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Mining the next block BARU

It is probably safe to say that mining is the most controversial aspect of the entire cryptocurrency industry. Stories and articles condemning the energy consumption of Bitcoin in particular have been surfacing for almost as long as the blockchain itself has been running. The environmental aspect of crypto mining has definitely drawn its fair share of ire over the years. But why is mining necessary? How justified are the criticisms levelled against it?

First things first, it is important to understand just how crucial mining operations are within the context of blockchain infrastructure. Fundamentally, a blockchain is a continuously maintained record of transactions. The revolutionary aspect of the technology lies in how the blockchain reaches a consensus on which transactions are included within it. In order to add transactions to the blockchain, users first broadcast their intentions to the network, where they are collected into something called a mempool, which is a kind of waiting room for all unconfirmed transactions. At this stage, nothing has been finalised, users have merely stated how much crypto they want to send, and to where. To set things in stone, to permanently add those transactions to the blockchain, a measure of authority is needed.

This is where miners step into the game. Mining is the process of solving a very complex mathematical problem and receiving a reward for getting the correct answer. Imagine a problem that cannot be solved by any known mathematical formula, the answer can only be brute forced with a huge amount of computing power. It would be like putting a code into a safe over and over again until it opened, except there are trillions of possible combinations.

Miners throw their computing power at the problem until someone solves it. Concretely, the solution requires the generation of something called a hash, which can then be used by other network participants to check the validity of the operation. Very difficult to calculate; very easy to verify. Whoever generates the correct hash first is responsible for adding all those unconfirmed mempool transactions to the next block, making them permanent and updating the blockchain to its new state. The victorious miner then receives a reward in the form of the cryptocurrency they were mining.

Miners are in essence the stewards of the crypto sphere, they underpin the security and immutability of the blockchain, but are also responsible for introducing new coins into the circulating supply. Adding to the blockchain requires expending a large amount of computing power, and by extension, electricity. These energy costs are typically covered by selling the mined rewards. This economic incentive is the cornerstone of blockchain technology; everything depends on it.

Mining comes down to running a computer program on a piece of hardware, and then running it for as long and as hard as possible. Anyone can download the necessary software, set up a mining operation and start mining Bitcoin for example. Given that this is the case, what is to stop the whole world from getting in on the action and mining as many bitcoin as they want?

This is indeed how it all started. In the prehistoric days of crypto, one person alone mined the first blocks of the Bitcoin blockchain: Satoshi Nakamoto. Later on, more people got on board and contributed their processing power to the network, earning block rewards for doing so. The problem is that Bitcoin has a fixed supply, so the more people mining it, the faster the supply limit would be reached. Once the last bitcoin had been mined, there would be no more block reward, leaving very little incentive for miners to keep adding blocks (barring transaction fees), effectively killing the chain due to an absence of computing power securing it.

This is where a mechanism called the difficulty adjustment comes into play. The Bitcoin blockchain is designed so that a new block is mined roughly every ten minutes. This keeps the network at a relatively constant speed for a more stable user experience. In order to keep the generation of blocks consistent, the difficulty of mining a block is periodically tweaked to compensate for the variations in total mining power. For Bitcoin, the adjustment occurs every 2016 blocks, or around two weeks. The more people mining, the more difficult mining becomes. This is why mining is much harder now compared to in the past. More people are competing for the same share of the pie.

In the early days, a simple CPU sufficed to mine Bitcoin. Although not very efficient, the difficulty was such that users could make a significant amount of bitcoin just by running the software in the background on a rusty old laptop. As the network grew, so did the amount of computing power dedicated to securing it. We have a useful metric for this, called the hashrate. The hashrate tells us how many hashes are being generated to solve a block by the combined might of all currently operational mining hardware. At the time of writing, the global hashrate stands at over 500 Exahashes per second. That’s a five with twenty zeroes behind it.

It only took a few months for people to realise that graphics cards were much more efficient at mining than CPUs were. The year after that would see the first real dedicated hardware solutions in the form of FPGAs, or Field Programmable Gate Arrays. The year after that would witness the introduction of the first ASICs, or Application Specific Integrated Circuits, which remain the de facto mining hardware to this day. Mining technology evolved because of the pressures from increased competition, increased difficulty, and of course soaring bitcoin prices.

Mining is no longer the basement-dwelling pastime it used to be. Economic realities have long since pushed mining deep into industrial territory. The scale of some of the larger mining farms are truly awe-inspiring. The energy requirements are now on the level of entire power plants. It simply isn’t a viable domestic operation anymore.

The massive growth in hash rate between 2017 and 2021 was largely fuelled by the development of gargantuan mining farms in China. Entire warehouses full of dedicated mining rigs were directly hooked up to hydroelectric dams in the western reaches of China. Tucked away in the remote mountainous regions of Sichuan, Xinjiang and Inner Mongolia, vast operations were busy at work, taking full advantage of the excess electricity during the rainy seasons. During this time, it is estimated that up to 80% of the world’s hashrate was concentrated in China.

Such a geographical concentration of mining power gave rise to understandable concerns about the uncensorable nature of blockchain technology. Is it really a global currency if one nation has a controlling share of the mechanism that secures it? Debatable, but such concerns would dissipate before they could manifest, when the Chinese government subsequently enacted brutal measures to shut down all mining operations within its borders. China has famously “banned crypto” many times over the past few years, only to walk back on such measures further down the line. In the case of mining however, the ban was final. By mid-2021, the vast majority of Chinese miners had packed up and moved their operations abroad, never to return. The balance in hash power shifted significantly following the crackdown, firstly across the border to Kazakhstan, but more permanently to the United States, which now boasts about 40% of the global hashrate, higher than any other nation. Within the United States, Texas is in the process of firmly establishing itself as the central hub of crypto mining and is now home to the largest mining farms in the world.

Moving on to the energy consumption aspect of mining, this is where the data becomes a bit more difficult to pin down. We know exactly what the hashrate is, thanks to the way proof-of-work blockchains operate and the way difficulty adjustments work, but this doesn’t perfectly correlate with energy consumption for the following reasons.

The first is that we don’t know which type of miner is being used to do the work. Mining equipment has evolved dramatically in the last ten years. Current ASICs are one hundred times more efficient compared to the first models, going from roughly 2000 Joules per TeraHash in 2013 to under 20 J/TH today. We have no idea which miners are being used.

An elaborate balancing act comes into play here. A mining operation that has been around for a while will no doubt have a bunch of old miners lying around collecting dust. It won’t typically be worth plugging them in because the electricity costs of running them will outweigh the profit gained by selling the crypto they generate. The more efficient miners will increase the hashrate to the point that it simply is not profitable to connect the old miners to the grid. The profitability of a miner depends on many things: electricity cost, mining difficulty, miner energy efficiency, but also the price of the crypto being mined. What if the price were to suddenly shoot up? Suddenly the calculations change and it might be worth bringing less efficient models back online, if only before the difficulty increases again.

The second point is related to where the electricity comes from, which ties back to the geographic aspect of mining. In China, mining operations have been notoriously difficult to track down because a lot of the time, and particularly since the 2021 crackdown, such operations have been intentionally obfuscated. Some mining farms were often not even connected to the main power grid, but hooked straight into local power stations. In the case of hydroelectric dams, the fact is that during periods of heavy rain they can remain full for weeks, often draining excess water, bypassing the turbines entirely because there is no energy demand on the grid. In this situation, the electricity is essentially free, which massively changes the viability of older mining equipment. Redundancy is never a factor for such setups; a mining farm is not a data centre. A broken mining rig is unceremoniously thrown away, immediately switched out for a functional replacement. The mining rigs are run hard until they break.

Despite the difficulty in establishing exact figures on global energy consumption, we can still establish reasonably accurate estimates. Claims of the Bitcoin network consuming the same amount of electricity as entire countries are indeed accurate. In 2024, the annualised electricity consumption of Bitcoin mining activities is estimated to be around 150 TWh, which puts it on par with the likes of Poland, Malaysia or Argentina, or roughly 0.5% of global demand. A new bull run in the crypto markets would swiftly change the economic balance of mining and probably result in a huge increase in this figure.

The significance of the above figure really boils down to a question of opinion. So what if crypto mining uses a lot of energy? We waste about a tenth of all generated electricity just in transmission and distribution losses. In the grand scheme of things, how big of an environmental impact does crypto mining represent?

The massive energy expenditure of proof-of-work blockchains is not a design flaw, it is entirely intentional. The energy is what secures the chain. If a nefarious actor wanted to attack the blockchain, reorganising the chain of transactions for personal profit, they would need a controlling share of the power to do so. This is what is known as a 51% attack. To put it bluntly, Bitcoin is secure because it would take the energy demand of entire nations to subvert it. Ethereum used to have comparable energy requirements, until it changed its consensus mechanism from proof-of-work to proof-of-stake, which reduced its electricity demand a thousandfold.

If there is one convincing argument against cryptocurrency mining, this is probably it. If the Ethereum blockchain, and other PoS blockchains, can convince enough people that they are just as secure as their PoW counterparts of a similar size, then it does become harder to defend the massive energy requirements of PoW blockchains. Perhaps there is another way. Time will tell.

June 21, 2024

Market watch: 21st June 2024 BARU

The Swiss National Bank and the Bank of England both elected to maintain their respective interest rate targets at current levels yesterday, in line with predictions. The BoE decision followed the publication of the year-on-year inflation rate in the UK, which has now fallen to 2%. The 2% inflation figure has long been touted as one of the primary conditions that would enable the central bank to lower interest rates, not just in the UK but in other major economies as well. The data point, coupled with Thursday’s statement, edged the odds of an August rate cut up to 50-50.

Currency traders have not had much to wet their whistle so far this week, with the possible exception on the Japanese Yen, which gained 0.54% yesterday to close at 158.9 Yen to the Dollar. The pair is once again flirting with levels that prompted direct intervention from Japanese authorities in the beginning of May. Addressing the elephant in the room, Japan’s top currency diplomat stated that “the government will respond to excessive currency moves” and that “there is no limit for forex intervention resources”. Strong words, not to be ignored by those planning to long USDJPY. As an aside, Japanese inflation unexpectedly rose to 2.8% this morning, beating expectations of just 2.5%, further complicating the equation.

The US bank holiday seemed to have finally killed off the momentum in tech stocks, with the Nasdaq Composite breaking its streak of seven consecutive record closes to fall 0.8% on Thursday. Nvidia (NVDA) lost 3.5% by the closing bell; a multitude of major tech companies also took a breather.

June 21, 2024

Market watch: 19th June 2024 BARU

The Nasdaq Composite struck its seventh consecutive record high close yesterday, once again piggybacking off optimism in the AI sector. Never far from the headlines, Nvidia (NVDA) climbed 3.5% yesterday, earning itself a market cap of $3.33 trillion, making it the world’s most valuable company, dethroning Microsoft (MSFT) and Apple (AAPL). The jostling for position will no doubt continue, but the idea of the chipmaker even standing shoulder to shoulder with such giants would have seemed absurd just a few short years ago. Nvidia now controls about 80-90% of the market for AI chips.

The S&P 500 and DJI also started the week on strong footing, with consecutive closes in the black over the past two sessions. The moves manifested despite poor retail sales data published yesterday, the year-on-year figure dropping to 2.3% versus expectations of 2.8%. US markets are closed today due to a public holiday, so expect markets to be at the mercy of lower liquidity later on in the day.

Sabre-rattling in both the Middle East and in Eastern Europe has contributed to a rise in oil prices early this week, despite an unexpected build in US crude inventories. Brent crude is now up to $85 a barrel, WTI $81. Gold seemed content to remain range bound for the time being, currently hovering around $2,330 an ounce.

Very little on the economic calendar today, but currency traders will need to pay attention to both the Swiss National Bank and the Bank of England’s interest rate decision tomorrow, both predicted to stick to their current respective rates of 1.5% and 5.25%.

June 19, 2024

Market watch: 17th June 2024 BARU

Markets closed the week with an uneventful whimper last Friday, although the Nasdaq Composite managed to eke out a fifth consecutive all-time high by the skin of its teeth. US indices were at the whims of two opposing forces last week: on the one hand rising tech stocks provided a decent amount of buoyancy thanks to AI related optimism, on the other hand lingering inflationary fears forced the Fed to dial back on its former commitment of three rate cuts this year down to just one. The result was an impressive 3.2% gain for the Nasdaq Comp and an adequate 1.6% rise for the S&P 500. The Dow Jones, lacking the crutch of major tech companies, lost half a percent on the week.

The going was a lot tougher for European indices, many of which at the mercy of political turmoil. The UK’s FTSE100 and German DAX closed the week 1.2% and 3% lower respectively, but the French CAC 40 boasted the biggest losses with a 6.2% close in the red. The fall comes as markets digest the implications of the snap election called by Macron, now just two weeks away. The usual fears of contagion will no doubt continue to agitate market participants for the rest of the month.

On Wednesday the US Bureau of Labour Statistics surprised markets with lower than expected inflation figures, however the good news was not enough to offset the significant amount of data pointing in the opposite direction. Several Federal Reserve board members were indeed keen to douse enthusiasm concerning imminent rate cuts. A quick glance at the Dollar currency index tells us all we need to know about the immediate prospect of a monetary pivot - the DXY gained over half a percent last week to secure the 105.5 level.

June 17, 2024

Market watch: 14th June 2024

The Nasdaq Composite and S&P 500 strike four for four, both indices setting record highs every day of the week so far. Lower than expected CPI figures published on Wednesday constituted the most recent bullish narrative, with the year-on-year inflation and core inflation numbers falling to 3.3% and 3.4% respectively, both ten basis point below consensus. The data lend credence to a cooling off economy, which in turn gives the Federal Reserve the justification necessary to lower rates.

Fed Chair Jerome Powell commented on the figures, admitting that there had been some recent encouraging signs of progress, but still lacked the confidence to act just yet. Moreover, the Fed is now forecasting only one rate cut this year, down from the three initially planned.

A potential problem is brewing under the surface. Despite the impressive performances seen in the S&P 500 and Nasdaq Comp, the fact of the matter is that the growth is almost entirely due to large tech stocks. Apple (AAPL) and Nvidia (NVDA) are both up over 7% this week on the back of AI related promises. The problem is that the number of declining stocks outnumber the advancing ones at a ratio of 2 to 1 on both the Nasdaq and NYSE. A small number of stocks are doing all the heavy lifting, which makes the upward momentum observed recently more fragile than it appears in raw numbers.

It may take a while for markets to fully digest this week’s data publications. There have been a few mixed signals of late, parsing them may take a little more subtlety than usual. That’s the problem with contradicting numbers – they can’t all be correct. The elephant in the room of course is the reliability of the data we’re given in the first place. Many of the metrics we use to gauge what’s going on can undergo significant revisions further down the line.

June 14, 2024

Crypto basics: Oracles

In our article covering the blockchain, we went over the advantages of such a technology, the salient point being the ability to send money from one person to another without having to rely on a centralised and censorable system. In our article covering smart contracts, we developed the concept further, explaining how this technology could be used to construct much more elaborate tools. Instead of merely transferring funds between wallets, smart contracts could allow people to do all sorts of interesting things with their money. Trading digital assets, borrowing and lending funds, buying and selling derivative and insurance products, using a savings account and earning interest were now just as feasible as in the real world, with the added benefits of distributed ledger technology. The emergence of a new class of finance culminated in what we now call decentralised finance - DeFi for short.

DeFi was an important step in the evolution of cryptocurrencies, but it had one critical weakness: all the applications described above require a bridge between the blockchain and the outside world.

For all their strengths, it is important to remind ourselves of the severe limitations of blockchain technology. Blockchains excel at sending cryptocurrencies from one address to another in a way that every node of the network can agree upon. However, they are completely self-contained systems and as such have access to almost no information outside themselves. The bitcoin blockchain does not know what the price of bitcoin is; nor do other blockchains for their respective cryptocurrencies. Blockchains do not even know what the time is; they are isolated systems by design and cannot access so-called “off-chain” data. Smart contracts face the exact same limitations by extension.

We need to be able to connect blockchains and smart contracts to the outside world in order to do anything genuinely interesting with them - arguably for them to have any real use at all.

Oracles are the tool that allow us to do this. Oracles are the bridge between the outside world and the blockchain. In normal software development, when two distinct applications or programmes need to communicate with one another, they would do so via an API. As we have just explained, this cannot work in the case of a blockchain because the blockchain cannot interface with anything else. Instead, oracles work by fetching the necessary off-chain data and submitting it to the blockchain in the form of a transaction. Oracles are typically granted the mantle of “blockchain middleware” because they occupy the liminal space between the on-chain and off-chain worlds.

This presents a bit of a quandary, known as the oracle problem.

Decentralisation is the core tenet of blockchain technology. It is what sets apart the realm of cryptocurrencies from traditional finance. Crypto without decentralisation is not crypto at all. But what happens when a smart contract or DeFi application is reliant on an external, centralised data input? It would be like using an electric car that gets its electricity from a 50-year-old coal power station. The green credentials of the car become somewhat questionable.

So it is for smart contracts. What would be the point in using blockchain technology if the created system still relied on a central point of failure in the hands of a singular actor? It defeats the entire point of adopting such an approach in the first place. If decentralisation is the end game, then every component of the system must be so.

Let’s say Barry and Dave have a bet. Barry thinks that the price of Ethereum will be at or above $5,000 on the 25th of December 2025; Dave thinks otherwise. The loser agrees to pay out the winner one ETH on the settlement date. Both ardent crypto enthusiasts, the pair agree to set up the bet as a smart contract, all coded in advance. The date finally arrives and the price of Ethereum is around $5,500. Barry rubs his hands as he checks to see the extra Christmas present sitting snugly in his wallet. Where is the ETH he won? It’s not there… How could this be? He won the bet fair and square… He checks the smart contract and confirms that it worked exactly as designed, but for some reason the oracle submitted a price of just $4,000 per ETH.

What happened? The problem here is that the smart contract used an oracle that fetched the price of Ethereum from a singular source. In this case, a very low liquidity crypto exchange with a less than stellar reputation. Just before the contract was set to trigger, a large whale sold into the paper-thin order books, crushing the price of Ethereum on the dodgy exchange. Before the arbitration bots could step in to rebalance the books, the smart contract reached maturity, the oracle submitted the incongruent Ethereum price to the contract, which then payed a handsome reward to Dave.

Everything worked exactly as intended in the example above, but someone was still unfairly treated. The decentralised, trustless, uncensorable nature of blockchain technology could not save Barry from a poorly designed oracle solution. A singular, centralised data feed had exclusive control over the execution of the smart contract. In the end, it was no better than a regular contract.

What do we do about it? The solution here is to apply the same logic that got us this far in the first place. To bypass the oracle problem, the oracle itself also has to be decentralised, taking on the form of an entire, customisable network of nodes and data sources to deliver off-chain information to the smart contract. Returning to the example above, a better oracle solution would have been to pull the price of Ethereum from a wide range of different sources, use a filter mechanism to exclude outliers, average out the remaining respondents, and perhaps homogenise the results over a slightly longer timeframe. A number of clauses and insurance policies could also have been implemented, further mitigating any unexpected outcomes.

One may raise the point that the above still does not stop the oracle node operator from misbehaviour, and they would be correct. Once again, economic incentives are an answer here. Just as miners have an economic incentive to add legitimate blocks to the blockchain, so too would node operators to submit the correct data to a given smart contract.

It is worth making the point that debates surrounding oracle infrastructure do not necessarily stem from purely ideological grounds - nor should they. Decentralisation for its own sake is a waste of time. On an entirely pragmatic level, a decentralised oracle network provides the kind of security, redundancy and freedom that spurred on cryptocurrencies in the first place.

Such security concerns have been ignored countless times in the past few years, with disastrous consequences. Even with the best of intentions, oracle attacks are behind some of the worst losses in crypto history. Some of the more impressive schemes are mind-bogglingly complex. According to some estimates, in 2022 alone, DeFi protocols lost over $400 million because of oracle manipulation attacks. Despite this, the relevance of the appropriately named oracle problem remains overlooked by many crypto proponents who really should know better.

June 13, 2024
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