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Byte Me: Bitcoin’s ticking timebomb

bitcoin bom

If you’re thinking about getting hold of some bitcoin, you have 690 days to figure out what mining is. But if you don’t, you can still board the bitcoin boat, but it might turn out to be the Titanic.

Bitcoin, like the World Cup, is, for better or for worse, a universally known brand. But, as is obvious this summer, just because people talk about something incessantly, it doesn’t mean they understand what’s going on.

For most people ‘mining’ is a mysterious black box into which electricity goes in and bitcoins comes out. But mining is far more than an engineering curiosity and, in 690 days, you can expect everybody to be yapping about it. The cryptocurrency’s credibility is at stake.

Mining is the process of verification that powers the bitcoin network, and the only activity that generates bitcoins — which are paid to the miners which discover them. 

If you want to pay someone in bitcoin, the information of how much bitcoin you want to pay is sent to every computer engaged in mining bitcoin (these are known as ‘nodes’). The nodes add your transaction to the shared record of bitcoin transactions — the blockchain — and lo, it is done: the network credits your bitcoin to the account of whomever you sent it to.

Really, bitcoin works like a bank; except that instead of sending information to a huge impersonal corporation’s computer to process, you send it to a huge impersonal network of computers.

The big difference is that no one in the network can understand the information they receive (unlike your bank) as it is disguised by the magic of cryptography. So by the magic of zero-knowledge proofs, nodes can check that you really have the bitcoin you’re spending without ever knowing how much you are spending.

Mining is a big industry. The network mining bitcoin is the most powerful computer network in the world. So why do bitcoin miners spend so much money on electricity to run and cool the vast farms of servers that keep the bitcoin network honest? It’s not from the goodness of their hearts. Miners receive 12.5 bitcoins (about $82,000) for being the first in the network to identify a new block in the blockchain. As this happens every 10 minutes, there’s almost $11m worth of bitcoin up for grabs every day.

When mining undermines

But in 690 days, that reward will be halved. Satoshi Nakamoto, the shadowy creator(s) of the bitcoin protocol decreed at the outset that a permanently inflating money supply erodes the value of your savings and is therefore evil. So bitcoin was designed, so new bitcoins would be produced at a decreasing rate until there were 21m of them — which is due to happen sometime in 2021 — at which point all the bitcoins there will ever be will have been made.

While increases in the price of bitcoin would go some way to compensating miners for their reward being halved, margins are unlikely to be so generous that miners are able to swallow such a drastic loss of earnings easily. 

The last time the reward for finding a bitcoin fell was in July 2016 and, remarkably, passed with little incident. But bitcoin’s price is now 10 times higher than it was then (although it is languishing at around a third of its peak price) and, more to the point, 20 times as much computing power is going into mining bitcoin than two years ago.

When the reward halves, the profitability of bitcoin mining does not do the same. Miners make some money (around 12% in 2017) from fees levied from those who want their bitcoin transactions processed quickly. But, without a rapidly rising asset price adding to miners’ income, the degree of profitability will become a hot topic. That is because as profitability drops, some miners will shut or shrink their operations. And as servers around the world shut off, the security of the bitcoin network drops.

Mining security

Bitcoin’s security is predicated on the assumption that to enter fraudulent transactions in the blockchain, you have control more than 50% of the network. Otherwise, somebody else will mine bitcoin before you and your fraudulent transactions will not be processed.

With three mining pools already controlling more than 50% of the network, a meaningful fall in the processing power mining bitcoins could bring us closer to the point where one organisation could hold the majority of the processing power.

If that happens, bitcoin’s credibility vanishes. It may have a reputation as a means of money laundering and purchasing drugs, but the bitcoin network itself has never been hacked. Exchanges have been hacked and inadequately stored bitcoin stolen, but nobody has ever been able to mess with the mining process. It would destroy the network.

Bitcoin made it through 2016’s ‘Halvening’ without much trouble. That doesn’t mean it will make it through this time.

As the fateful reward halving nears, bitcoin’s price will start to reflect how holders expect it to react: volatility is in store.

Global crypto code?

Attempts by the cryptocurrency industry to self-regulate are nothing new. Cryptocurrency magnates the Winklevoss Twins — made famous by their sulky portrayal in The Social Network — announced in March that they were looking into starting a self-regulatory body for exchanges. 

In June, the crypto industry body Global Digital Finance launched a consultation on a new code of conduct and taxonomy for the crypto market. It’s an ambitious idea and has quite a few prominent backers, including cryptocurrency exchanges Huobi and Coinfloor, as well as blockchain consortium R3.

Figuring out how to regulate cryptocurrencies has been tough for regulators around the world, and an agreed set of definitions and principles for operating in the market could help countries achieve regulatory convergence of some sort. But the jurisdictions that have made a move on the issue seem poles apart, and the market is a complex and changing one. 

For example, French securities regulator AMF and the French government are keen to introduce a whole new regulatory regime for initial coin offerings. US regulatory agencies, on the other hand, have resorted to labelling most cryptocurrenices  as a security or a commodity and been done with it. Many secretly hope for bespoke rules from US Congress, but it seems a long way away for now. 

Jeff Bandman, a fintech consultant and co-founder of the GDF, admitted to Byte Me that the principles identified in the code of conduct could be more granular. But he also said that it was “already a measure of success to bring together hundreds of community members” to reach consensus on the document and a transparent consultation process.  

If the GDF can keep the conversation going and include regulators wherever possible in its discussions, it could yet make a positive impact on the trajectory of cryptocurrenices .