As you might have herd, China has been cracking down on Bitcoin miners for quite some time now. The crypto community has been raising some concerns and uncertainty for the near future as the Chinese miners were forced to halt their operations, pushing the hashrate to an 8-month low. To clarify some of this development and help you understand what implications will follow, I’ve created this short explanation of Bitcoin mining, hashrates and their relation with Bitcoin’s capabilities and price action.
Bitcoin mining is close to what you’d guess from the name — it’s a process of creating new Bitcoins with a few additional “features”. Unlike the Western stories of digging for gold with shovels and pickaxes, Bitcoins are mined by high-powered computers that solve complex computational math problems that heavily tax even the most powerful computers and mining rigs.
With mining, the Bitcoin network achieves two important goals, creating new Bitcoins and verifying Bitcoin transactions in a secure and trustworthy manner. Moreover, mining enables Bitcoin to be fully decentralized, enabling anyone to participate in its development and transaction verification while preventing any individual or single organization to dictate or own the currency, unlike the traditional payment systems.
Now you might ask yourself: “What exactly are miners trying to calculate?” The answer is a “Hash”, equal or smaller than a “Target hash”. I know this sounds very technical or a bit too complicated but bear with me here. A hash is a 64-digit hexadecimal numeric value that represents the latest block. The computers are trying to guess the correct hash by guessing thousands and thousands of hashes per second, hoping that they’ll guess the correct one. The one that succeeds receives the block reward that halves roughly every four years (at the launch of the cryptocurrency it was 50 BTC and currently, it stands at 6.25 BTC). Besides block rewards, miners also get paid relatively small transaction fees that users pay to send Bitcoins to each other. After around the year 2140, the last Bitcoin will be mined and hopefully, enough miners will remain verifying transactions solely for transaction fees.
While setting up automatic mining operations and receiving Bitcoins from time to time sounds like a great opportunity, it’s become quite competitive over the years. At the start in 2009, individuals could easily compete for block rewards simply by mining on their desktop computer. Today however, the only entities that can stay profitable by mining Bitcoins are companies that run large mining operations and mining pools — aggregates of many smaller miners that unite their hashing power and divide the rewards. The reason for this is that the difficulty of mining changes over time. To ensure smooth functioning of the blockchain and enable it to process and verify transactions seamlessly, the Bitcoin network aims to produce one block every 10 minutes. If there are millions of miners competing to solve the hash problem, chances are they’ll solve it faster than if only a hundred miners are working on it. To solve this, the Bitcoin network adjusts the difficulty of mining every 2016 blocks or roughly every two weeks. When enough miners unplug their operations like the recent case in China, the hashrate (mining difficulty) automatically decreases.
A large amount of hashing power leaving the network has some consequences though. Before the hashrate adjusts, the pace at which blocks are mined subsequently slows down, resulting in confirming fewer transactions, filling the Bitcoin mempool with unconfirmed orders. This state of slower transactions makes the blockspace on the network a scarce resource, forcing users to pay higher transaction fees. After some time, the network adjusts either by miners resuming their operations, incentivized to reap the rewards of high transaction fees or by the network decreasing the hashrate. If the hashrate decreases, the network becomes a bit less secure, because if the hashrate is lower, it’s easier to perform a 51% attack as you need less computing power.
Either way, a temporary decrease in hashing power is eventually resolved and has little to none long-term effects according to the historical data and hashrate decreases since the inception of Bitcoin. Some do believe that a downward spiral may occur if the hashing power would decrease so rapidly that the huge network transaction fees would cause people to lose faith in Bitcoin, dumping it and discouraging miners from continuing on with their operations. While it is theoretically possible, the Bitcoin is quite flexible and resilient to such extreme events as everyone participating has an incentive to keep the network useful. They can adjust the system by reducing the number of transaction confirmations or by reducing the hashing difficulty.
Personally, I believe something similar will happen through this recent turn of events in China. For those of you that let the news slip under your radar, Chinese authorities have been cracking down on cryptocurrency mining, stopping more than 26 large mining projects for examination because of suspected fraud in power consumption. Some have seen the writing on the wall months ahead of time, correctly predicting the migration of hashing power out of China that has already started to undergo. Historically, China hosted more than half of the world hashing power and now it’s sharply declining as Chinese miners are already migrating their operations to new locations with more favorable legislation and cheap power supplies. Even though the hashrate has dropped close to 50%, we’re probably witness a bounce back up as miners resume their operations after migrating.
Lastly, many believe that there is a correlation between the price of Bitcoin and its hashrate. One school of thought believes that “the price follows the hashrate” and the other believes that “the hashrate follows the price”. While either can be true, it’s still too early to get a definitive answer on which if any of these is correct, and we’ll probably need another 10 years-worth of data to know for sure.