In any well-functioning economy which runs on fiat currencies, central banks have exclusive control of the supply of money and possess the right to earn seigniorage, which is the profit from minting new money. In contrast, cryptocurrencies, true to their libertarian ideologies, is fully managed by a network of computers and anyone can earn seigniorage by engaging in activities referred to as mining or staking, depending on the nature of the cryptocurrency.
Mining and staking are essential functions of any cryptocurrency. A person who mines or stakes are said to be a miner or a forger respectively. Both activities serve the purpose of validating transactions and building consensus on the cryptocurrency networks. Miners and forgers are incentivized engage in their respective activities by block rewards, a pre-defined quantity of cryptocurrency that is awarded to whoever successfully validates a block of transactions. Mining requires the use of computing power in solving cryptographic puzzles. Staking, on the other hand, as the word suggests, involves putting one’s cryptocurrencies on the line. In other words, mining and staking are two different consensus mechanisms which require different inputs.
Cryptocurrencies which rely on mining are said to run on a proof-of-work consensus algorithm. Bitcoin, the first cryptocurrency, is an example of such. Cryptocurrencies which are secured by staking are said to run on proof-of-stake consensus algorithm and staking was developed to address the growing concerns over the energy intensive nature of mining among other inefficiencies with the proof-of-work consensus algorithm.(1) Today, many cryptocurrencies run on a variation of the proof-of-stake consensus algorithm and Ethereum, the second biggest cryptocurrency in terms of market capitalization is also slated to transition from proof-of-work to proof-of-stake consensus algorithm on January 2020.(2) Excluding Bitcoin from the total market capitalization of cryptocurrencies, proof-of-stake cryptocurrencies and Ethereum accounts for over 44% of the market capitalization.(3,4,5)
The consensus algorithm, the confirmation time (the time taken for transactions to be encrypted into a block) and the block reward and are among the several nuances which differentiates each cryptocurrency. For example, Bitcoin runs on the proof-of-work consensus algorithm, has a confirmation time of 10 minutes and its block reward is hard-coded to halve every 4 years. The block reward for Bitcoin currently stands at 12.5 bitcoin and will be halved in May of 2020.(6)
Mining Rigs, Mining Farms, Mining Pools and Cloud Mining
In the past decade of Bitcoin’s existence, mining has grown from being a hobby among Bitcoin enthusiasts to a multi-billion dollar industry. Each boom and bust cycle of the crypto market was followed by a fresh inflow of capital into Bitcoin mining. The cryptocurrency mining industry has grown significantly over the years and has spurred innovations in mining hardware manufacturing, which consequentially boosted sales in the semiconductor industry. Mining has also increased the demand for data centers.(7) To gain a better appreciation of how much the Bitcoin industry has grown over the years, consider Bitmain. It reportedly generated over $2.5 billion dollars in 2017 and over $2 billion dollars in just the first six months of 2018, which is impressive considering that bitcoin prices fell throughout the 2018.(8) Bitmain has announced plans to go public in the U.S. in the second half of the year.(9)
Although Bitcoin mining was originally envisioned as a democratic process where an average person could use their personal computers to participate in the network as a miner, the profitability of mining led to an exponential increase in the amount of computing power used to mining bitcoin. As a result, mining has become a highly competitive activity that requires specialized hardware. For instance, bitcoin is typically mined using Application Specific Integrated Circuits (ASICs), which are hardware that have been optimized for solving Bitcoin’s cryptographic puzzle. In contrast, some cryptocurrencies like Litecoin is designed to be mined only on relatively more general hardware like Graphic Processing Units (GPUs).(10)
Investors looking to invest in the mining industry can consider mining farms. Competitive mining farms typically have one or more competitive advantages, which can be superior proprietary mining hardware, having access to cheap electricity, being located in cool regions, which can help cut cost on cooling mining units, and/or setting up operations in Economic Opportunity Zones for favorable tax treatments among other factors.
Investors can also consider joining a mining pool where two or more miners pool their computing resources to mine cryptocurrencies using their collective computational power. Alternatively, there are also cloud mining services where anyone can pay a subscription fee to rent some computing power over a period of time. The payout model varies from company to company, but the revenue on mining is determined by the amount of computing power of the mining operation relative to total amount of computing power on the network. The amount of computing power is measured in hash rates and the hash rate on the Bitcoin network is available online on websites such as Blockchain.com and Bitinfocharts. Because the hash rate is dynamic, in order to keep the block confirmation time constant, the mining difficulty is programmed to adjust periodically, every two weeks in the case Bitcoin. Therefore, a drastic drop in Bitcoin price does not necessarily indicate that miners are no longer profitable. Over time, less competitive miners will be forced to halt their unprofitable operations, leading to a decline in the total computing power in the network. Consequentially, the mining difficulty will eventually fall, attracting miners whose operations were previously unprofitable to resume their operations.(11)
Although some people have hypothesized that the computing power would become entrenched in a few large players over time, a report from Canaccord Genuity Group found that mining activities have become more decentralized over the recent years,(12) with many new miners setting up operations in Scandinavian regions and in Washington State in the U.S..
In staking, anyone holding proof-of-stake cryptocurrencies can become a forger, or in other words volunteer to validate transactions, by staking their coins. The probability of the forger successfully validating a new block of transactions is determined by the quantity of cryptocurrencies staked in proportion of the total quantity of the cryptocurrency in circulation. If successful, the forger receives the block reward. However, if the forger is found to be acting dishonestly by validating false transactions, he or she would lose all of the cryptocurrencies that have been staked in a process referred to as slashing.
Proof-of-stake was developed under the assumption that the forger have an invested interest in protecting the value of the cryptocurrency. In order for a malicious actor to successfully attack the network of a proof-of-stake cryptocurrency, he or she would have to have possess at least 51% of the cryptocurrency supply, which will not only be extremely expensive to acquire but also economically unsound as the cryptocurrency will cease to have value the moment its network is compromised.(13)
New iterations of proof-of-stake have also been introduced, most notably delegated proof of stake (DPoS), which is fundamentally the same as proof-of-stake but differ in that forgers have to be elected. The elected entities, known as delegates, are then entrusted with validating transactions on the network, and can easily be replaced by the voting community if they are found to be acting dishonestly.(14) One of the greatest pros of DPoS is that it allows for faster confirmation times compared to proof-of-work and proof-of-stake algorithms. Staking is a rapidly growing industry, with some estimating it to grow into a billion dollar industry by the end of the year.(15)