Every time Bitcoin crashes 80% or more, headlines all over the world claim that this time it is really the end of Bitcoin. These crashes have already happened several times in the past and will happen again. So does that mean that Bitcoin is a speculative investment? Of course it is, just like it was a speculative investment to buy Amazon stock when it started trading 20 years ago. But because something is a speculative investment does not mean that it is devoid of value, it means that the chances of success are uncertain. Bitcoin holds a promise, the promise of a censorship-resistant, government-free, decentralized currency.

Of course there is a very high probability that the experiment will fail, but do not look at short term changes in price as a reliable indicator of such probability, because what is driving short term changes in price is more complicated than that. There is no doubt that the price of Bitcoin went up too much too quickly in 2017, that many companies that had raised bitcoins and ethers through ICOs in 2017 had to offload them in 2018, and that many retail investors got spooked by the price volatility and decided to either sell their coins or delay getting into the market. But one factor that is often overlooked as one of the potential causes of the 2018 bear market is the cost to secure the Bitcoin network, which increased significantly in 2018 as a result of the 2017 rally.

The Bitcoin network became too expensive to secure too quickly

To achieve decentralization, the Bitcoin protocol relies on miners to secure transactions. As the price of Bitcoin increased exponentially in 2017, many mining companies assumed in their business plans that the price of Bitcoin would remain high and invested billions of dollars in specialized mining equipment on this basis. As more mining capacity was added to the network, the difficulty of the network also increased exponentially, such that it would still take ten minutes on average to mine a new block. What used to be a niche market when mining revenues were relatively limited became a multi-billion business when the price of Bitcoin skyrocketed in 2017.

At $10,000 per Bitcoin, the daily revenues from Bitcoin mining are $18 million, which equates to $6.5 billion per year. This means that just to secure the network, a minimum of $6.5 billion of net fiat currency inflows were needed to buy the newly mined Bitcoins from the miners which were securing the network, and this is excluding any sale of Bitcoins by existing owners. This assumes that many miners cannot afford to hodl until the price recovers. The Bitcoin network therefore became at the same time exponentially more secure but also exponentially more expensive to maintain.

The increase in hash rate was financially unsustainable

While the price of Bitcoin increased from $1,000 up to a maximum of $20,000 in 2017, the hash rate (number of computations per second) “only” increased by 550% during the same period. This means that existing miners enjoyed a windfall profit in 2017, as the hash rate was lagging the price increase. In economics this is what is called an excess profit: the “profit of a firm over and above what provides its owners with a normal (market equilibrium) return to capital.” Economics would expect that such excess profit would not be sustainable as new entrants would enter the field and compete to get a share of the excess profits, which would eventually drive the excess profit down to zero. This is exactly what happened.

The hash rate was multiplied by four in 2018, which means that the market share of the mining equipment that was already in operations at the end of 2017 was down to 25% at the peak of the hash rate in September 2018, while the Bitcoin issuance rate remained identical. Since January 2017, while the price of Bitcoin increased by 220% from $1,000 to $3,200 (as of December 16, 2018), the network hash rate increased by 2,500% at the peak in September 2018. Miners were therefore competing harder than ever for the newly issued Bitcoins while the Bitcoin price was not keeping pace with the increase in hash rate. It was a recipe for disaster.

When the price of Bitcoin started going down at the end of 2017, mining companies had no choice but to sell their Bitcoins at depressed prices. The weight of the security of the Bitcoin network precipitated the price collapse. The fall in hash rate observed since September 2018 is evidence that miners are pulling the plug and going bankrupt. Many mining companies that had borrowed funds and invested in mining equipment could not afford to wait. What is most likely happening right now is a liquidity crunch. Retail investors who had driven the 2017 bull run are nowhere to be seen while institutional investors have not entered the cryptocurrency space yet, but the miners have to sell, no matter the price.

The issuance of new bitcoins cannot adjust to demand

Unlike other commodity markets where a drop in buyers does not necessarily cause such a sharp drop in price, the Bitcoin market is different. It is different because there is no flexibility on the supply side. If the price of gold or oil drops, producers reduce their output such that supply adjusts to demand and the price eventually recovers. The Bitcoin market cannot do that. Every ten minutes 12.5 Bitcoins are mined, whether there is enough demand for them or not. And miners have to sell them to pay their electricity bills and repay their debt. Eventually the increase of Bitcoin supply is going to slow down (the next halving is scheduled in May 2020 and the following one in 2024) and miners will have to rely on transaction fees instead of block rewards, which will considerably relieve the pressure on the Bitcoin price. But the transition is going to take time.

The Bitcoin network was not ready to afford such a large mining capacity

The likely outcome of the current bear market is that many mining companies will go bankrupt and that the excess of mining equipment that was added to the Bitcoin network in 2017–2018 will be offloaded at very steep discounts or retired entirely. Which means that the cost of mining will mechanically go down to more sustainable levels.

So what is next for mining? Either the centralization of mining power will get worse if only large mining operations can weather the storm and acquire mining equipment from bankrupt miners, or the opposite will happen and mining will become once again decentralized as individuals who are mining in their basement, and who can afford to pay their electricity bill at the end of the month without selling any coin, will be able to wait until prices recover.

Of course there are many more reasons why the price of Bitcoin fell in 2018, but the billions of dollars invested in mining equipment was undoubtedly one of the catalysts that precipitated its fall.