage of getting faster new miners first before miners from other countries have finished dealing with shipping their ASIC miners. Of course, Chinese miners also benefit from china’s fast and efficient courier delivery services.

Another factor is how fast a mining chip can be delivered to the miner. As Bitcoin mining is a competitive process, getting a chip delivered earlier means more profits to the miner. As many of these chips are manufactured in China, Chinese miners have the advantage of getting hold of these chips faster and upgrading their facilities faster than their competitors.

Cool Climate

This is more applicable to the temperate climates in northern China than the subtropical climates further south.

Electronics work better in cooler temperatures, because electrical conductivity is better when the components are cooler. This means that an ASIC would work closer to its full capacity given the same power input.

Just like how your computer can overheat if you overwork it, ASICs can get very hot since they work all day and night.

To mitigate temperature issues, ASIC miner units come with its own fan, which is one of its distinguishing features when you look at it from the outside. Miners also keep their ASICs cool by installing them in the shade, and using big fans the circulate air in the rooms they are kept in.

However, cooling is aided by favorable environmental temperatures. With cooler temperatures, ASICs stay cooler more easily, and so they work better.

This is the reason why miners such as Bitfury and Genesis mining have operations in Iceland, where average annual temperatures are only at 11C, among the coldest among any country.

In China, colder regions in the north are preferred, such as Liaoning province in northern China, although there are miners everywhere throughout China.

** **


Factors that may make miners quit

Some factors that affect mining profitability include:

Halving events

Although miners also profit from transaction costs collected from users, block reward is currently the biggest source of income. With the decrease of the block reward, mining revenue is halved and this can make mining unprofitable for miners with higher marginal costs.

The last bitcoin halving saw a major bitcoin mining pool, KnCminer, drop out of the game. Each halving represents a drastic drop revenues, and can result in miners dropping out because it is no longer profitable for them.

Drops in Bitcoin market price.

The costs of mining are in fiat currencies, but revenues are in Bitcoin. Should the price of bitcoin drop precipitously with little hope of rebounding, it can be difficult for some miners to have a positive profit from their operations.

Without the financial incentive, miners will shut down their operations to avoid losing money. This leads to a high difficulty with low hashing power. This hypothetical event can leave the infrastructure crippled as it will take very long to mine each block, and reduce confidence in the infrastructure, causing further drops in price.

Changes in market price can be due to various factors, from macroeconomic factors, financial crises, hacking events etc. Investors should be constantly aware of the news to be able to anticipate these sudden changes.

Genesis mining, for example, cites a production cost of around USD200 at current hashing rates and difficulty levels. If the price of bitcoin decreases, it would decrease profit margins of the mining operation.


Cloud mining

Many amateur investors might be interested in investing into bitcoin through mining. However, it is now very difficult for investors to see returns from mining.

One of the ways to invest in mining is through schemes called “cloud mining”. Cloud mining refers to contracts for mining. You can purchase a contract from reputable cloud mining firms such as Genesis mining and Hashnest by BitMain. As a purchaser of the contract, you put in money to set up a mining set up. This mining setup will mine Bitcoins, or your selected altcoins, and the profits will go to you.

However, contract owners do not usually see their actual set up, and there are usually long breakeven times regardless of the cloud mining provider. Hence, there is a high chance of fraud. Contract owners also have less freedom over how the setup is run and optimized. Some mining platform have a secondary contract market for investors to sell their contracts when they decide to exit, but many platforms do not have such markets.

Cloud mining companies other than these 2 are likely scam operations, and we advise our users to do thorough research before committing their money in it.

Even if you put your money into a reputable cloud mining company, we advise you to do your own profit & loss projections. It can be difficult to earn a profit from it, and many investors have suffered losses in their investments into cloud mining, even if they are legitimate operations.


Internet speed

Reliable internet speeds are also a necessary factor in bitcoin mining. Fast internet means that a mining operation can obtain the necessary transaction data to mine the next block promptly. This data includes the hash of the block that was just mined, as this is an input to the hash of the next block.

China is by no means the fastest internet. In fact, internet speeds in China are lower than the global average. However, the Great Firewall of China might have given them an unfair advantage despite the slow internet speed.

Miners outside China have complained that the firewall has limited outgoing bandwidth. This slows data download and mining by miners outside China, with little impact to miners within China. This causes delay between obtaining the block data in and outside China.

Every second lost is time lost for mining the next block, and gives miners outside China a disadvantage.

Due to the large number of miners within China, this delay is non-trivial: Bitcoin Core contributor Pieter Wuille estimated that this delay results in an** 8%** advantage to Chinese miners.


Looking forward

In the foreseeable future, China is likely to continue leading in Bitcoin and altcoin mining.

The factors of production are unlikely to change dramatically for China. We can also foresee that mining equipment will continue to improve rapidly, and difficulty level will be higher than ever.

However, market conditions change all the time, and there are upcoming developments to Bitcoin. Any changes to the block size limit, which can be expected soon, will also have an impact on miners’ incomes. Major world events can also affect Bitcoin’s price. These events many have drastic effects on the incentives to miners, and affect their operations.


CoinHako is a friendly, safe and easy to use Bitcoin wallet in Asia! We offer BTC trading in SGD and MYR, and you can get your bitcoins instantly. Sign up for a wallet today!