Secrets of Bitcoin Mining

May 24, 2022

Secrets of Bitcoin Mining

From the basics of Bitcoin mining made clear and simple, to its ‘secret’ dynamics which many experts are not aware of: How miners really interact with Bitcoin’s price floor, miners’ seasonal migration and ‘bullish’ miners’ natural selection

Updated in May 2022

If you are familier with Bitcoin mining you can scroll down to the blue line.

Mining is a crucial part of the Bitcoin network. But to most Bitcoin holders it’s a relatively mysterious business. Mining is where Bitcoin connects the internet to the real world. A lot of electricity is needed for mining, and it’s crucial for the protection of the 19 million Bitcoins, worth today $550 billion, stored using Bitcoin’s decentralized financial records.

Mining is a very competitive business. Every 10 minutes, approximately, hundreds of thousands of mining computers around the world start competing for a new batch of 6.25 Bitcoins. The greater the quantity of mining chips that they are running, and the stronger they are, the higher the chances their owner have to win new Bitcoins.

While in 2010 you could mine Bitcoin with your personal computer’s regular chip, since 2013, mining has become much more competitive and requires specialized chips, called ASICs (Application-specific integrated circuit). Today, getting into Bitcoin mining is a serious business, mostly done in large warehouses full of computers with ASIC mining chips — nicknamed miners.

Mining rigs in a mining warehouse, nicknamed a mining farm. Source: Bitcoin Wiki

Bitcoin ASIC companies such as Bitmain and Canaan, compete to produce increasingly more powerful and efficient ASICs for Bitcoin.

Source: Global Patrol Prices
The percentage of Bitcoin mining power by country. Source: CoinShares

Electricity is 95% of the operation expense of a mining farm. That’s why most Bitcoin mining is done in areas with cheaper electricity, with over 40% of Bitcoin miners depending on renewable energy. Some mining farms use cheap hydroelectric power in places like Sichuan in China (until China banned mining) and Washington state in the United States. Other miners set up in countries like Kazakhstan and Iran which are rich in natural resources of coal and oil.

Investors in mining operations are also called miners, and they take a big risk. According to Seth Estrada, starting a worthwhile mining operation can cost millions of Euros (for the ASICS, mining facilities and setting up). The investors do not know how much competition will be coming into the mining network, or what Bitcoin’s price will be when they get started mining. These two factors that will highly affect their mining income. So why do miners go into the mining business? We’ll get to that after we explain a bit more about mining.

Video from a cryptocurrency mining farm

What’s the point of mining?

All the rules and math that create Bitcoin’s financial network and worldwide money system are open-source and decentralised so that any computer in the world can audit the entire thing. Anyone owning a computer with an internet connection can take part in storing Bitcoin’s transaction history and freely send and receive Bitcoin transactions. But to keep track of which files show the real transaction history and who owns which Bitcoins, the inventor of Bitcoin realized you need to connect a financial ‘weight’ to each of these crucial and important files, so they can be identified and authenticated by anyone.

A costless, open source method called hash-links or block-chaining keeps Bitcoin’s transaction history in a clear chronological order. We explained it in this post. While chaining in blocks doesn’t have anything to do with mining, giving each block in the chain a financial wight or high cost is. Costly ‘mining’, which we’ll explain in the next section, adds a financial weight to each new page of the records. The real transaction history of Bitcoin is defined as the records the Bitcoin network took the most resources to create.

What do mining machines do?

Creating new ‘pages’ needs to be provably expensive. To create a new page, the mining network is assigned a sort of puzzle, called a hash function, by the Bitcoin program. Solving this type of puzzle takes many resources- expensive ASICs and a lot of electricity to run them around the clock. The name of this puzzle is known as the hash function SHA-256. When the SHA-256 puzzle is solved by trial and error by one of the mining machines around the world, the new ‘page’,which in the world of Bitcoin is called a block, is mathematically stamped by the miner with the answer to the puzzle (and added to the block-chain). Each new block contains approved Bitcon transaction. The miner who solved the SHA-256 puzzle and stamped the new block with it, is automatically given by Bitcoin’s protocol 6.25 bitcoins.

Creating a new block and receiving compensation in Bitcoin is what keeps the miners working. If a miner would decide to add a damaged block or a block containing false transactions, even though it is stamped with the correct solution, the Bitcoin network would reject that page. The compensation of a miner is inscribed in this corrupted page, so his resources would be wasted. The miner’s job is only to create financial ‘weight’ for each page, while the rest of the network protects the legality of the transactions.

The Bitcoin network controls the speed of the creation of blocks by automatically adjusting the difficulty of the puzzle. The whole point of using the SHA-256 puzzle is that its difficulty can be changed according to how much mining power is connected to the network, so that the cost of mining is connected to Bitcoin’s value.

Miners create financial weight to Bitcoin’s records, so we can tell these are the real records. Linking each page to the previous one is done by using hash-links also known as block-chains. Combining the provable chronological order between each page in the Bitcoin records with the financial weight of each individual page created by the miners makes Bitcoin’s books unbreakable.

Bitcoin’s “natural selection” created bullish miners

Bitcoin mining depends on miners being rational actors who want to make money, and in return provide financial protection to Bitcoin’s records, but that doesn’t mean miners are purely rational.

The skyrocketing growth of the computing power directed at Bitcoin’s SHA-256 puzzles, counted in TerraHash/s

Miners have more conviction in Bitcoin than Investment Funds and Hodlers (holders). They have long time horizons. They invest in assets with long-term life cycles that cannot be repurposed nor quickly liquidated at fair market value. ASIC Mining Rigs have 3+ year life cycles and can only be used to mine Sha-256 Protocols (almost entirely Bitcoin). Bitcoin Mining Facilities have 5+ year life cycles and are typically restructured warehouses, specially designed for cooling mining rigs. On average, it will take a miner 18 months to break even after deploying capital to mining rigs, facility build-out, and electricity expenses.“ mining services company Blockware Solutions wrote in their research report published this March.

Source: Canaan’s SEC filing

CMS Holdings partner Dan Matuszewski, formerly the head of trading at Circle (previously one of the biggest Bitcoin Over-The-Counter trading desks) takes this idea further. Matuszewski told us that from his experience at Circle, where clients like large mining operations trade big amounts of coins, Bitcoin miners wanted to be exposed as possible to the price of Bitcoin. This can be explained by a type of natural selection — Bitcoin’s price has risen in almost a straight line since its inception. The most successful professional miners were not only optimistic enough to invest in an Bitcoin mining operation before 2014 but also so optimistic that they held onto coins through less profitable periods, and ended up selling for large profits post 2016, as Bitcoin ran up to $20,000 by then end of 2017. These miners could then heavily reinvest in buying newer and better mining machines to stay competitive. Less optimistic miners gave up their coins at lower prices or at a loss, and eventually left the sector or just stayed small. This “natural selection” might make Bitcoin miners the most bullish group of Bitcoin investors in the world.

Miners bullish tendency can be seen in the above chart. When the orange line is below the black line, the miners are selling less coins than they mine, and holding the rest for the future.

“In September of 2019, we discussed how some of the OTC Desk’s mining clients had deviated from their scheduled liquidations and elected to hold mined Bitcoin during July and August — thinking Bitcoin would continue running. Bitcoin topped late June [When Bitcoin reached $13,800] and those miners had to puke their coins later in September and October at much lower prices. Such scenarios accelerate sell offs in Bitcoin as additional sell pressure from liquidating the Bitcoin Treasury is created beyond just newly mined Bitcoin.” Blockware’s report added.

The above charts show how Bitcoin miners usually await rising Bitcoin prices to sell batches of mined coins

Mining difficulty adjustments

Bitcoin network difficulty May 2019-May 2022

The Bitcoin protocol knows how to adjust the speed of bitcoin mining by creating harder SHA-256 hash functions when more computing power joins the mining network or easier ones after mining power leaves. If some miners go out of business, the remaining miners will get a larger share of new coins. This ensures the resources needed to protect Bitcoin’s network are directly linked to Bitcoin’s market price, keeping the system stable.

Debunking popular belief: How miner capitulation helps create a price floor

Today the Bitcoin’s price is around $30,000 with 6.25 Bitcoin being produced about every 10 minutes. For mining to be profitable right now, the electricity cost of a mining operation should be less than $30,000 for each new coin it mines, or the mining farm will be losing money.

Above: A live representation on of the last blocks mined. This image shows the block number, mining pool, how long ago it was mined, and the time gap from the last block creation.

27,000 Bitcoins are mined per month. A significant proportion of the 27,000 Bitcoins must be sold by miners to cover their electricity expenses. Miners with higher electricity rates must sell a greater proportion of earned Bitcoin to cover their electricity costs. If Bitcoin’s price is crashing, miners with a low profit margin will add selling pressure to the situation: The lower Bitcoin’s dollar price is, the larger the percentage of newly mined Bitcoins they need to sell to to cover their mining electricity costs. The closer Bitcoin gets to the price of production, the more miners add to the selling panic.

The percentage of mining power operating at different electricity costs. Source: Blockware Solutions research report.

As in any part of the economy, some entities are stronger than others. Some miners have lower electricity prices or newer and higher efficiency ASICs: Bitmain’s newer model Antminer S17 consumes 50% more energy but produces 300% more hash power than the older S9, one of the most popular miner models. Some miners also have more financial ability to operate at a loss for a longer period of time, if needed.

When the price of Bitcoin becomes too low for the weaker miners to be profitable, according to Blockware’s report, they often keep mining at a loss due to their contracts with mining warehouses or electricity providers. But eventually these miners will go broke/capitulate, and sell all their coins and machines. This increases the selling pressure of Bitcoin while coins are selling for less than their mining price. After the weakest miners leave, Bitcoin’s network has a favorable difficulty adjustment, awarding the remaining miners a bigger share of new mined coins, as the difficulty of the SHA-256 is decreased while their mining power stays the same. This lowers the amount of coins that must be sold to cover costs and Bitcoin’s price can stabilize while there is a healthier profit margin for the remaining miner.

The price floor for Bitcoin is not held up by the Bitcoin mining cost, buy by Bitcoin’s price crashing under the price of production and cleaning out weaker miners, making the remaining miners’ profit margin bigger and decreasing selling pressure of coins.

Black line: Bitcoin’s price. Orange line:Bitcoin’s hashrate (reflecting the amount of mining computation on bitcoin’s mining network)

The chart above shows a situation which fits Blockwares explanation: From October 2018 after Bitcoin’s price was bouncing around $6,000, the hashrate fell quickly with the price. This suggests that $6,000 was the price of production for some of the miners. This sharp fall of the hashrate is a sign of miners going out of business, and the strong price drop might be effect by those miners selling their inventories of mined coins to cover losses.

Black: Bitcoin’s price Orange: Miner outflows (coins moving out of miner’s Bitcoin accounts)

Glassnode and other websites provide charts showing how many coins Bitcoin miners are transferring for the first time, likely selling them. The above chart shows that after the price and hashrate drop at the end of 2018, Bitcoin miners sold mined coins in an magnitude only seen over a year beforehand when Bitcoin was skyrocketing from $,1000 to $6,000 in 2017. This selling must have been by the weak miners going out of business. After the selling ended, and with a lower hashrate that increased the profit margins of the surviving miners, the price could stop dropping. In retrospect this action was happening at Bitcoin’s price floor in December 2018, a floor which is yet to be broken.

Blockware’s article clarifies that mining is very much a game of competition and survival- a mining operation that can out-survive its competitors wins a bigger share of the coins. An ability to keep mining during a price downturn, either due to better mining machines, lower electricity costs or even just having deep pockets and an ability to operate at a loss are all an important advantage for a mining business.

It’s important to clarify that miners do not determine the price of bitcoin, but react to it. They do affect the price, increasing or decreasing the selling pressure of coins close to market peaks or floors.

Mining migration

If Bitcoin wasn’t strange enough, it turns out that up until 2021 when Bitcoin mining was banned in China, many Bitcoin miners migrated seasonally seeking cheap electricity. China which hosted over 50% of Bitcoins hashrate up until 2021, is big on hydroelectric power generated from the flow of rivers.

The region of Sichuan has a distinct yearly ‘wet season’ or Fengshui, in which heavy summer rain creates flooding, increasing the electricity production which is sold for bargain prices. This raining season usually starts between April and May, and continues through the fall.

Over the years Sichuan became e a Bitcoin mining center, drawing many more miners to set up there during the season. According to CoinShares mining report, during the rain season electricity is as cheap as roughly 2.5 cent for kWh.

Average rain fall by month in Chengdu, the capitol of Sichuan. Source: Weather & Climate

Leo Zhang, the founder of Anicca research, told Cointelegraph: “Over the years, the mining industry started to organize itself around this schedule. Manufacturers did their product announcements in May. Facilities offer their special deals right before the rainy season begins.”

Hydroelectric power station built on a river in Sichuan source: China Morning Daily

The wet season is also nicknamed flooding season. In summers of 2018 and 2019 pictures and reports circulated on the internet of mining farms damaged by severe floods in Sichuan.

In orange: Bitcoins hash rate between June 2017 and May 2022

Looking at Bitcoin’s hashrate chart, the impact of the rain season was not noticeable as bitcoin’s hashrate is constantly rising throughout the years. The only noticeable correlation was at the end of the rain season in 2018, when Bitcoin’s hashrate and price dropped at the end of October, is this a coincidence or not? It’s hard to tell.

Dry season migration

“When the dry season returned, electricity prices rise again, causing some miners to migrate to Xinjiang and Inner Mongolia where cheap coal and wind power is available year around. Some sources suggest that as many as 500,000 mining units migrated to and from Xinjiang in [2019]. Migration, however, is an expensive endeavor restricted to the most well-capitalised miners.” concluded the CoinShares mining report.

Thoman Heller, the global business director of F2Pool mining pool added to this picture: “As these older machines are no longer profitable to mine at the electricity price in China, Canada, USA, or Europe, they eventually end up in other locations, such as Kazakhstan, Russia, the Middle East and South America,” he told Cointelegraph.


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