This is the second in a two-part series on the boom in Bitcoin computing infrastructure, and what it means for the data center industry. See Part One, Mining Heads to the Data Center.

LAS VEGAS - What's the end game of the Bitcoin mining arms race? Miners are building ever-more powerful hardware and larger data centers, trying to stay a step ahead of their rivals and keep pace with "the difficulty" - algorithm changes that make it progressively harder to earn new bitcoins.

Some Bitcoin watchers believe the network will ultimately shift from mining for new coins to a model based on transaction fees, which could accelerate a shift of Bitcoin hardware into data centers and the creation of peering networks to manage fees, just as current peering agreements seek to reduce network transit costs.

The long-term outlook for Bitcoin is important for the data center industry, where some leases can run from three to 10 years. The emergence of Bitcoin has seen the cryptocurrency soar in value, accompanied by rapid advances in the hardware required to successfully capture new coins. The Bitcoin protocol is designed so that these rewards will become harder to earn and will shrink over time. That means that the economics and business models of bitcoin could shift over the life of a data center lease.

Fees and the Future

The Bitcoin economy is supported by a global network of computers that use processing power to verify transactions between Bitcoin owners. Those who participate can benefit in two ways:

The issuance of new bitcoins, which happens about every nine minutes with a "block reward" of new bitcoins to the miner that processes that transaction. The block reward diminishes over time. It was initially 50 bitcoins, but is currently 25 bitcoins, or about $23,000. In 2016 it will be reduced to 12.5 Bitcoins.

Miners earn transaction fees, which can be awarded in every bitcoin purchase or transaction, and have historically been a tiny amount (often less than a cent) left as a gratuity for the miner. Slightly larger fees can be offered for transactions that require more data crunching, to ensure that the transactions are processed without delay.

Over the past two years, gaining block rewards has become progressively more difficult, forcing miners to upgrade their hardware from CPUs to GPUs and then FPGAs (Field Programmable Gate Arrays) and finally specialized ASICs (Application Specific Integrated Circuits) optimized for bitcoin data-crunching. As the hardware has become more expensive, many enthusiasts have been priced out of the mining market.

Princeton University computer science researchers Ed Felten, Joshua Kroll and Ian Davey have studied the bitcoin reward system and foresee a shift ahead.

"At present, the mining reward seems to be large enough, but under the current rules of Bitcoin the reward for mining will fall exponentially with time," the Princeton team wrote in a recent paper on Bitcoin economics. "Transaction fees, which are voluntary under the current rules, cannot make up the difference. The only way to preserve the system's health will be to change the rules, most likely by either maintaining mining rewards at a higher level than originally envisioned, or making transaction fees mandatory. The choice is likely to drive political disputes within the Bitcoin community."

Researchers from Microsoft and Cornell have also explored this scenario and outlined refinements that would be needed to make incentives work in a shift to transaction fees.

The bitcoin community is "debating that (shift)," said Emmanuel Obiodun, founder and CEO of Cloudhashing, which leases computing power to customers. "It's becoming more expensive to mine coins. But transaction fees are very low right now, and have very small profit margins. For now, there's still a lot of upside in bitcoin mining."

One Vision of a Fee-Based Future

The future of mining was a hot topic at the Inside Bitcoins conference in Las Vegas in December, where Josh Zerlan, Chief Operating Officer of Butterfly Labs, gave a presentation on the future role of transaction fees.

"In the future, there will not be much incentive to mine (for block rewards)," said Zerlan. As rewards become harder to achieve and the growth of bitcoin leads to more transactions, Zerlan says that fees will need to increase to ensure that miners continue to support the network. As this happens, miners will gravitate towards transactions with higher fees attached to them, which will be processed before those with smaller rewards.

If bitcoin gains wide acceptance as a payment platform or even as a currency, the growth of fees will present several challenges, Zerlan said.

“If you're a large company, you have a problem (with paying transaction fees)," he said. "The solution is to maintain a large mining farm in your data center to process your own transactions for free, and your customers' transactions for free. You can also earn extra income to processing others transactions."



"Mining is Not Dead"

Zerlan said medium-sized companies would likely hire out their bitcoin transaction processing, leading to the creation of specialized mining companies to serve this market niche. These companies would need data center space to run their operations. "There's a lot of opportunity in this space,” said Zerlan. "No one is actually doing this yet, but a lot of people are looking at this.

“Mining for profit is going to become a razor thin margin," said Zerlan. "The whole shift is from profiting from mining (block rewards) to maintaining a mining farm. That's where the real money will be going forward. But mining is not dead.”

Zerlan said this could prompt the creation of peering-style agreements between players with large bitcoin operations, which could reduce network costs and transaction fees. “You're going to see the large companies and mining companies peering with one another," he said. "You'll see this in mining.”

Peering allows two providers exchanging large volumes of traffic to save money by connecting directly, rather than routing traffic across their paid Internet connections. Peering is often free as long as the amount of traffic exchanged is not out of balance, providing substantial cost savings for bandwidth for high-traffic sites and networks. Data center operators provide the physical network connections between networks.

Some of Bitcoin's developers are already working on peering, creating a High-speed Bitcoin Relay Network for peering among large exchanges and miners. Their primary motivation is network stability, rather than mining economics.

"This system will act as a fallback in the case that the public Bitcoin network encounters issues and decrease block propagation times between miners," writes Matt Corallo, a member of the bitcoin development team. "It is NOT any kind of attempt at centralization, and I still encourage interested parties to establish their own private peering agreements with large miners as needed."

Distributed vs. Centralized

As we noted yesterday, a shift to professional data centers and cloud computing platforms would make the bitcoin network more efficient. But there's also a built-in cultural challenge: much of the bitcoin community remains wary of efforts to centralize the network.

Earlier this month bitcoiners raised alarms when Chinese mining pool GHash.io was gaining 45 percent of new coins - approaching the level where a single participant could undermine the network by controlling a majority of its power (known as a "51 percent attack").

The growing power of mining pools - consortiums organized to combine the mining power of individuals - has been a concern for some time. This week the four largest mining pools (GHash.io, BTC Guild, Eligius and Slush) held a combined market share of 75 percent of the network's power, as measured by computing hashrate.

"We've already centralized the mining system," said Zerlan. "There are already large pools to control a large percentage of the mining. Centralization of mining will be a good thing."

Zerland believes the Bitcoin community can adapt to the tradeoffs of a more centralized infrastructure. “It creates a more desirable target, but I think that's something we have to manage," he said.