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Price Slump Tests Bitcoin’s Self-Correcting Economics

A crash in the value of Bitcoin has made it too expensive for some companies to “mine” the currency.
January 18, 2015

Those watching or betting on the digital currency Bitcoin could be in for an interesting week.

That’s roughly how long it will be before the decentralized software that operates the currency can correct for the effects of a plunge in the value of Bitcoin since the start of the year. A Bitcoin is currently worth just over $200, down about one-third from where it began January. It peaked at more than $1,000 late in 2013.

The low price threatens the operations of the “miners” who use powerful computers to mint new bitcoins—and whose activity is also needed to confirm and process Bitcoin transactions. As the value of new coins has tumbled, the cost of the computers and electricity needed to mine them have not—a similar problem to the one that has stranded some oil companies as the price of crude has dropped.

Several Bitcoin companies ceased operations last week, saying that they couldn’t operate profitably. Small-time miners talked in online forums about having to shut off their equipment.

It is hard to know how many miners experienced similar problems, given the variations in electricity prices and the cost structures of different companies. Mining companies contacted by MIT Technology Review on Friday did not respond. However, data from the Bitcoin network indicates that the revenue generated by all miners each day has roughly halved since the start of the year.

In theory, Bitcoin’s self-regulating setup should prevent this situation from cascading into significant problems for the currency. The Bitcoin software has a mechanism that is designed to ensure there are always enough miners working to keep the currency operating and to regulate their output. It does that by altering the difficulty of the work that mining software has to do so that their miners’ combined rate of output is always the same. Since Bitcoin got started in 2009, the difficulty has increased again and again to compensate for the growing sophistication of mining computers (see “Custom Chips Could be the Shovels in a Bitcoin Gold Rush”) and to keep too many Bitcoins from being created.

Now that interest in mining is softening, the mining difficulty is set to drop so as to keep the Bitcoin network running correctly. That would give miners a break on their power bills. But the difficulty is only reevaluated roughly every two weeks (the exact timing depends on the combined output of the miners). The last update happened just before a sudden slump in the price of Bitcoin last Wednesday. Unless the price of Bitcoin recovers, miners won’t get relief until next week.

Benjamin Edelman, an associate professor at Harvard Business School who has studied the economics of Bitcoin, says that’s not soon enough to prevent the pain of miners from spreading more widely.

“I think that miners are pulling out and dumping Bitcoin to make up for lost revenue, which itself changes the value,” says Edelman. Those that do continue mining will contribute to the problem because they will have to immediately sell any new Bitcoins they mine, he says.

Edelman believes that a selloff like that could become sustained because Bitcoin has failed to gain enough significant use cases.

“What’s supposed to happen in most markets is that there’s some fundamental value of the asset,” he says. For example, a company’s cash flow or real estate might limit the depths of a tumble in its stock price. “With Bitcoin, it’s not at all clear what the fundamental value is—it’s only valuable to the extent that others treat it as valuable.” Although the same might be said of the American dollar, unlike Bitcoin, it has the backing of the U.S. government and Federal Reserve. You need dollars to pay U.S. taxes or buy government bonds, for example.

Gavin Andresen, chief scientist for the Bitcoin Foundation (see “The Man Who Really Built Bitcoin”), doesn’t share those fears. Although the mining difficulty is set to drop, “I don’t see any mass exodus of miners,” he says. “I think the system can adapt fast enough.”

Andresen says he wouldn’t be concerned even if half of miners suddenly gave up. “The result would just be one month where the average transaction took 20 minutes to confirm instead of 10 minutes,” he says. “For Bitcoin users that would be a minor nuisance not a major disaster.”

Not everyone might be so unshaken by such a sudden shift in the performance of Bitcoin, or the prospect of it taking so long to resolve. Edelman points out that Bitcoin’s automatic mechanisms can’t respond as quickly as governments’ central bankers can to many kinds of behavior—such as sudden changes in mass psychology—that play out during financial shocks. “The system is self-tuning and self-optimizing, but only in part,” he says.

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