A central tenet of cryptocurrencies is their decentralized nature. In cryptocurrency lore, anyone with a computer can manufacture a coin by connecting to the mining network. As the popularity and market for cryptocurrencies has evolved, however, that idea seems to have fallen by the wayside. Large mining pools with operations spread across multiple countries have become a standard method for minting new coins.
According to a recent paper by Cornell University researchers, bitcoin and ethereum, the two most prominent cryptocurrencies, have centralized mining operations. The top four miners in bitcoin and the top three miners in ethereum accounted for more than 50% of the overall hash rate for those cryptocurrencies.
Approximately 56% of all bitcoin is mined in datacenters. For ethereum, the same figure is 28%. Three miners of ethereum accounted for 61 percent of average weekly capacity.
The centralization of mining pools presents within cryptocurrencies presents its own set of advantages and disadvantages. In turn, the mining pools themselves have a bearing on its price.
The Advantages Of Mining Pools
The philosophical argument for decentralization apart from centralized mining operations offer several advantages.
The first one is faster processing. In bitcoin mining, each node competes with the rest of the network to add to the overall blockchain. Blocks are “found” only when other nodes within the network agree to its discovery. Having multiple blocks within the same network can speed up the discovery process because it reduces latency or delays. (See also: How Does Bitcoin Mining Work?)
It also irons out discrepancies in Internet connections between nodes placed in different geographies. In turn, more direct network connections between bitcoin nodes speeds up the notification process.
Second, large numbers of mining systems within the same network also makes for an efficient mining process because it reduces the number of “orphan blocks,” or blocks that are not selected to be part of the blockchain.
Pools also help bitcoin mining firms achieve economies of scale. The difficulty of problems that miners must solve in order to earn bitcoin has increased over time and is expected to further increase as the rate of production of bitcoin slows down. (See also: 20 Percent Of Bitcoin Remain To Be Mined.)
From a technical standpoint, the introduction of new ASIC hardware machines might make the process more efficient. But bitcoin miners still have to contend with increased electricity costs, which comprise 90 percent of overall costs, to run these machines. According to some estimates, high electricity prices can also make bitcoin prices unsustainable over the long run.
Governments and power companies have nudged bitcoin mining operations towards mining pools by offering subsidized electric rates. Like most industrial products, scale is useful to drive down costs.
Centralization Could Lead To More Power
But the paradigm shift from decentralized to concentrated mining pools has not occurred without controversies.
They started with a 2013 paper by Cornell professor Emin Gün Sirer, in which he claimed that bitcoin is broken because it enables selfish mining. In this type of mining, a group of miners join forces and “hide” their generated blocks from the main blockchain. This enables nodes within their network to discover the blocks and quickly generate additional blocks. The hidden blocks are revealed only after the hidden chain of blocks has a length equal to that of the new blockchain. According to Sirer, the profits generated as a result of this type of mining provides incentives for small mining groups to join large ones.
The launch of Bitcoin Cash, a cryptocurrency that was forked from bitcoin’s blockchain in August 2017, also generated much discussion about the power of bitcoin miners. Jihan Wu, Bitmain’s CEO, threw the resources of his mining pools behind the cryptocurrency even as small and independent miners boycotted it. The result was a surge in its price resulting in a high of $3,706 in December 2017. As of this writing, it is trading at $945. That’s not a bad trajectory for a coin that is six months old.
The other, more serious, charge relates to manipulation of cryptocurrency prices by mining pools. Because they control supply of coins to the market, centralized mining pools can control its prices by restricting the number of coins available for trading. Specific concerns in this regard are targeted at Chinese miners, who are responsible for mining approximately two-thirds of all bitcoin in existence currently.
In a Washington Post article last year, Sirer said Chinese miners were being painted “with too broad a brush.” It’s not the case that all Chinese miners are part of the same enterprise or are colluding,” he said. (See also: High Bitcoin Prices Boost Profits For Miners In China.)
But he did point to another problem that could result from China being the world’s largest supplier of coins. “They would not be able to usurp funds, but they could stop the motion of funds,” he said, alluding to a situation that could result from the Chinese government’s restrictions on bitcoin mining.
The Chinese government has already called for an “orderly” closure of bitcoin mining operations within the country. But that doesn't mean a complete shutdown to the creation of new bitcoins as Chinese bitcoin mining firms are beginning to expand abroad. (See also: Are Bitcoin And Crypto Prices Totally Dependent On China?)
The Bottom Line
Cryptocurrency mining has transitioned from an operation that was distributed over groups of individual computers to centralized mining pools involving large investments and industrial outfits. That change is primarily a result of the cryptocurrency’s popularity and increase in transaction volumes. There are several benefits and drawbacks to centralization of bitcoin mining pools.
Investing in cryptocurrencies and other Initial Coin Offerings ("ICOs") is highly risky and speculative, and this article is not a recommendation by Investopedia or the writer to invest in cryptocurrencies or other ICOs. Since each individual's situation is unique, a qualified professional should always be consulted before making any financial decisions. Investopedia makes no representations or warranties as to the accuracy or timeliness of the information contained herein. As of the date this article was written, the author owns small amounts of bitcoin.