The Economics of Investing in Bitcoin Mining

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Would you pay $32,000 for a box that let you create money out of electricity? That’s how much one eBay seller is asking for some of the latest and most powerful dedicated Bitcoin mining hardware. The catch? The hardware hasn’t been delivered yet, and nobody knows when it will be.

Background: The Dynamics of Bitcoin Mining, A Billion-Dollar Industry

The facts are indisputable: at current exchange rates of around $120 to the BTC (Bitcoin), the total number of Bitcoins already ‘mined’ by armies of computers crunching cryptographic problems is worth more than $1.3 billion, and roughly the same number remains to be mined before the potential supply of 21 million Bitcoins will be complete. We’re a little more than halfway there, and even if the price of the cryptocurrency were to drop by 50%, hundreds of millions of real dollars still await those who are mining it.

All that’s required to mine Bitcoins is computing power.

It’s easy enough to plug in the details of computing power, electricity costs, and so forth, press a button on one of the standard profitability calculators, and come up with an estimate of how much incremental return you can expect from a given investment in Bitcoin mining power. However, just because because it all looks quantitative and precise doesn’t mean it is.

In reality, the Bitcoin system is designed to adapt itself relatively quickly to changes in the amount of computing power being dedicated to the job of mining. Every time a certain number of the cryptographic problems have been solved (specifically, every 2016 blocks), the difficulty of mining is adjusted according to how quickly the required calculations were performed. The aim is to keep the total time relatively constant at around two weeks, making the job harder when more computing power is available and making it easier when computing power leaves the network.

Therefore, quantitatively evaluating any investment in Bitcoin mining hardware requires not just straightforward empirical data about computational performance and costs for both hardware and electricity (which I’ll assume will be in a fiat currency such as dollars), but also an estimate of two factors:

  • the future exchange rate of BTC vs. USD or your other preferred fiat currency, and
  • the future collective power of the entire community of Bitcoin miners.

Let’s take a closer look at the second of those unknowns, before returning later to the first.

Radical Transformation of the Competitive Landscape — Any Day Now?

Back in the dark ages of Bitcoin mining — 2009 — the process was commonly undertaken with nothing more than the CPUs (central processing units) of ordinary PCs. Then advancements in graphics processing hardware turned GPUs (graphics processing units) into the primary mining platform. Next up were even more powerful dedicated units made with FPGAs (field programmable gate arrays), and just appearing are incredibly powerful dedicated units built around ASICs (application specific integrated circuits) designed for the sole purpose of mining Bitcoins. The key feature of each transition to a new technology is that each one renders virtually all of the previous technology literally worthless in current terms: because of the increases in difficulty which I described above, it becomes a money-losing enterprise to continue mining with the previous generation. That is why very few people now mine Bitcoins with CPUs, or even with any but relatively new and powerful GPUs, except for fun or experimentation, or where the hardware is already a sunk cost. To do so would be to pay a premium for Bitcoins that could simply be purchased outright for less fiat currency than would be required to pay for the electricity and hardware.

The primary reason why GPUs are even still viable for Bitcoin mining is that neither FPGA nor ASIC mining hardware has yet to become widely available. (And only some of the FPGA hardware which eventually appeared actually lived up to its potential of besting the performance of the most capable GPUs at a given price point, which has further extended the viability of GPU mining.)

Therein lies the problem for anyone considering entering mining today. The total current Bitcoin mining network power, measured in hash computations, is around 78 terahashes per second (78 TH/s) as of 20 May 2013. But several specialist builders, including Butterfly Labs (with the Jalapeno, BitForce, and BitForce Super Computer Mini Rig), BitSyncom (with the Avalon), and others have announced powerful ASIC-based mining hardware with performance ranging from 5 GH/s up to a whopping 1500 GH/s. It doesn’t take many of those to radically change the Bitcoin mining landscape. In fact, it would take just 52 units of dedicated hardware capable of delivering 1500 GH/s to double the current total power of the entire Bitcoin mining network. At last count, the number of pre-orders across all ASIC products offered by Butterfly Labs alone was around 1,000 times greater than that — i.e., over 50,000 pre-orders, many for multiple units, are reportedly already on their books. If we suppose that Butterfly Labs ultimately delivers even a tiny fraction of those pre-orders, mining with anything other than ASIC-based hardware could become economically pointless in very short order. And that’s just Butterfly Labs itself, without even considering the impact of Avalons or other dedicated ASIC hardware. (If you’re au fait with the technical underpinnings of Bitcoin, you may also wonder about the potential for a so-called 51% attack, where one entity controlling more than half of the available computing power on the Bitcoin network can wreak havoc with the system.)

Today’s Value is Tomorrow’s Space Heater

Clearly, if you could get your hands on one of these devices today, you could quickly make a bundle: 1500 GH/s will currently generate Bitcoins worth over $8000 per day, while consuming only a tiny fraction of that for electricity. Even a mere 5 GH/s will still grab you nearly $27 per day at current exchange rates; considering the device only sells for $274, the prospect of breaking even in a little more than 10 days seems like quite the bargain.

However, because of the periodic increases in difficulty linked to the total computational power dedicated to mining, those numbers only work out if you get your hands on the hardware but other miners do not.

That is why time is at a premium when it comes to procuring advanced bit mining hardware: those who get the hardware early enough can create money at a rapid clip, while those who get it later may find that their investment is quickly rendered worthless when increases in difficulty push their Bitcoin yield down below the cost of electricity. And that, in turn, is why people are now bidding thousands of dollars not for actual mining hardware, but for rights to pre-orders that were placed for mining hardware many months ago and have not yet been delivered. One eBay seller is offering a 60 GH/s miner pre-order from July 2012 for $32,000. That’s just slightly more than Butterfly Labs was asking for their promised 1500 GH/s mining rig when it was briefly listed as available a few weeks ago. (It’s now shown as “Out of Stock”; that’s a funny status given that zero evidence is available to suggest it has ever existed as anything except a prototype.)

Those who pre-ordered mining hardware from Butterfly Labs nearly 1 year ago are still waiting to see any return on their investment — an investment which, somewhat analogously to an option contract, continues to decay in value every day until at some point it becomes nothing more than a complicated space heater. Notably, at the start of June 2012, one could buy Bitcoins outright for a little over $5 each. Today’s price of around $120 to the Bitcoin implies that in June 2012, one could have bought Bitcoins that would be worth $32,000 today for an investment of just $1333. And the original pre-order price, including shipping, of the Butterfly Labs miner currently being offered for $32,000? You guessed it: exactly $1333. (The actual pre-order date for the miner in question was 19 July 2012, by which time BTC had risen to just over $9 each, requiring an investment at that time of $2400 to reach $32,000 today.)

And that brings us back to the two unknowns I mentioned above, the two uncertainties which figure into any calculation of potential returns from investing in Bitcoin mining hardware. The second concerns the trajectory of future computing power that will be dedicated to Bitcoin mining, and I’ve described how that looks to be shaping up rather crazily. The first, which I skipped over previously, is the future ratio of BTC vs. USD. That exchange rate bears not just on fiat-denominated mining costs like electricity; it also bears on the opportunity cost of investing in mining hardware rather than in Bitcoins themselves.

I get the sense that many Bitcoin enthusiasts are deeply attracted by the idea of mining their own Bitcoins; maybe there’s something that feels creative and pioneering and fulfilling about being the one to bring these units of currency out of the Platonic realm of mathematics and into the real economy. I appreciate there is value in that, and I understand that some miners probably lean on that subjective value and personal satisfaction in convincing themselves that it makes good economic sense to pony up thousands of dollars to buy hardware with an unknown delivery date and an uncertain expected return. But I think many also lean on an assumption — maybe explicitly, maybe implicitly — that Bitcoins will appreciate markedly against the dollar and other fiat currencies and that the appreciation they anticipate will offset the uncertainty created by mysterious delivery dates for massive amounts of computing power. Leaning on that assumption, however, seems to me to raise the risk of a serious error of judgment: to the extent that appreciation in Bitcoin value ameliorates the uncertainties about future changes in Bitcoin mining difficulty (and indirectly makes difficulty worse, by attracting more miners to the effort), it also increases the opportunity risk of investing in mining rather than in Bitcoins themselves. In other words, investors trying to convince themselves to take a risk on mining by envisioning a rosy picture of Bitcoin appreciation should consider the gains they may miss out on by tying up available funds in hardware with an unknowable usable period of profitability, rather than simply investing those funds in Bitcoins.

As I said at the outset, sums exceeding one billion dollars await Bitcoin miners in the coming years, provided the value of the cryptocurrency doesn’t plummet. But that doesn’t necessarily make it 1849 all over again.

Or maybe it does: some of the forty-niners traveling to California soon after the discovery of gold in 1848 became rich, especially the early ones, but many others wound up going home again with little or nothing to show for it.

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