Introduction to Proof-of-Work and Proof-of-Stake 3.0. Part 2

Issues with Proof-of-Work

There are two main algorithms that cryptocurrency networks use to attach blocks to the main blockchain of a network. The first one is proof-of-work (PoW) and the second one is proof-of-stake (PoS).

Bitcoin uses proof-of-work and because Bitcoin was the first cryptocurrency to solve the issue of double spending and gain mass adoption, many other cryptocurrencies are also using PoW that they have borrowed from Bitcoin’s open source code.

The essence of PoW approach is a computational lottery. Miners that perform computations faster win. Because Bitcoin and most other cryptocurrency networks have open source code and a high degree of transparency, while the process is a lottery, it is an honest lottery, meaning that miners who create blocks of the blockchain on a regular basis also win rewards on a regular basis. However, PoW has its own problems, the biggest one being a large waste of energy because to win rewards for block creation miners need to burn a lot of electricity. According to an article in the Guardian from November of 2017, in 2017 cryptocurrency miners have burned more electricity than the entire country of Ireland.

Another issue with proof-of-work is the decline of return on investment in mining. For example, during the twelve month between April 2013 and April 2014, investors have spent large amounts of money on mining hardware. The increase in investments has been exponential, which has led to a decrease in return on investment because Bitcoin mining, just like mining on many other cryptocurrency networks, in a competition against other miners and the more miners there are out there competing for the coins, the less are the chances of winning the rewards, which means smaller rewards.

The main measure of the quality of equipment that miners use to mine coins on the Bitcoin network is hash rate. This rate shows the speed with which the equipment can create hashes for sets of data. In the beginning of 2013, on January 1, 2013, the hash rate of the Bitcoin network was 23 terahashes per second. On December 31, 2013, this rate was 11,741 terahashes per second (an increase from twenty-three to almost twelve thousand). On January 1, 2018 the hash rate of the Bitcoin network has been around 16.5 million (16,415,541). You can see the chart for the hash rate of the Bitcoin network on the official Bitcoin Blockchain explorer at https://blockchain.info/charts/hash-rate?timespan=all

At the same time, because of how the Bitcoin network is adding coins to the circulation, miners are competing for a smaller and smaller number of coins. For example, during the same period as described above, from April 2013 to April 2014, the number of coins that the network has added to circulation has increased the number of coins in circulation only by 15% (the total number of coins on the network in these twelve months went from 11 million to 12.6 million).

While it is hard to say how much of the hash power increase was due to the advances in technology and how much was due to the growing popularity of cryptocurrencies, it is obvious that investors have spent huge sums of money on the mining equipment. It is also obvious that the increase in the number of miners and the hashing power of the Bitcoin network mean that miners would see a decline in the revenue from their investments because all miners are competing for the same coins and the number of coins that the Bitcoin network will add to circulation will not increase under any circumstances. When the hash rate of the network doubles, assuming that the price of electricity is not significant and the price of bitcoin is somewhat stable, each miner’s income divides by 50%.

Here is a specific example: let’s say an investor spends USD$5,000 on mining equipment and earns USD$2,000 from mining Bitcoins in the first month. Most people will make an intuitive guess that the investment will be profitable in the long run. However, this is not necessarily the case. For example, if hashing power doubles every month, it means that the income will divide by half every month, and so each next month the $2,000 will be divided in half and become first $1,000, then $500, then $250 and so on. This is a geometric sequence with a common ratio of 0.5 and the sum of all the numbers in the geometric sequence of 1, 0.5, 0.25, 0.125 and so on equals to 2. When the progression starts with 2, the sum will equal 4. This means that if the return during the first month is USD$2,000, yet it divides in half every month, then the total return would be USD$4,000, which is USD$1,000 less than the original investment of USD$5,000.

It is fairly easy to calculate how much money all the Bitcoin miners have made since the inception of the network in 2009. For this, two numbers are needed: the market price of Bitcoin at the time of coin creation and the number of coins added to circulation. Both numbers are known, which is why the task is so simple. For example, it is easy to estimate that as of April of 2014, when the hashing rate of the network has already been growing exponentially and continued doing so into 2018, the miners have been making about 60 million dollars per month.

What is not simple is trying to calculate how much miners were spending on equipment and what their return on investment was. One of the reasons for it is that there are only several manufacturers of ASICS mining chips and none of them have been publishing information in a timely manner for the whole duration of the manufacturing of the electronic components. In addition to this, buyers of the equipment would often have to wait for months before getting the equipment, which, in light of the exponential growth of the hash rate, means that the wait was literally costing them significant amounts of money.

For example, if someone was to order a device at the end of 2013 and receive it a year later, which was not uncommon, it would mean at least 1000 times less in earnings. If the price of bitcoin was to go up 10-20x during that time, the person would make not 1000 times less, but 100 less, which is still a staggering loss.

Because of all the hype in the market, many companies have been collecting money for the devices they haven’t even started manufacturing yet and some of these companies turned out to be scams and criminal enterprises that were selling non-existent products.