Bitcoin and the other altcoins now have more “experts” than perhaps any other market. I am no such “expert”: I am neither a cryptographer nor a computer programmer. I am a currency and commodity trader of thirty-plus years, and I approach the cryptocurrency market from that perspective.

The cryptocurrency market cannot easily be dismissed, despite the fact that several high-profile people and institutions have called it a fraud, a Ponzi scheme, and a scam. The altcoin market surpassed $700 billion in market capitalization in late 2017, even though it is about half that now. This extraordinary volatility is caused by the immaturity of the market along with other factors that will be analyzed below.

Most discussions of cryptocurrencies revolve around two core questions: whether the trading values of Bitcoin and other cryptocurrencies are justified, and whether cryptocurrencies’ underlying blockchain technology will live up to its disruptive billing. Such discussions, however, too often end up as abstract, irresolvable debates between blockchain optimists and pessimists. In contrast to these typical approaches, I will focus mainly on the quantifiable elements of the Bitcoin mining process, not only to suggest a reasonable range of values, but also to explore the larger economic and political issues surrounding cryptocurrencies and blockchain technology. While most commentators tend to emphasize the differences between virtual currencies and physical commodities, I will focus on the similarities. Indeed, it is the similarities to conventional mining that are likely to determine cryptocurrencies’ future trajectory more than their virtual aspects. As is the case with commodity mining (over the long term), Bitcoin mining will continue to increase in capital intensity; for Bitcoin, such a trend is effectively built into the system. As a result, the shift toward corporate centralization, which has already begun, will likely accelerate. Although cryptocurrencies began under the guise of a libertarian ethos, market and mining conditions will steadily lead them back toward corporate cartelization and state involvement.

Bitcoin and the Blockchain

First, a bit of background on the origins of Bitcoin as well as the distinguishing features of blockchains. Bitcoin (BTC) was created by the person or persons using the pseudonym of Satoshi Nakamoto, who released a white paper on the concept right after the collapse of Lehman Brothers in 2008. The key component of Bitcoin, like those of the other altcoins, is the blockchain. The blockchain is a decentralized ledger. In contrast to many other tech applications—social networks, mobile phone ecosystems, and the like—the Bitcoin network is not administered by or dependent upon a corporate (quasi-)monopoly. In theory, it is the antithesis of one. No central authority is in charge, and its protocols are subject to change with the user base consensus. This is the main promise offered by cryptocurrencies, and, if nothing else, BTC so far has offered solid evidence that a peer-to-peer system can create a secure database: there have been no hacks of the system to date (although participants have been hacked). This fact in itself demonstrates that the blockchain has some value.

In a blockchain ledger, each transaction is recorded by a population of “nodes.” These nodes are the miners, which are required to solve computational puzzles before anyone else in order to receive compensation for their efforts. The miners are the backbone of any crypto system. It is the miners that have to validate every transaction on the blockchain. To do so, they need to build and store all the blocks on the blockchain and then reach a consensus on which blocks make it into the blockchain.

This network of distributed nodes replaces the trust and centralization needed in a hierarchical system. In fact, the Bitcoin network is the most powerful computer network in the world, and this is the true source of its value. The price of Bitcoin is directly correlated with the revenue opportunity for securing the Bitcoin network.

Bitcoin Mining

The first thing to ask about any market is whether it can become sufficiently liquid. BTC has achieved this, and the binary risk of its going to zero is for now alleviated: BTC is mainstream. To understand the underlying value of Bitcoin and its blockchain more precisely, however, it is necessary to understand the incentive structure that supports the blockchain. Without appropriate incentives, a decentralized system cannot sustain itself. Although the “decentralized” character of the blockchain has attracted the most attention, the incentive structure for mining Bitcoins is gradually adding crucial “centralized” elements to the cryptocurrency market’s overall character.

Unlike fiat currency systems, under which a central bank or other central authority determines the supply of money, in BTC the total supply is determined by supporting the blockchain, which occurs through the activity known as mining. Mining is governed by an algorithm: everyone knows when each supply of BTC is produced as well as the maximum total quantity, which is 21 million Bitcoins. For BTC, the mining algorithm initially offered a reward of fifty Bitcoins per block until the first 210,000 blocks were mined, and then the reward per block halved. The current reward is 12.5 Bitcoins. Reaching 210,000 blocks requires about four years of mining, given that each block has been structured to be mined in about ten minutes. The ten-minute block average is maintained by a difficulty adjuster. This difficulty adjuster is changed every 2,016 blocks, or about every two weeks, based on how fast miners were able to mine the previous 2,016 blocks. This block reward system should end around 2140. There are also rewards through transaction fees, which have become a major component of compensation for the miners (though not without creating other controversies).1

Since Bitcoins are produced only by mining, understanding the costs and difficulty of mining is key to understanding the supply side of the equation. A major cost of mining is the computer hardware. Leading-edge chips are needed to compete effectively for blocks. The many similarities to the physical mining business make it quite appropriate that nodes are called miners. At block 512,500 in the blockchain, for example, mining computations become quite difficult and require a significant investment in hardware before one can even become a player in the field. Much like in physical exploration, there are no guarantees that the miner will get a return on this up-front investment. The most important pieces of hardware for BTC miners are ASIC (application-specific integrated circuit) chips, and only the latest, most expensive chips are sufficient for effective competition. Moreover, the lead times on the production of these chips are long and costs are prepaid to the vendors.

Finding the right location for mining operations is also crucially important. A mining location needs three major attributes—a cold climate, cheap and widely available electricity, and good internet speeds. Given the magnitude of computing power involved, mining uses an enormous amount of electricity and produces a lot of heat. To be competitive in the mining sector, costs of electricity typically cannot exceed five cents per kilowatt hour (kWh), and a miner will need a reliable electrical network capable of delivering megawatts of electricity per hour.

Although results can be highly variable, miners can use a Poisson distribution to predict the expected blocks to be mined. The Poisson distribution is used for modeling the number of times an event occurs within an interval of time. A mining operation can calculate the probability of finding blocks over the life of its chips in order to decide whether the operation is likely to be of value. The block probability is directly affected by the global hash rate (the speed at which an operation in the Bitcoin code is completed) versus the amount of hash power the miner has. Usually miners have a set capacity of hash power until additional investments are made in new chips. Miners can thus expect their probability of successfully mining blocks to decay over time.

To reduce block volatility, many miners have joined mining pools. Herein lies a major risk, at least in theory. The top twelve mining pools currently control 13,225 petahashes per second (at the time of writing), while the total network speed is about 20,000 petahashes per second. The top three mining pools control almost 40 percent of the power of the whole network, and the top six control a majority of network power. That is a lot of power in the control of a few top miners. Remember that cryptocurrencies are supposed to be decentralized systems. Even though each pool represents many miners, there is a real risk that decentralization could be undermined, should the top six mining pools initiate a 51 percent attack on the system. The main point here, however, is simply that the power of the system is controlled by a few, given the complexity and cost of mining. Another potential challenge to maintaining BTC’s decentralization is that only two companies dominate the market for the hardware underpinning cryptocurrencies: Bitmain Technologies Ltd., a closely held company in China, and Bitfury, a Georgian company. Bitmain, moreover, is believed to be much larger than Bitfury.

Such growing concentration and cartelization is relevant because everything in the Bitcoin world is done by consensus. When consensus breaks down and some miners want to follow a different set of rules, a fork is created in the blockchain. How much support (via mining power) each fork gets will determine the success of that fork.

Although the miners are the key players in the Bitcoin ecosystem, there are other important members, including the core developers and the buyers of BTC itself. Other components of the Bitcoin ecosystem include those who use Bitcoin for transactions, such as merchants and their respective customers, along with any intermediaries and payment services.

Bitcoin Valuation:

The Limits of Demand-Based Calculations

Since the buyers of or investors in BTC represent the demand side of the equation, we need to understand how they value BTC. As we shall see, these methods cast some light on BTC’s possible valuation, but their predictive value is limited. Some investors in BTC and other altcoins use exponential models to project prices for cryptocurrencies. These models use variants of Metcalfe’s law and Zipf’s law. Metcalfe’s law looks at the change in nodes and squares them (n2). Zipf’s law takes a less aggressive approach, using logarithms and multiplying the nodes by the log of the nodes or (n log (n)). For example, let us assume a network of 100,000 members that generates $1 million. In this example, if the network doubles its membership to 200,000, Metcalfe’s Law says its value grows by (200,000/100,000)² times, quadrupling to $4 million, whereas Zipf’s law says its value grows by 200,000 multiplied by log(200,000) divided by 100,000 multiplied by log(100,000), or to only $2.12 million. Applying the two models to the node growth from last year and looking at the price of BTC/USD, we see the two models imply the following price: One year ago there were 5,625 nodes and today there are 11,714. So using Metcalfe’s Law, the BTC price should have increased by (11,714/5,625)² times or 4.34 times. Last year, BTC was $920. So using Metcalfe’s Law, BTC should be $4,000. Under Zipf’s law, BTC should be (11,714 × log(11,714))/(5,625 × log(5,625)) or 2.26 times $920—about $2,100. Needless to say, these methodologies have not proven especially useful in predicting prices and constitute little more than applying basic formulas to the major unknown variable—network size.

Clearly, expanding the network is extremely important to the success of a peer-to-peer system. Attempting to quantify this, other investors seek to value BTC based on relative values. One such approach to BTC valuation includes comparing the market capitalization of BTC to the narrow money supplies of the major economies of the world. When BTC hit $20,000, the total BTC market capitalization was about $340 billion. If one BTC equals $10,000, the market capitalization for BTC is about $170 billion. For perspective, the M1 “narrow” money supply of the United States is $3.6 trillion. This puts BTC at 5 percent of the narrow supply of money of the United States.2

The comparison is probably a poor one, however, given that the cryptocurrencies are not really transactional currencies, even though the amount of entities accepting BTC is increasing daily. In addition, the multiplier effect for cryptos is probably close to one as there is no real lending market to date, unlike for fiat currencies.

Maybe the best comparison for market capitalization is to gold. In fact, at a major mining conference held in March 2018, it was standing room only at the gold-versus-BTC session. Gold, like BTC, is not a transactional currency but more of an accumulation asset or store of value. Best estimates are that there are 187,000 tons of gold above ground. At $42.8 million per ton, the market capitalization of all gold is around $8 trillion. BTC market capitalization, then, equates to about 2 percent of gold’s market capitalization.

In 1911, the economist Irving Fisher introduced the “Equation of Exchange,” MV = PT, where M is quantity of money, V is the velocity, P is price, and T is transactions. If we solve for price we get P = MV/T. If we fill in the BTC statistics, we can solve for P. M is the easiest to answer. The amount of BTC in circulation is 16.8 million. The velocity of BTC is harder to answer, but there is a good argument that it is around 1. The higher the velocity, in theory, the higher the price of BTC. From the model, we observe that transactions have a decreasing effect on price. Hence the rising price of BTC could be in part attributable to the accumulation of BTC rather than to the adoption of BTC as a medium of exchange. In fact, if BTC becomes more like a currency than an asset, it could negatively impact its price, ceteris paribus. Nevertheless, using this model for BTC or any currency is too simplistic, in my view, to have any particular meaning, but I include it here as another methodology commonly used to justify BTC’s price.

BTC Breakeven Costs

In my opinion, the most important factor in determining the value of BTC—and for understanding its long-term trend toward centralization—is one fundamental to any commodity that is mined: the breakeven cost of bringing that commodity to market. The comparisons we made to other currency markets are exercises in relative value, but the cost of supply of BTC should be paramount in determining, at the very least, the lower end of the value of BTC. Most of the components of mining are commoditized, so the lowest-cost miners will be the most influential, just as in the case of a physically mined commodity. The major costs of mining are the ASIC chips as a fixed cost and electricity as a variable cost. Some of the larger miners are mining in countries where their electricity costs are between zero and five cents per kilowatt hour.

Furthermore, although current network speeds are known, the future growth rate of network speed will need to be projected. BTC network speeds have increased rapidly, as we have discussed. A more rapid increase in network speeds translates to fewer BTC being mined from a fixed system. As such, BTC price will also be a function of the network speeds. This makes implicit sense in that the value of BTC lies in the network itself.

Miners are dependent on speed or hash rates per second. Since the reward for mining new Bitcoins remains the same during the four-year period, the expected number of Bitcoins mined will decline as increasing amounts of chips are deployed—an increasing network speed decreases the number of Bitcoins per given hash-rate speed. In fact, over the last year, the network hash rate for BTC increased by a factor of seven. Assuming no changes in ASIC chips, this increase in speed would reduce a Bitcoin miner’s reward by one-seventh. That is a huge decay in power over a twelve-month period, though not without precedent in natural resource extraction. In fact, it is similar to shale gas exploitation—in which an exploiter receives over half of the gas from a twenty-to-fifty-year well within the first three years. Likewise, more than half the number of BTC mined will be harvested within the first three months of chip use, and by the end of two years, the mining chips will be obsolete.

We can derive a breakeven price from these underlying inputs. On the basis of (1) $0.02 per kWh in electricity expenses, (2) the current cost of ASIC chips, (3) a network speed of 22,000 petahashes per second, and (4) consensus assumptions around the growth of network speeds, the current breakeven price of BTC is $8,500. In other words, the internal rate of return (IRR) would equal zero at this price for the lowest-cost miners. At a $10,000 price of BTC, ceteris paribus, the annualized IRR is about 50 percent. It is important to understand that all these assumptions are subject to constant fluctuation: this breakeven price is for one moment in time and only that moment in time. As the price of BTC fluctuates along with network speeds, so does the return on mining. In addition, when the hash-rate speeds increase, the miners’ costs increase as they either employ more ASIC chips and power to maintain their percentage of the network speed or see their percentage of the network continually drop. Keep in mind that, although the trend of the network’s hash power is increasing rapidly, it remains quite volatile. Hence, BTC is volatile.

Since breakeven mining costs will continue to have an upward trajectory, the incentives toward further centralization of Bitcoin will grow as well. Given that the overall difficulty of mining BTC increases every two weeks (when looked at over longer periods) and given the increasing scarcity of BTC (about every four years the reward for mining halves), costs are expected to continue to rise. The debate over whether BTC remains a truly peer-to-peer, distributed ledger will intensify over the years ahead, as rising costs likely imply that only the best-funded, largest, and most expensive mining operations will survive.

Moreover, cheap electrical power is one of the main necessities for mining. Energy consumption from BTC mining alone increased 4.5 times over the last year. This may be a further constraint on mining’s rapid rise. Mining operations are probably using excess power supplies built during the commodity boom. But given the growth in BTC power usage (and other global growth in energy demand), that excess power generation may disappear. Indeed, power usage could be the major constraint on BTC growth, as it can be difficult to access 50 to 100 megawatts of power. Power plants would need to be built in low-temperature environments, and there may be resistance to new power plants using carbon power such as coal or even natural gas.

Given BTC’s high volatility (and the volatility of that volatility), the risk premium must be high. BTC volatility fluctuates around 100 percent with the current volatility at 140 percent annualized. As a result, the IRR figures above do not look as outrageously high when volatility is taken into account. Given an IRR of 200 percent and a volatility of 140 percent, BTC mining gives a healthy Sharpe ratio (excess return divided by risk) of 1.42. The minimum acceptable IRR should be around 50 percent, considering the high levels of volatility. This implies a BTC price of about $10,000 under the current parameters. It should be expected that investors and speculators may get ahead of themselves in light of the rising hash rates, nodes, and costs. Given the breakeven IRR levels, they may have to wait years for the price to regain the euphoric levels of 2017.

If we use the current breakeven level of BTC of $8,500, a probability distribution can be imposed around it. Using an average volatility of 100 percent, and an average value of $8,500, theory tells us that, with 68 percent probability, the expected price of BTC will be between $0 and $17,000. Statisticians normally use plus or minus two standard deviations, or 95 percent probability, that can be attributed to chance around a value. Since BTC cannot go to negative values, the BTC distribution is skewed to the right. As such, BTC could be expected to trade within a range between $0 and $25,500. Even the wild price action of recent years is within the range of expected values. In fact, BTC never breached the upper bound even at the end of 2017, though the risk of investing and trading in extremely volatile markets should be apparent. In addition, it is difficult and expensive to short BTC given the underdeveloped nature of existing markets and exchanges.

Using option theory, however, one could create a synthetic mining operation in place of building a physical mining operation, through dynamic buying and selling. The risk here is that BTC trades to extreme values from its mean. On the other hand, one can begin to see a range of BTC values that are derived from the backbone of the system.

One theory from the physical commodity world that can help explain BTC price action is the concept of “peak”—such as peak oil. This concept supposes that there is a limited supply of a commodity in existence. More precisely, the theory implies that there is a peak supply of some commodity at a certain price, even if the commodity stores have not actually been exhausted. (Higher prices will eventually make uneconomical resources available.) With BTC, we know with near precision how many BTC will be in existence at any one time and we know that, regardless of price, the total supply can never surpass 21 million. As such, the peak theory is very relevant to discussing value: as hash rates increase, the cost to mine increases. To compensate for higher costs of the network, the value of the network must increase, thus the value of BTC should increase, or the system will break down (at least in theory).3

Demand Optimism and Pessimism

Many respected economists and business leaders would disagree with the analysis above. Most commentary on Bitcoin focuses on the demand side, which is significantly more difficult to evaluate than the supply side. As a result, many of the debates surrounding BTC tend to devolve into abstract discussions of techno-optimism or pessimism. For example, Robert J. Shiller wrote in the New York Times that “attempts to put a fundamental value on Bitcoin . . . will be intrinsically and absurdly inaccurate. The results of a serious attempt to assess the value of Bitcoin can only be ambiguous.” He argues that BTC is basically a case study in ambiguity and animal spirits, without any grounding in solid economics. But even if an equilibrium price does not exist, it is still possible to analyze the breakeven costs of mining and attempt to understand the implications of those costs, including the range of values that BTC is likely to trade within.

In a similar vein, Goldman Sachs issued a report in February 2018 titled “Is Bitcoin a (Bursting) Bubble?” The authors expressed skepticism about cryptocurrencies in countries with a well-functioning banking sector and argued that cryptocurrencies solve only limited problems. It is Goldman’s belief that BTC’s price action and behavior fit the definition of a speculative bubble, like the dot-com bubble in 1999. Goldman asks which of the cryptocurrencies will exist in five or ten years—implying that, similar to the first internet search engines, most will disappear.

Given the plethora of cryptocurrencies today, it does seem plausible that the majority of them will end at zero, one reason why I focus here on the largest and most liquid cryptocurrency. But, as the above supply-side analysis indicates, the volatile price action is not as whimsical as it might seem. The BTC network has grown exponentially and hence the price has grown equally fast. When the network growth rates slow down—whether due to limited supplies of electricity or other factors—one would expect the price increase to dampen.

The more important question Goldman asks is, Why do you need an alternative currency when the banking system is functioning? The Goldman report seems spot-on in arguing that countries with well-functioning banking systems do not need cryptocurrencies. But the relationship between need and adoption seems hardly straightforward. Individuals and institutions invest in many things—including many complex financial products created by Goldman Sachs—that they don’t really need. If anything, a robust banking system may actually facilitate speculation and experimentation with more exotic financial assets.

On the other hand, banking systems everywhere seem increasingly fragile, even though they may be larger and more efficient in processing transactions. Goldman might have asked: does the rise of cryptocurrencies say anything about past, current, or future financial markets and global economies? I believe the answer is yes. The concept of e-currencies has been around since the 1990s, but it was only after the collapse of the financial system in 2008 that BTC was introduced and began to gain popularity. I do not believe this is coincidental, nor is it surprising that some people may be looking for alternatives to a hierarchical banking system.

Others argue that we have had blockchain for nearly a decade with little to show for it. Despite billions of dollars and countless engineering and programming hours invested, blockchain is only used for speculation and money laundering. Payments and banking were supposed to be revolutionized by the blockchain, while Visa and Mastercard would become extinct. But that has yet to happen. At the same time, the very idea of smart contracts was dealt a blow when DAO (Distributed Autonomous Organization) was hacked.

Optimists counter that the functionality of blockchain will expand with time in applications like smart contracts, sensitive information, and in fact anything that can be digitalized. Writing in the Harvard Business Review (January/February 2017), Marco Iansiti and Karim R. Lakhani argued that the defining structures of our economic, legal, and political systems have not kept pace with the economy’s digital transformation, and that blockchain promises to solve this problem. Although they are concerned about excessive hype around blockchain—they view it as a foundational technology, not a disruptive one—they see parallels between the emergence of blockchain and TCP/IP (transmission-control protocol/internet protocol). Just as TCP/IP lowered the cost of connections, blockchain could reduce the costs of transactions. And, just as email took time to grow in importance, blockchain may still be decades from reaching its zenith. Iansiti and Lakhani expect that blockchain will eventually affect most businesses, though the timing remains uncertain.

It is worth recalling that the internet in its early days was confusing, too. Many were not sure how it would be used. Today, too many people may be focused on the currency aspects of blockchain, but there might be a range of other uses, since blocks are really data. For instance, blockchain may be used to transform title insurance—or anything with a “history” component—into blocks. Many types of businesses are exploring new uses of blockchain that could reduce the cost of verification. Some of these blockchain applications could even eliminate state entities like the DMV. In March 2018, Sierra Leone allowed the Swiss startup Agora to experiment with recording election votes using blockchain.

Back to Fundamentals:

Mining Costs and Network Concentration

However interesting debates between blockchain optimists and pessimists may be, I believe they tell us less about the future of cryptocurrencies than the supply-side dynamics that are observable and quantifiable now. Mining is going to become increasingly complex and capital intensive, and the breakeven cost will continue to rise. This suggests that economies of scale will become increasingly important, and network power will likely be concentrated in the hands of fewer and fewer miners and hardware/service companies. Today’s already significant level of concentration will only grow more extreme. Far from fulfilling the promise of a decentralized currency network, cryptocurrency mining seems poised to resemble other corporate tech oligopolies.

This further centralization strikes me as a far greater challenge for the future of blockchain technology than any questions about potential uses. It is fairly easy to imagine commercial applications for blockchain, even if timing is uncertain and implementation remains difficult. And cryptocurrencies have already established themselves as tradable financial assets. But it is more difficult to see how cryptocurrencies can continue to grow without network power becoming more concentrated, thus undermining their original promise. Likewise, other commercial applications of blockchain require monetizable incentives—typically with a corporation “owning” a blockchain. But once a blockchain is made proprietary, it is inherently centralized and hierarchic.

Another wild card is government regulation. Blockchain was supposed to eliminate governmental oversight of transactions. In fact, blockchain was supposed to help realize the libertarian dream of eliminating governments. Needless to say, this is difficult to imagine as long as people want cryptocurrencies convertible to fiat currencies. Christine Lagarde, head of the International Monetary Fund, has stated that international regulatory action on cryptocurrencies is “inevitable.” Her concerns are, as one might expect, related to the potential use of cryptocurrencies in illicit financial activities like money laundering or financing terrorism. But regulation around these activities would probably enhance the credibility of cryptocurrencies.

In March 2018, the SEC announced that cryptocurrency exchanges should be registered and subjected to oversight, though these regulations can take years to develop. In this respect, cryptocurrencies are not much different from other assets. Some regulation can improve credibility, while too much can be stifling. For example, an excessively strict regulatory environment could push cryptocurrencies offshore, similar to what happened in the 1970s with the dollar lending market, which caused the rapid expansion of the Eurodollar market.

The biggest regulatory concern, however, does not involve the trading of cryptocurrencies but rather the mining of them, since mining is the backbone of the blockchain. And as mining becomes more expensive, regulatory approaches to power usage and other inputs will only become more important. Indeed, it does not seem too far-fetched to imagine regulation becoming institutionalized within a resource tax system—levying royalties and so on—analogous to government treatment of physical commodities.

Regulators must also determine how to manage failures in the distributed system. What happens when the consensus breaks down or the system fails? Who shoulders the blame? Since internal blockchain governance is managed by consensus and ultimately by those who control the mining power of a specific blockchain, the success or failure of self-regulation will also be determined by whether mining can remain distributed and not concentrated as discussed here.

Bitcoin’s Biggest Challenge

BTC is built on sound technological principles regardless of its valuation. That is probably the reason why, in nearly ten years of existence, it has not disappeared but instead has been built upon. And, over time, blockchain technology seems poised to displace a variety of institutions as we find commercially viable uses for it.

The biggest problem for BTC and blockchain is not that they lack use cases or that they are too novel. The real challenge may be that they are not novel enough—that they are too similar to conventionally mined commodities and thus will fail to fundamentally disrupt economic or regulatory paradigms. “Failure” may not take the form of a price collapse or market crash, but rather the de facto abandonment of the decentralized ledger concept, along with an inevitable reversion to dependence upon a benign regulatory environment. A form of corporate centralization is already reentering through the back door.

This article originally appeared in American Affairs Volume II, Number 2 (Summer 2018): 65–79.

Notes