Bitcoin death spiral

A version of this article first appeared in our exclusive newsletter. If you’d like Block Explorer’s cutting-edge analysis before it hits our website, sign up now.

Sigh.

Another day, another slew of negative, fear-inducing, factually-inaccurate cryptocurrency reporting in the mainstream media.

The focus of my wrath is this article in Market Watch, titled Bitcoin is Close to Becoming Worthless.

Written by a professor of finance, it carries some weight.

But it’s also wrong on many technical levels.

The author’s basic claim is this:

With the price of bitcoin dropping, bitcoin mining has now become unprofitable.

If mining produces no profits, he says, miners will abandon the network. It will grind to a halt and bitcoin will become worthless. This phenomenon is known as the “bitcoin death spiral.”

Here’s why he’s wrong…

It’s true that bitcoin mining is currently unprofitable (we reported as much recently). However, the Bitcoin system is designed to adapt and morph to account for this.

It does so by altering the “difficulty” of mining.

This gets a little technical but bear with me.

Bitcoin Mining Background

In very simple terms, bitcoin miners process transactions in “blocks” by using extensive computer power.

That computer power directed towards the Bitcoin network is known as hash power. When lots of miners are working on the network, the hash rate goes up.

One Block Every Ten Minutes

The system is designed to produce one block every ten minutes.

Everything else being equal, if miners throw more computer power at the network, blocks will be produced faster. 

Too fast, actually. Miners get a reward (in bitcoin) for every block they produce. If blocks are produced too quickly, too much bitcoin is released.

That’s where the self-adjusting algorithm comes in.

When hash power is high, the algorithm automatically adjusts to make it more difficult to mine a block, slowing down production to meet the ten-minute block target.

The Problem Today

The problem we face currently is that miners are leaving the network. Some mining facilities are closing and throwing away equipment.

Hash power on the network is now lower, but the difficulty remains somewhat high.

In other words, the remaining miners have to work incredibly hard (using much more computer power) to produce the same block – hence the lack of profitability.

The “Difficulty” Just Readjusted

But it works both ways. With fewer miners contributing hash power, the algorithm will automatically adjust to make it easier and ultimately return to profitability.

That readjustment happened this week, with Bitcoin’s difficulty dropping 15%. 

Every Two Weeks

Bitcoin’s difficulty is set to re-adjust after every 2016 blocks (roughly every two weeks).

The “death spiral” is only possible if block production slows down so much that we don’t make it to the next difficulty adjustment.

Worst Case Scenario

If that reality plays out, there’s another option.

Bitcoin could execute a “hard fork” and form a new blockchain where the difficulty is lower.

Still confused? This tweet from Nic Carter sums it up quite neatly.

pastedGraphic.png

As blockchain expert Andreas Antonopoulos explains: “The chances of [a death spiral] actually happening are pretty low. The chances of it happening and nobody doing anything to fix it is near zero.”

So, as usual, the mainstream and financial media are blowing things out of proportion without explaining the full picture or technical background of bitcoin. 

Intrigued? Here are some more resources:

Proof of Work Explained: How Cryptocurrencies Keep Block Production in Check (Block Explorer)

Bitcoin Difficulty Targeting and the “Death Spiral” (Andreas Antonopoulos video)

A version of this article first appeared in our exclusive newsletter. If you’d like Block Explorer’s cutting-edge analysis before it hits our website, sign up now.

Nasdaq bitcoin futures

Last week, Block Explorer reported that Nasdaq was gearing up to launch a bitcoin futures trading platform. Well, those reports have now been confirmed by Nasdaq.

Bitcoin futures are coming to Nasdaq, the world’s second-largest stock exchange on the planet, in early 2019.

The news was confirmed by Joseph Christinat, the vice president of Nasdaq’s media arm.

Speaking to The Express, he said:

“Bitcoin Futures will be listed and it should launch in the first half of next year – we’re just waiting for the go ahead from the CFTC but there’s been enough work put into this to make that academic.”

Nasdaq is reported to have “run a few extra miles” with regulators to ensure their futures contracts are free from manipulation and other nefarious market practices. The bitcoin futures platform will integrate Nasdaq’s unique surveillance system which targets and minimizes manipulation.

“We’re Doing This No Matter What”

Asked about launching the trading platform in the midst of bitcoin’s biggest drop since 2013, Christinat was unfazed:

“We’ve put a hell of a lot of money and energy into delivering the ability to do this and we’ve been all over it for a long time – way before the market went into turmoil, and that will not affect the timing of this in any way. No. Period. We’re doing this no matter what.”

A UK broker at XTB confirmed Nasdaq’s sentiment, saying: “This isn’t a knee-jerk reaction or jumping on the bandwagon – this is a serious plan.”

Indeed, Nasdaq claims it has been in the blockchain game for five years now, working on the best way to tap into, and support, the market. It appears the fruits of its labor are now beginning to appear.

Many have claimed the launch of Nasdaq futures will act as a catalyst for the next price surge. However, it’s worth remembering that futures contracts also allow traders to bet against an asset, putting downward pressure on the price.

When the first bitcoin futures contracts were introduced in late 2017, it triggered a record price run, followed by a quick reversal.

Will history repeat itself when the Nasdaq futures platform arrives?

Further reading: Wall Street is Coming to Crypt; Nasdaq Bitcoin Futures Explained

'Fearless Girl' statue face off Wall Street Bull in New York

America’s second oldest bank, State Street, says there is a “high level of interest” in cryptocurrency from its customers. However, those customers are not rushing into the market.

State Street’s managing director, Jay Biancamano, said there was “no sense of urgency on the part of our clients to move into these assets right now.” In particular, State Street is seeing little demand for crypto custody – whereby an institution would safely store digital assets on behalf of its customers:

“Currently none of our clients are looking for us to house these assets in custody.”

Crypto custody is a hot topic on Wall Street right now. Fidelity is reportedly launching a crypto custody and exchange platform for its customers, while Goldman Sachs is also exploring ways to hold crypto assets. 

Despite the cautious tone, Biancamano said his firm is “blockchain friendly:” 

“We do talk to our clients who are interested in doing this and we are looking at this very closely. But we are not putting a sign that we are opening for business. That said, we are a blockchain-friendly firm; we are very involved in the vertical.”

State Street might not be throwing its arms around crypto just yet, but they will be ready when the next wave arrives. “There is no sense of urgency on the part of our clients to move into these assets right now. When they do, we want to meet them there.”

(Source: CoinDesk)

Further reading: Wall Street is Coming to Crypto; Nasdaq’s Bitcoin Futures Explained

Mining crypto currency. Farm for mining bitcoins. Vector flat illustration
  • Proof of Work is the algorithm that powers various blockchains, like Bitcoin, Ethereum, Litecoin, and Monero.
  • Miners solve complex mathematical puzzles using computer power to produce a “block” of transactions.
  • When a block is produced, the miner is rewarded with the native cryptocurrency: bitcoin, ether, or litecoin, for example.
  • Proof of work ensures that blocks are produced at a stable rate and are accurately verified.

Cryptocurrencies work on the principle of a blockchain, where blocks containing transactions are added to the chain to make transactions happen. 

The issue is, the speed and validity of blocks must be kept in check. Proof of Work solves this issue, let’s check out how.

The Problem

Blocks on the blockchain are quite powerful as they confirm the transaction of money between addresses. They also distribute new currency by issuing rewards to the block creator. 

For these reasons, there are two important rules for block production.

  • Blocks need to be verified some way, so that we know what order transactions happened, among other things.
  • We need to control the speed at which blocks are added. If the speed is not controlled, block rewards are added to the network quickly and the worth of the currency plummets.

Bitcoin, for example, has a target block time of ten minutes. If blocks are created too fast, too much bitcoin will be given out to miners, thus flooding the market. Something has to keep that block time regulated.

Enter Proof Of Work

Proof of work solves both of our issues. It’s based on the idea that we include some data in the block that is hard to calculate, but easy to verify. 

In most proof of work cryptocurrencies, this comes in the form of a cryptographic hash.

What is a Hash Function?

A hash function takes a message or piece of data and scrambles it into a long cryptographic, alphanumeric code. 

But the smallest change to the message or data creates huge changes in the code. 

For example:

The SHA1 hash of “Armin Davis” is: 397d23a20e7cf5065238d7cdda5430d62a68445b

But change the capital letters to lower-case…

The SHA1 hash of “armin davis” is: b1371918c95f4693273757a2bc51514dcdfd1697

The hashes are completely different and seemingly random.

But it’s not random. The same input data will always return the same hash. Meaning that we can easily verify that a given hash is right for a given block easily. 

And, if we include the hash of the previous block in ours, we can prove order too.

Enjoying this article? Subscribe to the Block Explorer newsletter to get exclusive crypto insights before they appear on the site.

proof of work
Proof of work compared against alternative algorithm “proof of stake” Credit: CryptoTechies

What About the Timing Issue?

Hash algorithms are perfect for our verification problem but don’t fix the issue of timing on their own. 

Hashes are designed to be fast to compute, very fast in fact. The time it took to calculate the above two hashes was less than one-hundredth of a second.

But we need to regulate the time, so blocks aren’t produced too quickly.

We have a simple solution to this: network difficulty. 

Simply put, you can change how long it takes to create a block by making it harder to solve the cryptographic puzzle.

bitcoin difficulty chart
As more and more miners devote hash power to the Bitcoin network, the “difficulty” has increased dramatically to keep block production in check. Source: Bitinfocharts

Usually, that means including a constraint that the hash must be below a specific number. And that that number is calculated at specific intervals. 

Now miners have to hash their blocks many times, with each one taking up some time and lots of computer power. In order for the block creator to change the hash of their block, an additional bit of information is added to the block called the nonce. 

A nonce is simply a number that can be modified as the block creator sees fit to change the output hash.

Each time a hash is calculated and does not meet the requirements of the network at that time, the nonce is incremented or otherwise changed and the hash re-calculated.

Often a miner will try a very large number of different nonces before they find one that will be accepted by the network. The total time all miners take to find a block should be somewhere around the block time (ten minutes for Bitcoin). 

And if not, the difficulty is adjusted to keep the timing in line.

Not all Proof of Work Algorithms are the Same…

The hashing algorithm a cryptocurrency uses directly affects how difficulty will work, and what hardware you can run the mining software on. 

To use Bitcoin as an example again; Bitcoin uses the algorithm SHA-256, which is an industry standard hashing algorithm used in many places. 

If you’ve saved a password on a website, odds are it was hashed with Secure Hash Algorithm (SHA)-256 before it was stored. Using industry standard hashing algorithms means they are proven secure and worked on by massive communities.

However, using industry-standard algorithms is both a blessing and a curse. 

A blessing because most hardware will be able to run your software. But a curse (depending on how you look at it) due to one word: ASICs.

ASIC (Application Specific Integrated Circuits) are mining hardware that gives your network a massive amount of mining power. That increases centralization due to price and power demands. The more ASICs you own or control, the more of the network you command.

Some other cryptocurrencies, like Monero, use their own hashing algorithm specifically designed for use in proof of work systems. These have the advantage that developers have complete control over what hardware the algorithm works on best.

Downsides to Proof of Work

There are a few downsides to Proof of Work when compared to other solutions.

First, Proof of Work requires a lot of computing power. And, the more mining power on the network, the higher the difficulty. Meaning that you very quickly run into a situation where those with the cash to buy hardware do. And when you have a lot of hardware, you tend to store all their hardware in one place, leading to centralization.

At worst, this could lead to a 51% attack, whereby one actor, or group of actors, control more than half of the network. If that happens, they could theoretically “double spend” the cryptocurrency on the network.

And second, that computing power needs a lot of electricity to run, and at the high end, miners go looking for the cheapest power possible. This means that miners start to congregate in cities or countries where the power is cheap, again leading to centralization.

Learned something new in this article? Subscribe to the Block Explorer newsletter to get exclusive crypto insights before they appear on the site.

bitcoin etf approval date

It’s the question on everyone’s lips right now: when are we getting a bitcoin ETF?

If, and when, a bitcoin ETF (exchange-traded fund) is approved, it would provide an easy way for institutional investors to get exposure to the crypto market, without having to buy or store bitcoin itself.

Many see the approval of a crypto ETF as a game-changer and the catalyst for a market recovery.

But if discussions at this week’s Consensus event are anything to go by, that bitcoin ETF approval date might keep moving further back.

Background reading: What is a Bitcoin ETF? (And WIll it Trigger a Price Surge?)

In a discussion with the chairman of the Securities and Exchange Commission (SEC) Jay Clayton, we got an insight into what the regulators need to see before approval is granted. Here are five stumbling blocks that need to be overcome.

1. Crypto Theft

One of Clayton’s biggest concerns is the threat of theft in the cryptocurrency market. Almost $1 billion worth of crypto has been stolen from exchanges this year alone and that number is weighing on the SEC’s decision.

“We’ve seen some thefts around digital assets that make you scratch your head,” Clayton explained.

Before we see the approval of a bitcoin ETF, we need an infrastructure of safe, reliable crypto storage.

2. Better Custody of Bitcoin

As Clayton went on to explain, “we care that the assets underlying [the] ETF have good custody, and that they’re not going to disappear.”

Custody and storage solutions are on the horizon. BitGo is one of the pioneers in digital asset custody services and many others are cropping up.

Fidelity will soon launch a cryptocurrency exchange and custody solution and Goldman Sachs is reportedly working to integrate a crypto custody service. Meanwhile, existing exchanges like Gemini have incorporated full insurance coverage in a bid to strengthen its custody security.

However, even with all the progress, Clayton maintained that these services “need to be improved and hardened.”

3. Market Manipulation

There’s still a dark cloud hanging over the crypto market in terms of price manipulation. It’s one of the key reasons cited by the SEC when rejecting previous ETF proposals.

In Clayton’s words, “what investors expect is that trading in the commodity that underlies that ETF makes sense and is free from the risk of manipulation. It’s an issue that needs to be addressed before I would be comfortable.”

He went on to say that he doesn’t trust crypto exchanges to halt market manipulation. Clayton has good reason to be cautious here. One research paper concluded that bitcoin’s 2017 bull run was driven by market manipulation at the Bitfinex exchange.

He did at least offer a hint into what mechanisms the SEC is looking for to counter manipulation:

4. Market Surveillance

Traditional stock exchanges are monitored by smart surveillance systems which spot signs of manipulation and wash trading. 

“Those kinds of safeguards do not exist currently in all of the exchange venues where digital currencies trade.”

Again, there are improvements on the horizon. Nasdaq’s new bitcoin futures market, for example, will integrate some of those surveillance features into the crypto trading arena. Similarly, the Gemini exchange (owned by the Winklevoss Twins) struck a deal with Nasdaq to integrate its surveillance technology.

Better regulated exchanges are likely to be a key requirement before a bitcoin ETF is approved by the SEC.

5. Anti Money Laundering Protections

The final point of contention comes down to anti-money laundering. In order to counter money laundering in the crypto space, exchanges would need to implement the following: 

  • Identity and background checks
  • Reporting of suspicious activity 
  • An internal task force to identify laundering

The global anti-money laundering task force is reportedly close to issuing a full set of guidelines regarding cryptocurrency, but the SEC needs to see wide implementation of these guidelines before approving an ETF.

Conclusion

Despite the excitement around the pending approval of a bitcoin ETF, we’re still a long way from satisfying some of the key concerns. Progress is being made, but it may be some time before that approval date comes.

Crypto Curious? Subscribe to the Block Explorer newsletter to get exclusive crypto insights before they appear on the site.