The gold rush days of bitcoin mining are over, and not because of the price

Obsession
Digital Money
Obsession
Digital Money

For all the volatility in bitcoin pricing, 2014 may be looked back on as a year when bitcoin began to move past the proof-of-concept stage and toward a mainstream market. Some 6.6 million bitcoin wallets have been set up so far this year, according to Coindesk, a fivefold increase over 2013. And 75,000 merchants now accept the digital currency, including giants like Dell, Expedia and Overstock.

But one area of the bitcoin economy is maturing much faster than the others, to the point where profits are increasingly harder to come by and consolidation and diversification are already happening: the mining of bitcoins. For years, bitcoins were mined largely by a far-flung network of desktop hobbyists. But increasingly, a smaller group of companies building large data centers set up for the sole task of mining new bitcoins.

Although “mining” is a throwback to pre-digital era of pickaxes and gold pans, bitcoins are mined in a unique way, by harnessing computing power to confirm transactions on a public ledger and increase security on the network. Miners compete not only to confirm transactions but to solve calculations that typically grow more difficult over time. The details of the process can be arcane, but the end result for miners is clear: rewards in transaction fees and freshly minted bitcoins.

In bitcoin’s earliest years, mining could easily be handled by desktop computers running a CPU or a powerful graphics chip. As more would-be miners emerged, companies like BitFury, KnCMiners and Cointerra began to sell ASIC chips designed for a single task: running mining software. Bitcoin developers, hobbyists and speculators found mining to be an easy and often profitable way to get involved in the bitcoin economy.

Quickly enough, that began to change. By design, the bitcoin reward offered for each block mined decreases over time. Currently, about 3,600 bitcoins are mined each day but the competition for them has surged over the past year. As economies of scale began to kick in, some miners found they needed to constantly spend the bitcoins they were earning on the latest, fastest hardware just to stay in the game. The hobbyist became sidelined, and the typical bitcoin miner became the industrial operator of data centers that could consume 10 or 20 megawatts of energy.

“The bitcoin mining industry is on its way to consolidation, as a few highly-skilled and well-capitalized vendors drive the industry,” says Valery Vavilov, CEO of BitFury, which sells mining gear, operates 40 megawatts of bitcoin data centers around the world and plans to boost its capacity to 100 megawatts.

“Only market players that can deliver the most energy-efficient equipment with the most cost-efficient capital and operating costs will thrive,” says Vavilov, “while small players with limited capability will struggle or drop out of the bitcoin race, which will result in a narrowing of the field over time.”

Several factors determine who profits the most from bitcoin mining—power consumption, data-center speed and cost, electricity rates and the current price of bitcoin. Each month, it becomes harder for a small player to keep up. The costs of new ASIC miners alone are steep: The price of current cutting-edge processors can run $5,000 or more apiece, while cheaper offerings can be unreliable in quality or even fraudulent.

The higher-priced mining equipment can employ 20-nanometer chipsrivaling speeds from Intel and AMD—and even faster 16-nanometer chips are on the way. Ever-powerful processors are necessary because the difficulty of the math calculations required to mine bitcoins is designed to increase as competition grows. That level of difficulty can rise substantially in a matter of weeks, rendering mining equipment outdated between the time it’s ordered and the time it finally arrives.

“It’s an arms race,” says Harry Yeh, a managing partner of Binary Financial, which invests in bitcoin startups. “It comes down to who can produce the fastest, most energy-efficient chips for the least amount of money and then deploy them quickly.”

Another obstacle for hobbyists is that electricity rates in most locations are prohibitively expensive: 13 cents per kilowatt hour in the US and even higher in countries like the UK and Germany. Some companies have set up industrial mines in Iceland, where geothermal energy is cheap, and in pockets like central Washington, where public utility districts offer low industrial rates (and where Microsoft, Yahoo and others have built their own data centers).

In response, individual miners have formed mining pools like GHash.IO, sharing processing power and splitting rewards. Meanwhile, companies like BitFury and KnCMiners have started selling access to their data centers through cloud mining services, finding it an easier approach than managing impatient buyers of mining equipment. Cloud mining was a natural progression for mining-gear retailers, but it required them to diversify into areas like designing chips and running large data centers.

Perhaps the biggest squeeze on smaller miners has been the drop in the price of bitcoins. After surging from $99 to $1,147 late last year, bitcoin has fallen back to $344 this week, a decline of 70% from the peak. One big reason for the decline is thought to be the race itself to mine bitcoins: As miners sold their bitcoin rewards to finance new equipment, those coins added to the overall supply in the market.

The twin pressures of rising mining investments and falling bitcoin prices have forced some smaller players out. “It’s a very capital intensive business,” says Yeh. “The costs of mining now outweighs the benefits for some miners, and so some people are exiting the space.”

The defection of smaller miners has caused a rare occurrence in bitcoin mining: the difficulty factor—which is adjusted according to the computing power miners use on the bitcoin network—declined last week as more miners pulled the plugs on older, obsolete mining equipment.

The makers of the specialized chips that mine for bitcoins may soon run into the same technical limitations under Moore’s Law that chip giants like Intel and AMD already face. But as long as the fastest processors can keep pushing up the difficulty of the mining process, more of the older, slower mines will be switched off. As more miners throw down their digital gold pans, the business of mining bitcoins consolidates around the remaining players.

Monopolies are a threat to most markets, but the prospect of one in bitcoin mining is especially dire because of a vulnerability in the system known as the 51% attack. If a single entity controls more than half of the processing power, it could abuse that control to allow fraudulent transactions or obstruct other miners from profits.

This scenario became real for a few hours in June, as mining pool GHash reached the dreaded 51% level. Some miners in the pool responded by quickly moving their mining activities away from Ghash. The company operating GHash later vowed to keep its share of the network below 40%. In recent months, a Chinese mining pool called Discus Fish emerged to surpass GHash’s share of the network.

Despite such concerns, consolidation among miners is likely to continue next year. Cloud mining companies are merging, while companies like Cointerra are expanding into adjacent markets through acquisitions. BitFury’s Vavilov says the company recently launched an investment arm that plans to invest in all areas of the bitcoin ecosystem, including consumer-electronics devices that can disitribute some of the mining work.

There’s an adage that people make more money in gold rushes by selling pickaxes than by mining for gold. In the world of bitcoin, it seems, you make money by doing both. And, increasingly, by acquiring other companies that are doing the same.

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