Abstract: In this third piece on crypto-mining incentives, we look at the different time periods miners may choose to maximize profits; short-term or long-term. We draw analogies with related concepts in “traditional” mining, such as “high-grading”. In corporate finance circles there are rumours of potential IPOs for crypto-miners, which could mean management focus shifts to the short term, as they may unfortunately need to justify quarterly earnings to investment analysts. We then look at the implications of this on potential network issues, such as Replace By Fee (RBF), ASICBOOST and the blocksize limit. Whether one likes it or not, we think full RBF is coming.
Bitmain mining farm in Inner Mongolia – Photograph & Satellite image – Bitcoin mining is no longer for hobbyists
Source: Google Maps satellite image
Back in September 2017 we wrote two pieces on mining incentives. Part 1 focused on the mining cost curve and compared it to the dynamics of the cost curve in “traditional mining”, while part 2 looked at circumstances in the energy industry which could result in attractive opportunities for crypto-miners, concluding that failed or otherwise uneconomic energy projects may be best suited for Bitcoin mining. In November 2017 we wrote about miners chasing short term profits in the Litecoin vs Dogecoin “hashrate wars” of 2014 and how this was repeated again with Bitcoin Cash, as the hashrate oscillated between coins, as miners attempted to maximize short-term profits, rather than make decisions based on ideological support for their favored coin.
In this piece we look at whether miners will focus on short-term profit maximization (perhaps even next block profit maximization) or alternatively if miners may focus on promoting the long-term viability of the system, by enacting policies designed to improve the end user experience, thereby potentially increasing long term profits. We conclude that the level of competition in the industry, as well as the level of profitability, can alter the focus between short-term and long-term profit maximization decisions. Higher levels of competition and lower profit margins may result in a more short-term outlook. We then go on to look at implications each strategy could have on various issues facing Bitcoin, such as replace by fee transactions, ASICBOOST or the blocksize limit policy.
We believe that mining is becoming less ideological and more commercial. At the same time the intensity of competition may increase in the coming months and years. Therefore we predict full RBF will become prevalent in Bitcoin mining, as miners seek to maximize short-term profits.
Long term vs short run
It is widely accepted that most businesses want to maximize profits and Bitcoin mining is likely to be no exception to this. In the past perhaps some miners were hobbyists or idealists, but this era now appears to have ended and now profits are seen as a main driver as the industry grows and becomes more commercialized. However, profit maximization can be a more complex concept than one may think. Strictly speaking, investors should select projects which maximize discounted returns, and how to value the difference between profits today and profits tomorrow – the discount rate – is often a challenging metric to evaluate.
Analogy with traditional mining – High-grading
In “traditional mining”, high-grading is the practice of mining a higher grade of ore in a way that reduces the overall return of the mine, by wasting or destroying lower grade ore. This is often seen as a destructive process, which reduces the value of the ore body, by making some ore inaccessible or literally destroying it to access higher grade ore. Mining management teams may engage in this process due to short-term pressure, for example to boost profit margins to satisfy short-term shareholders, to generate cash flow to satisfy debt holders, or boost their own performance-linked bonuses. Management teams might then conceal the conduct of the activity from the public or from investors.
High-grading often occurs during prolonged periods of price weakness of the relevant commodity, when profit margins are low, debt levels are high and there is considerable pressure on management teams.
The question is, are the companies going to re-cut their business long-term at a lower gold price, or are they going to re-cut their short-term business hoping they’ll be rescued in the long term by the gold price? That second one is called high-grading and it’s a disaster.
Source: Randgold Chief Executive Mark Bristow
The below diagram illustrates what a high-grading open pit mining plan may look like. The initial plan for a larger mine captures more of the ore. However, the alternative plan, shown below, increases the grade of the ore mined, but permanently destroys or removes access to some high grade ore, potentially against the long term interest of mine owners.
Source: Exploration Alliance
Revising a mining plan due to changes in discount rates, costs or commodity prices can of course be entirely legitimate in some circumstances, however high-grading has negative connotations and is normally associated with reducing the value of assets in an inappropriate manner.
Although there is no direct link between high-grading and crypto-mining, the concept demonstrates that when mining teams are under pressure, they can make some short-term decisions which can destroy long-term shareholder value. This is particularly relevant in the listed space, where shareholders may have less control, less information or more of a short-term focus.
Whether miners make these “destructive” short-term focused decisions or not often depends on the level of profitability, which can be determined by the price of the underlying commodity. If the price of the commodity or crypto asset falls, such that a miner is not profitable, they may be faced with three options:
- Operate at a loss – Perhaps making a contribution to fixed costs
- Suspend operations – In legacy mining this could reduce the supply of the commodity increasing the price. On the other hand, in crypto-mining this could lower the difficulty, increasing profit margins for the remaining miners
- Modify mining policies – In legacy mining this could be a modification to the mining plan – for example, high-grading. In the case of crypto, it could be engaging in full RBF, overt ASICBOOST or, in the event of an unlimited blocksize limit, clearing the memory pool to scoop up all the fees, despite the negative impact this could have on pricing in the transaction fee market, destroying industry prospects.
In general lower profitability can increase the pressure on management teams, such that they make more short-term decisions, for example to pay down debt if they are under pressure from banks or to return to profitability if they are under pressure form shareholders. Higher margin companies may have more freedom to focus on the long term and may be able to invest for the future.
In addition to profitability, another factor to consider in crypto-mining is the level of concentration in the industry.
Mining pool concentration over the last 6 months
Source: BitMEX Research, Blockchain.info
The above chart illustrates the level of concentration among mining pools, however one could also analyse the level of concentration in the industry by looking at chip production or the control of mining farms. With respect to chip production, we estimate that Bitmain may have a 75% market share in Bitcoin.
If a miner has a large market share, their policies may have a significant impact on Bitcoin, which could impact the value of the system. In contrast, the policies of a small miner with a low market share may not have much impact on the system as a whole. A tragedy of the commons type situation could therefore occur, where policies which are best for the system as a whole, are not what is best for each small individual miner. For instance if a small miner with a 1% market share can engage in action which increases profits, but would damage the term prospects of the system if all miners engaged in the practice, why not conduct the activity, since 1% alone will not make much difference.
In addition to this the level of competitive intensity may also matter. If miners are ruthlessly competing against each other for market share, they may be more focused on doing whatever it takes to improve profit margins to win business.
Replace by fee (RBF)
Replace by fee is a system that enables the replacement of a transaction in a miner’s memory pool with a different transaction that spends some or all of the same inputs, due to higher transaction fees. A variant of this feature was first added by Satoshi, before Satoshi later removed it. Bitcoin Core then added in an opt-in version of the technology, where users must specify that the transaction can be replaced when making the transaction.
RBF has always been controversial, both the full version and the opt-in version, with detractors claiming it reduces the usability of Bitcoin by undermining zero confirmation transactions. Supporters of RBF claim, among other things, that miners will eventually adopt full RBF anyway, as it boosts short-term profits by selecting transactions with larger fees, even though it may harm long term profitability by reducing the utility of the system, which could lower the Bitcoin price. Again, its sometimes seen as a tragedy of the commons type problem. Opponents of RBF may counter this by saying miners have more of a long term focus, and therefore RBF advocates are solving a theoretical game theory type problem which may not apply.
One can thing of the type of industry characteristics, where this short-term profit driven motive and therefore full RBF, become more or less likely:
|Short-term profit – full RBF more likely
||Long-term profit – Full RBF less likely
|A period of falling Bitcoin prices
||A period of rising Bitcoin prices
|Lower profit margins
||Higher profit margins
|Lower levels of industry concentration
||Higher levels of industry concentration
|More intense competition and a rivalry between miners
||A less intense competitive environment and collaboration between miners
|Publicly owned mining companies
||Privately owned mining companies
|Profit driven miners
||Ideologically driven miners
An unlimited blocksize limit
As anyone following Bitcoin knows, the “blocksize debate” is a complex issue which can be looked at form many angles. One such angle is that of the interrelationship between the fee market and mining incentivization. Supporters of larger blocks sometimes argue that a fee market would still work with an unlimited blocksize, while “smaller blockers” often dispute this point.
An element of this argument is related to whether miners focus on the long term or the short term, just like for RBF above. Supporters of an economic blocksize limit claim that we need an economically relevant blocksize limit, by claiming that without a limit miners may focus on maximizing short-term profits and scoop up all the fees, resulting in low fees and insufficient mining incentives. “Larger blockers” then counter this by claiming miners will have more of a long-term focus and would not take such action, as it would damage the long term viability of the system, and therefore their businesses.
The history of the “death spiral” argument
In some ways, this short-term vs. long-term incentive discussion, or the “death spiral” argument, goes right to the genesis of the blocksize debate, back in in April 2011.
The death spiral argument assumes that I would include all transactions no matter how low their fee/priority, because it costs me nothing to do so and why would I not take the free money? Yet real life is full of companies that could do this but don’t, because they understand it would undermine their own business.
Source: Mike Hearn (April 2011) – Bitcointalk – One day earlier Mr Hearn thought that “The death spiral failure mode seems plausible” but then changed his mind after thinking about the issue further.
Although ironically, the narrative from some of the “larger blockers” has somewhat shifted in recent years, to a “pro mining” type philosophy of chasing short term profits. Perhaps this is because ironically a large miner, Bitmain, has been one of the most prominent advocates of larger blocks. Most “larger blockers” appear have shifted the narrative on to some other valid points, although, as we explained above, this short term vs. long term line of thought can be considered as the genesis of the blocksize debate and part of the initial reason for the division in the community.
In our view, there is no right or wrong answer to these questions. Whether miners have a short-term focus or long-term focus depends on many factors, including profitability and market share, as we explained above. In our view the industry may go through cycles, where the industry shifts between the long-term and short-term focus depending on conditions in the industry. This phenomenon is visible in traditional mining, driven by commodity price cycles impacting industry conditions.
Changing times – A short-term profit focus will be king
The Bitcoin community is rapidly changing, the transformation from a cohesive group of people with a shared vision working together to build a revolutionary technology, to a much larger community made up of competing profit-driven factions, is almost complete. It may have seemed unrealistic a few years ago to assume miners would be primarily driven by short-term profit maximization, however this is increasingly accepted as the norm now, certainly after the hashrate swings caused by Bitcoin Cash’s EDA.
Mining is a business: TSMC has reported that one crypto mining business may be spending US$1.5bn per annum on chips, and growing. In some corporate finance circles, rumours are circulating that large mining pools or chip producers could conduct an IPO shortly, something almost unimaginable a few years ago. This could put management of the mining pool in the unfortunate position of needing to justify operating profit margins to investment analysts and shareholders, each quarter. At the same time, many expect the mining industry to become more competitive this year, with new companies expected to launch competitive products.
In this new world, RBF type behavior and the fee market “death spiral failure mode”, seem more and more inevitable. Perhaps early fee market and RBF advocates were too obsessed with unrealistic and complex game theory, and maybe they were too early, when a better tactical decision could have been to focus on the user experience before adopting RBF and full blocks. Although now Bitcoin has changed, short-term profit maximization is the new mantra.
In the coming years, we predict that many miners will engage in full RBF and even overt ASICBOOST (which can also boost profits), as they do all they can to maximize short-term profits. Whether one likes it or not, in our view, it’s coming…