Bitcoin Mining Industry - Part I
Confidential Research Report by Matt McDonagh
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Last month a friend who owns several hundred bitcoin miners in Texas reached out and asked if I wanted to invest.
Normally I don’t mix friendship and business.
That said, in a potential sign from the universe, I had already been considering investing in a small basket of the publicly traded bitcoin miners and the amount he was asking for was relatively small (with solid terms too).
I don’t risk even “small” amounts of money without due diligence so I kicked-off a massive deep dive into the bitcoin miners, starting with:
How does bitcoin mining work?
How do miners make money?
What are the expenses and how have they trended over the last 5-years?
Why isn’t every power generator converting watts to sats and bypassing the miners entirely?
What’s the financial performance difference of a pure BTC miner vs a hybrid offering HPC and other services?
I needed to learn fast so I pulled down the annual and quarterly reports for the 10-largest BTC miners by market cap. Then I fed them to AI and starting asking questions to develop a baseline understanding.
I shared my research with an analyst (soon to be PM!) friend from college / Wall St who said “publish this immediately”.
So here we are.
Bitcoin Mining Industry
Research Analysis by Matt McDonagh of WealthSystems.ai
Bitcoin mining is the lifeblood of the Bitcoin network, a decentralized process that ensures the integrity and security of the cryptocurrency.
This industry utilizes energy as an input cost utilized by computers, known as miners, competing to solve complex mathematical problems. The first miner to solve the problem adds a new block of transactions to the blockchain, the public ledger that records all Bitcoin transactions, and receives a reward in the form of newly minted Bitcoins.
This process is known as Proof of Work (PoW).
Miners play a crucial role in the Bitcoin ecosystem.
Miners not only validate and confirm transactions but also secure the network against attacks. By dedicating substantial computing power, miners make it extremely difficult and costly for malicious actors to alter the blockchain or double-spend Bitcoins.
The Mining Process
The mining process involves several key steps:
Transaction Verification: Miners gather pending Bitcoin transactions from the network and verify their validity.
Block Creation: Verified transactions are grouped together into a block.
Nonce Discovery: See below, this alongside the difficulty adjustment are what shape the mining process.
Block Addition: Once a miner finds the correct nonce, they broadcast the solved block to the network.
Block Confirmation: Other miners verify the solution and add the block to their copy of the blockchain.
At the core of Bitcoin mining lies cryptographic hashing, a process that transforms any amount of data into a fixed-size string of characters.
Bitcoin utilizes the SHA-256 hashing algorithm, which produces a 256-bit hash. This hash acts as a unique digital fingerprint for the input data. It's a string of characters generated by a mathematical function (called a hash function) that takes in any amount of data and outputs a fixed-size string.
Here's a simple analogy: Imagine a machine that takes any object, no matter the size or shape, and turns it into a unique QR code. You put in a banana, it gives you a QR code. You put in a car, it gives you a different QR code.
That code is like a hash.
Hashes ensure that the data in a block hasn't been tampered with. Even a tiny change to the block's data will result in a completely different hash.
Miners compete to find a special number (called a nonce) that, when added to the block data and hashed, produces a result that meets certain criteria. This process is what makes Bitcoin mining difficult and secures the network.
Each block's header includes the hash of the previous block. This creates a chain of blocks (hence "blockchain") where each block is linked to the one before it. This makes it very difficult to alter past transactions because changing one block would require changing all the blocks that come after it.
Think of it like a detective inspecting a crime scene. They want to make sure that nothing has been moved or altered. They might take photographs… but to go the extra mile they also record the position of every object relative to each other!
The hash is like a comprehensive record of the entire crime scene, ensuring that everything is exactly as it should be.
The target, represented by the network difficulty, determines how hard it is to find a valid hash.
The mining difficulty adjusts every 2,016 blocks (approximately every two weeks) to maintain an average block time of 10 minutes. If the network hash rate, the combined computing power of all miners, increases, the difficulty rises to keep the block time consistent. Conversely, if the hash rate declines, the difficulty adjusts downwards. This dynamic adjustment ensures the stability and predictability of the Bitcoin network.
Block Structure
A Bitcoin block consists of a header and a list of transactions. The block header contains crucial information, including:
Version: Indicates the block version.
Previous Block Hash: Links the current block to the previous one, forming a chain.
Merkle Root: A summary of all transactions in the block, constructed using a Merkle tree data structure.
Timestamp: Records the time the block was created.
Difficulty Target: Specifies the required threshold for a valid block hash.
Nonce: The random number miners adjust to find a valid hash.
Mining Hardware
The evolution of Bitcoin mining hardware has been driven by the pursuit of higher hash rates and energy efficiency.
CPUs: Early Bitcoin mining utilized CPUs, but their limited processing power quickly became inadequate.
GPUs: Graphics Processing Units (GPUs), originally designed for rendering images, offered significantly higher hash rates than CPUs.
FPGAs: Field-Programmable Gate Arrays (FPGAs) provided further performance improvements due to their customizable circuitry.
ASICs: Application-Specific Integrated Circuits (ASICs) are purpose-built for Bitcoin mining, delivering unparalleled hash rates and energy efficiency.
ASICs are specialized computer chips designed for a single purpose. Unlike general-purpose processors like CPUs, which can handle a wide range of tasks, ASICs are optimized to perform a specific function extremely efficiently.
ASICs have played a pivotal role in the growth and security of the Bitcoin network. Their unmatched hash rate and energy efficiency have made them the dominant force in Bitcoin mining. As technology continues to advance, ASICs are likely to remain at the forefront of the industry, driving further innovation and ensuring the long-term viability of Bitcoin mining.
ASICs are designed to perform the SHA-256 hashing algorithm used in Bitcoin's proof-of-work system.
ASICs offer significantly higher hash rates compared to CPUs, GPUs, or FPGAs. This translates to a greater chance of solving a block and earning Bitcoin rewards. The latest generation of ASICs can achieve terahashes per second (trillions of hashes per second), while even the most powerful GPUs struggle to reach gigahashes per second (billions of hashes per second).
It isn’t all about power.
This is a business after all, which means operating efficiency must be economical.
ASICs are designed for energy efficiency, consuming less power per hash than other types of hardware. This is crucial in Bitcoin mining, where electricity costs are a major factor in profitability. While early ASICs were power-hungry, advancements in chip design and manufacturing have led to significant improvements in energy efficiency.
ASICs are specifically designed to perform the SHA-256 hashing algorithm used in Bitcoin mining. This specialization allows them to achieve higher performance and efficiency compared to general-purpose hardware, which is not optimized for this specific task.
ASIC miners are typically compact and designed for easy deployment in mining farms. This allows for efficient use of space and simplifies cooling requirements.
Evolution of ASIC Technology
The development of ASICs has been a key driver of the Bitcoin mining industry's growth. Early Bitcoin mining was done using CPUs, then GPUs, and later FPGAs. However, the introduction of ASICs in 2013 revolutionized the industry, leading to a dramatic increase in the network hash rate and making it virtually impossible to mine Bitcoin profitably with other types of hardware.
Over the years, ASIC technology has continued to advance, with each new generation offering higher hash rates, improved energy efficiency, and lower costs per terahash. This ongoing innovation has driven competition among ASIC manufacturers, leading to rapid advancements in the field across many dimensions that influence performance.
Future of ASIC Technology
The future of ASIC technology in Bitcoin mining involves rapid advances in materials science, artificial intelligence and cooling technology.
The Bitcoin mining industry is in a constant state of innovation, with manufacturers relentlessly pushing the boundaries of ASIC technology. This drive is fueled by the competitive landscape, where miners are always seeking an edge to maximize profitability.
Key areas of innovation include advanced chip design, using cutting-edge fabrication processes and exploring new materials to increase performance and reduce power consumption. Improved cooling systems, like immersion cooling, are also critical for maintaining optimal operating temperatures.
Sophisticated power management systems are being developed to optimize power delivery and minimize energy waste. Since power is the biggest COGS in mining these advances promise to increase margin and provide pathways to future profit.
Finally, machine learning is being applied to optimize various aspects of ASIC design and operation, including predicting hardware failures, optimizing cooling, and dynamically adjusting mining parameters. This continuous innovation leads to a higher network hash rate, lower energy consumption, and potentially increased decentralization of the network.
Clearly a great deal of R&D and capital is being spent on managing the cost profile of mining. Let’s discuss the broader investment thesis and key considerations.
Investment Considerations
I’m interested in BTC mining because I believe the underlying (bitcoin) is going to become the #1 “wealth battery” for humanity over the next 10-years.
I see $150T from the CRE market and $100T from the bond market ending up in the Bitcoin box (little tiny one, top left). When you add another $5T from Gold and say $15T from Equities that means $270T to $300T is bitcoin’s projected market capitalization.
I want to own as much of that 270x to 300x upside as possible, and getting exposure to bitcoin miners: