As the World Moves Further into Chaos, Bitcoin Is A Way Out
In tracking metrics such as mining difficulty, it’s becoming all the more clear that Bitcoin is truly a hedge against the fiat-run financial system.
2020’s rolling on and the world’s cracks are beginning to show further by the day.
Wherever you’re from, you’re not immune to rising unemployment, tumbling markets, and the exponentially increasing global debt compared to GDP growth. As Jeff Booth says in his seminal work, The Price of Tomorrow:
“since 2000, the world economy has grown from US $33.5 trillion to about US $80 trillion, but to achieve that growth, the total debt has grown to over US $247 trillion as of the third quarter of 2018, according to the Institute of International Finance. In other words, it has taken approximately $185 trillion of global debt to achieve $46 trillion of global growth.”
In short, the current, fiat-driven financial system doesn’t work.
There has never been a better time to look for a way out and a way forward. and it’s my view that Bitcoin and the crypto space at large, are that way forward.
The more time that elapses, the more data backs up this assertion. Still, with the sheer ocean of voices across the internet telling you which way to turn, the only way to understand that data is to first break down the leading cases for Bitcoin’s value, then break down the data they depend on.
The first part of that process has already begun over at the Norwegian Block Exchange, for which I’m the writer. If you’re interested in that content, head here.
As to the second, due to how many metrics exist and how complicated they are, it’s best to start with one at a time. Because it has hit the headlines as recently as yesterday, I’m kicking off my personal exploration of Bitcoin’s value with a discussion of mining difficulty adjustments and their correlation with Bitcoin’s price movements. I hope that once you’re familiar with the below, you find it easier to also understand the true impact of miner activity on Bitcoin’s growth.
What is mining difficulty?
First, it’s important to define mining difficulty as a concept and a process, then dig into its impact on Bitcoin as a whole. If you’re already familiar with its definition, head further down.
At its core, mining difficulty is just what it sounds like.
Remember that in the context of Bitcoin, mining is the process of verifying transactions so that they can be added to the Bitcoin blockchain. The first miner that creates a block of transactions and adds it to the Bitcoin blockchain receives the block reward, which is currently 6.25 bitcoins as well as the only way that new bitcoins are issued. Now, with this in mind, you can picture mining difficulty as the measure of how hard it is to be the first miner to solve for a block and receive the block reward.
Why does mining difficulty matter?
Historically, when mining difficulty drops, it’s been said to relieve network congestion as well as high network fees and consequently, bring Bitcoin back to a truly usable state. Today, CoinDesk and others reported that “Bitcoin’s mining difficulty has just seen its largest drop in 9 years.” What’s perhaps most significant in CoinDesk’s report is the assertion that the continuing bull market put together with the drop in Bitcoin’s mining difficulty will bring in a horde of new miners. If you understand the concept of a profit margin, then you’re already familiar with why.
A profit margin is the measure of how much a company makes after all of its costs are taken out of the equation. With miners, these costs are the sunk costs on mining hardware plus the cost of the electricity that said hardware uses. When mining difficulty goes down, technically both of these costs go down as well since it becomes possible to use less expensive hardware to mine bitcoins, which requires less electricity to keep running.
It’s important to note, however, that for a drop in mining difficulty to result in a truly significant mining boom, it would have to persist over the long-term. Adjustments in mining difficulty happen “every 2016 blocks,” which means that they’re hard-coded into Bitcoin (foregone conclusions). The only question that remains, in that case, is whether each adjustment will be an increase or a drop in difficulty. The technical importance of drops is that they happen when the Bitcoin network needs to move faster and more efficiently, so mining becomes easier. On the flip side, an increase occurs because it becomes so easy to mine bitcoins, that the average block time moves significantly away from the ideal of 10 minutes per block, as stipulated in the Bitcoin white paper.
To make sure that difficulty never adjusts too far, it’s restricted to increases or decreases of no more than a factor of four. If this wasn’t set by the algorithm that controls difficulty adjustments, then it would be fairly easy for Bitcoin to fall victim to all sorts of attacks with the aim of taking control of its network.
So, what does the recent decrease in Bitcoin’s mining difficulty actually mean?
Historically, when difficulty drops, Bitcoin’s price tends to increase.
Research such as Adam S. Hayes’ paper titled, “Bitcoin price and its marginal cost of production: support for a fundamental value,” sheds light on why this is the case. Amongst its findings are that Bitcoin’s price is driven by its marginal cost of production, which in simplified form, can be expressed as the “daily cost of being a miner.”
In Hayes’ findings, he details what he sees as the ideal equation for making this calculation. For simplicity’s sake, imagine it as all of the costs of mining added and multiplied together to get the current, total cost of doing so per day. Using this figure, Hayes went on to develop an equation to determine the market price of Bitcoin with the marginal cost of its production and the “expected daily level of Bitcoin production.”
Below, you can see with that looks like.
Here, the left side of the equation represents market price, with the top of the right being the marginal cost of production and the bottom of the right being the number of bitcoins produced per day. With this, it’s important to clarify that the marginal cost of production is expressed as “per unit of mining power,” aka “per each unit of electricity used.” Furthermore, “BTC/day” is determined by block reward x hash power used per miner x a constant representing how many seconds are in an hour. The product of this is then divided by the product of mining difficulty as measured by “units of GH/block” and 2 to the 32nd power. Finally, that product is multiplied by another constant, which is the number of hours in a day. In the end, what we’re left with is the expected number of bitcoins that will be produced in a day based on all of these metrics.
This is then applied to the equation for determining Bitcoin’s market price, as shown above. According to Hayes’, the viability of that equation rests on the idea inherent in microeconomics that when marginal product equals marginal cost, these measures can be plugged in as previously detailed to determine the selling price that achieves equilibrium. This then explains the conclusion that the product, P*, doesn’t represent Bitcoin’s current market price, but its “lower bound,” which means the lowest price it can fall to before miners start exiting the network due to increasing losses and non-existent profits.
How do these ideas apply to mining difficulty?
The above ideas directly apply to the significance of mining difficulty, in that they show how if difficulty increases too much, revenues or fees need to exponentially increase to match it, which in turn, decreases the overall efficiency of the Bitcoin network. It’s this decrease that can drive a subsequent drop in Bitcoin’s price because as it becomes less viable to create bitcoins, miners tend to sell them more to account for their rising costs.
At first glance, history seems to support this.
On March 20 of this year, Cointelegraph penned a post in which they examined the historical relationship between downward difficulty adjustments and price decreases. While they did find several instances in which difficulty decreases seemed to tank Bitcoin’s price, it’s important to keep in mind that this may be a spurious correlation. If you’re not familiar with the term, just think; “two variables that appear to correlate but are actually only related due to a third factor that is often difficult to find.”
One alternate way of looking at the relationship between difficulty adjustments and Bitcoin’s price movements would be to say a decrease in difficulty should attract more miners to the Bitcoin network. If this were true, it could then be concluded that as Bitcoin’s aggregate number of miners increases, its hash rate goes up, but interestingly enough, its issuance remains the same. This is because the block reward is set in stone until the next halving occurs, regardless of other measures.
Using these ideas, it is possible to say that price movements are independent of mining difficulty because supply isn’t affected by miners either selling or buying more bitcoins. Saying so, however, would leave out the question of the effect of miners on Bitcoin availability, which is different from simple issuance.
Since a miner always receives all newly minted bitcoins (6.25 per block), they control the release of bitcoins to public markets. Most commonly, this occurs by miners selling the bitcoins they receive to Bitcoin exchanges, who then make them available for trading and “HODLing.” So, using this as a rule of thumb, it becomes clear that the more bitcoins that miners sell, the more bitcoins will be available, thus decreasing the asset’s overall scarcity (but not its total supply-based scarcity).
So, then, what can be concluded about the relationship between mining difficulty adjustments and Bitcoin’s price?
In my mind, the logical conclusion is that for Bitcoin’s value to increase, demand needs to be increasing in parallel with scarcity. What current data shows is that the relationship between supply and demand has become increasingly independent of mining difficulty over the years.
Looking at the graph above, you can see the relationship between Bitcoin mining difficulty and price, with the former represented by the green line and the latter, by the black line. By mid-2017, these two lines diverged and never returned to anything close to a near-perfect correlation. What this indicates is price movements are now largely independent of price. In his research, Hayes echoes this sentiment.
“Despite a significant deviation in price to the upside from the Fall of 2017 through early 2018, the cost of production model has remained resilient as the market price did ultimately converge with the model. This novel pricing method leads us to expect that during periods of excess demand (e.g. a price bubble), either the market price will fall and/or the mining difficulty will increase to resolve the discrepancy.”
Here, it can be concluded that market price movements and mining difficulty both serve as mechanisms that resolve the gap between Bitcoin’s price and miners’ costs. At least preliminarily, the third variable that seems to drive this relationship is the hard-coded limit of no difficulty adjustment of more than a factor of four.
In future posts, I’ll continue to examine this relationship amongst others and try to develop more conclusions about them based on the evidence at hand. For now, suffice it to say that mining difficulty adjustments are driven by the need of the majority of the Bitcoin network miners’ and so, not only those from one province as media outlets have suggested.
Furthermore, because Bitcoin has arguably only achieved significant adoption outside of early adopters this year, only time will tell what comes of the correlation between Bitcoin difficulty adjustments and price movements. With that in mind, you can expect that as with all things Bitcoin and crypto, I’ll be with you both here and at NBX to discuss it further over time. Overarching all of my efforts is my main thesis on Bitcoin’s value, which aligns with that of Raoul Pal, Jeff Booth, Anthony Pompliano, Robert Breedlove, The Crypto Curator, and many others in the space. Until next time, if you feel you’ve learned anything here, make sure to subscribe to both blogs and remember that in the Bitcoin space, as well as in the crypto industry-at-large, we’re all in this together.
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Disclaimer: None of this is meant to be financial advice. I’ve researched and worked in crypto since 2016 and I aim to merely educate people on the upsides and downsides of all sorts of projects and the market itself. Additionally, I’m a student just as all of us are. Therefore, my thoughts on projects evolve naturally over time as I learn more about them. Last but not least, none of these posts represent the thoughts of NBX unless otherwise stated and this includes all posts that preceded this one. In this case, my views here happen to correlate with those of NBX if you compare the blogs both because I write both and because of NBX’s vision.
