Professional Bitcoin Mining in China

Submitted by Pater Tenebrarum  –  The Acting Man Blog

A Major Mining Operation

Since recovering from a brief plunge to $150 intraday in January, Bitcoin has moved in a trading range roughly between $210 and $270. Most recently the currency traded around $235. As we will explain further below, at what price Bitcoin changes hands may actually be relevant for the sustainability of its crucial infrastructure backbone. Here is an hourly chart of the action on the Bitstamp exchange over the past 10 trading days:

bit coin, hourly chartBitcoin hourly. Since the low at $150 in January, the crypto-currency has traded in a range between approx. $210 and $270, via bitcoincharts.com, click to enlarge.

This brings us to a very interesting video of a major professional Bitcoin mining operation in China that has recently been brought to our attention. As you can see in this video, the times when people could mine Bitcoins at home with a souped-up graphics card are long gone. These days entire floors of buildings stuffed with computing hardware are needed to “mine” a halfway decent amount of Bitcoins (many smaller private miners nowadays join pools which share the Bitcoin found by communal effort whenever a member of the pool manages to solve a block of the Bitcoin block chain).

The reason why such huge operations are necessary for Bitcoin mining these days is that the complexity of the calculations required to solve the mathematical puzzle that leads to the discovery of new Bitcoins continually increases the more miners are active.

The operation in China presented in the video consists of six sites, that have together managed to mine a little over 4,000 Bitcoins per month as of October 2014 and represent approx. 3% of the global network’s computing power. 3,000 individual dedicated mining machines per site manage to mine between 20-25 Bitcoins per day. Each site requires some 1,250 kWh in electrical power per month.

However, there are a number of other costs as well: rent must be paid, there are employees on the sites who need to watch for equipment breakdowns or other problems and if necessary perform repairs, and a lot of equipment in fact needs to be replaced on a regular basis. By now the operation has a huge graveyard of discarded hardware.

The rate of coin discovery has plummeted sharply over time due to the increasing complexity of the calculations (e.g. the Bitcoin mining rate of the operation presented in the video has plunged by 75% since its peak). When the value of Bitcoin began to increase sharply in 2012-2013, a great many people started mining Bitcoins, which eventually pushed computing requirements very quickly to levels that required the use of dedicated machines capable of very high so-called hash rates, and made Bitcoin mining an activity requiring industrial scale. The report on the operation in China is quite fascinating:

A large-scale professional Bitcoin mining operation in China

A Potential Flaw?

It is important to keep in mind that this mining activity is not just an idle waste of electrical power in order to solve mathematical puzzles. Rather, the miners are rewarded with coins for keeping the infrastructure that is needed for the functioning of the Bitcoin network going. The block chain technology on which Bitcoin is based ensures that Bitcoin payment streams are safe against tampering and that payments are properly recorded and allocated. It is essentially an endlessly growing transaction record that collects timestamps of transactions – a public database that is distributed all over the world via a peer-to-peer file sharing network. The details of the process are described here.

However, as the complexity of the calculations increases, the cost of mining coins increases accordingly. Both the hardware needed for mining has become a lot more expensive and electricity costs keep surging as well. It is therefore not unimportant at what price Bitcoin is trading. As the WSJ reported when margin calls forced numerous traders to sell in January and Bitcoin fell to a new low for the move:

“As the price of Bitcoin falls against the dollar and other fiat currencies, it induces miners to shut down operations, because they can no longer cover costs such as equipment, rent and electricity quoted in those traditional currencies. The problem was made more acute by what had been a yearlong, exponential buildup in mining infrastructure – machines comprised of highly specialized, super-powerful computers – which made competition for Bitcoins tougher. Bitcoin’s core software algorithm periodically adjusts the difficulty of its mathematical puzzle to keep it in line with the amount of computing power in the network. That way, new Bitcoin payouts are kept to more or less a 10-minute schedule regardless of how well equipped the miners are to solve the puzzle.

On Monday, CEX.io, a company that mines Bitcoins on behalf of clients that rent out its computing power, announced that it would temporarily halt this “cloud mining” operation, citing “the recent Bitcoin price drop, as well as the upscaling of the mining difficulty.”

And on Tuesday, CoinTerra Inc. confirmed that it had been forced to default on a bond payment after being shut out of a Utah data center in which it had run a Bitcoin mining operation that once accounted for around 3% of the total Bitcoin network. The facility owner, C7 Data Centers Inc., has sued it for non-payment of fees.

These and other developments have for the first time led to an unprecedented sustained decline in the hashrate, a metric that measures the overall computational power of the total Bitcoin mining network, and for the first time, a downward adjustment in the algorithm’s difficulty function. Over the prior year the hashrate had increased 30-fold to the point the total computational capacity of the network was 13,000 times that of the world’s 500 largest supercomputers combined.”

(emphasis added)

There is an evidently an equilibrating tendency built into the system due to the fact that the hash-rate can decrease as well as increase – if the network’s size decreases, downward adjustments in the difficulty level will lower costs for the remaining miners. However, the market price of Bitcoin as such is independent of this. Bitcoin miners have no influence on the subjective evaluation of Bitcoin of market participants or whether traders are forced to sell due to margin calls. We would assume that there is some price threshold at which it will become very difficult to justify the cost of mining for many of them, even though the hash-rate will decline further the more miners are throwing the towel.

Bitcoin experts are seemingly unperturbed by this, but we are not quite sure what to make of the comment by the Bitcoin Foundation’s chief scientist Gavin Andresen below:

“Gavin Andresen, who as the Bitcoin Foundation’s Chief Scientist leads a team of mostly volunteer software developers who maintain Bitcoin’s core code, said he’s not worried about depleting the mining stock, known as hashing power. “A lot of hashing power is not going away,” he said. “These are people who basically have free power and who are running industrial miners that they are going keep running no matter what the price.”

(emphasis added)

Industrial-scale mining operations definitely do not have “free power” at their disposal. As the video on the mining operation in China above shows, their power costs are in fact quite daunting. It seems highly unlikely that industrial-scale miners will continue mining Bitcoin “no matter what the price”. If their mining activities begin to lose money, they will stop.

As noted above, if lower Bitcoin prices drive a large enough number of miners out of business it is of course possible that the associated decline in hashrates will be sufficient to restore the profitability of the remaining miners. This could keep enough computing capacity around to ensure that the network continues to operate flawlessly. From what has recently happened we can however already conclude that prices in the $200-$270 range are no longer high enough for all miners – and obviously, those affected thus far were in fact running large scale industrial operations.

Conclusion:

The rising cost of Bitcoin mining, which is an activity necessary to keep the Bitcoin network up and running, could turn out to be a potential flaw of the crypto-currency. It is too early to come to a definitive conclusion with respect to this though. We will have to wait and see what actually happens should prices stay at current levels or go even lower. That may of course not happen, but we suspect that that we will hear of more mining operations closing down before the shakeout is over.

Addendum:

Our knowledge of the technical aspects of Bitcoin is quite limited – we are mainly interested in its economic aspects. The fact that it originated in the marketplace and that it is a decentralized system are the characteristics that interest us most. We have been made aware that the explanation forwarded by former Mt. Gox CEO Mark Karpeles for the company’s bankruptcy is subject to considerable doubt (we mentioned it last week as an example of Bitcoin-related fraud that has harmed the currency’s reputation). Mr. Karpeles has blamed the so-called “transaction malleability flaw” that was allegedly exploited by a group of unknown hackers for the disappearance of the Bitcoin deposits administered by the company. However, many people seem to think an inside job is the far more likely explanation. More color on this can be found here and here. Police detectives investigating the case in Japan are reportedly leaning toward the inside job explanation as well by now.

Mark KarpelesFormer Mt. Gox CEO Mark Karpeles

Photo credit: AP

It was reported in April of last year that Mr. Karpeles was unwilling to show up in a US court in person on occasion of the company’s US bankruptcy hearing. The judge however insisted that he had to make himself available for questioning since he had filed the case. We couldn’t find any recent updates on this story, but it has in the meantime been insinuated by Ross Ulbricht’s defense team (Ulbricht is alleged to be the “Dread Pirate Roberts” who ran Silk Road, the illegal drug market place that initially caused interest in Bitcoin to rise sharply) that Karpeles was in fact involved in Silk Road, and may even have been its actual proprietor (not surprisingly, Karpeles denies this vehemently).