[E14.2] Proof of Work: a digital proxy for energy
High-Density Computing settles transactions every 10 minutes on the Bitcoin blockchain
Dear Reader,
In this Post for Product | Strategy | Innovation I will discuss a core feature of bitcoin called Proof of Work (PoW) consensus in Part 2 of a 3-Part Series on Power Density as a catalyst for change. Bitcoin and emerging AI applications are driving rapid innovation for computing with Power Density to mine bitcoin 20x what is needed for cloud computing.
PoW consensus enables transaction settlement on the Bitcoin blockchain without any intermediaries. But this requires adequate network scale, decentralization, computing power, and energy to maintain security and reliability.
Alternative assets to bitcoin like gold require locating a viable source of gold, capital to acquire mining equipment and labor plus energy to operate the mining equipment. Not only is gold scarce, but the requirements to mine it at scale provide significant barriers to mine more of it.
One way to define bitcoin is a digital asset backed by the computing power (in kW) and energy used (in kWh) to mine each new bitcoin through transaction settlement. Bitcoin by design is scarce. There will only be 21 million bitcoin mined. And the rate new bitcoin are mined is also predetermined per the Bitcoin protocol. Competition to mine bitcoin is a function of its price and the cost of capital to build out and operate bitcoin mining capacity.
Most large bitcoin mining operations are now publicly traded companies and can raise capital efficiently through public offerings. So bitcoin’s price has become the primary catalyst to scale bitcoin mining. And the scale of bitcoin mining worldwide determines the resilience of bitcoin as a digital asset.
In this Post, I will first provide some Background on bitcoin. Then, I will cover PoW consensus in 3 sections plus some Final Thoughts.
Bitcoin Layer-1 blockchain
Proof of Work consensus vs. alternatives
Proof of Work consensus drives High-Density Computing
Sustainable energy is the future. We should use available levers to accelerate the transition to sustainable energy. Bitcoin as a digital asset and Store of Value offers one such lever. This is possible when bitcoin miners scale low cost sustainable energy capacity to satisfy their growing demand for co-located High-Density Computing. This is already happening in Texas.
Background
To cover bitcoin and its PoW consensus mechanism in this Post, we must first review some relevant background on core use cases for money, how network effects drive price and some key bitcoin features.
For a more detailed review on Money, I covered this topic in a prior Series.
Money as a Medium of Exchange vs. Store of Value
A core feature of money that drove early adoption many centuries ago was as a Medium of Exchange versus direct barter. If I have a skill, I can barter for the goods and services I need in exchange for applying my skill. But what if my skill is not in demand for a good or service I really need. Barter quickly limits the scale of an economy. A Medium of Exchange like the US Dollar or Euro allows goods and services to be easily bought and sold by anyone who holds or can acquire an adequate amount of this chosen “medium”.
For low cost goods and services, reliability is important, but high transaction volumes and low transaction costs are the primary requirements. Currency-backed credit cards cover fraudulent charges to help scale adoption and the 2% transaction costs are absorbed by businesses to close more sales. Consumers also get some benefits from using a credit card like loyalty points. But as the transaction volume and total associated revenue continues to scale, aggregate transaction costs and inter-currency transaction friction become bigger issues.
And as the cost of a good or service reaches something like a real estate buy/sell transaction, reliability becomes a primary requirement even while accepting lower transaction volumes and higher transaction costs. Cross-border transactions like remittance to a home country introduce another level of complexity. Such edge cases drive innovation for alternatives.
Another limitation for currencies (example: Venezualan bolivar) is inflation or even hyperinflation due to the issuing central bank creating more units to meet the government’s debt obligations or to expand services. Therefore, an important feature for some specific assets is as Store of Value to hedge against inflation. More units can be created for many assets like stocks, bonds, currencies and commodities like gold.
However, some assets have barriers to create more units like the cost to mine more gold. This has made gold a desired Store of Value over time. The more scarce and reliable an asset is, the more capable it is to sustain its value over time. Gold is good, bitcoin has been better, but bitcoin in the future with more network effects to reduce volatility could be great, or even the “apex” Store of Value.
Network Effects drive bitcoin’s price
Bitcoin as a Store of Value benefits from many attributes like its reliability and scarcity. But what will really drive its value in the future is its ability to disrupt alternative assets and serving multiple use cases for money.
What are some global proxies for a Store of Value?
Global remittance by 2030 is $1 trillion
Gold’s total addressable market worldwide is $13+ trillion
Global equity market’s total addressable market is $100+ trillion
Global total addressable market for commerce is $100+ trillion
Global real estate total addressable market is $300+ trillion
If bitcoin consolidates a portion of these markets as the apex Store of Value with a $40+ trillion market cap (3x Gold’s current market cap) in the future, the corresponding target spot bitcoin price would hit $1.9 million per coin assuming 21 million bitcoin at its limit.
Additional network effects for bitcoin include its role as a direct or indirect Medium of Exchange.
Bitcoin miners allocate capital to settle transactions on the Bitcoin Layer-1 blockchain every 10 minutes to seek the Bitcoin reward.
Bitcoin’s Layer-1 blockchain is used as “rails” to secure Layer-2 solutions like the Bitcoin Lightning Network to lower cost and increase transaction volume as a Medium of Exchange.
Bitcoin is purchased on Layer-3 exchanges like Coinbase and Cash App using US Dollars or another currency and stored on the exchange in a digital wallet.
Bitcoin is allocated on Layer-3 exchanges like Coinbase to collateralize loans.
Bitcoin is self-custodied off Layer-3 exchanges by transfer to a secure, portable, hardware wallet. Multiple companies sell these devices.
Exchange-traded funds (ETFs) from BlackRock, Fidelity and other companies are a recent addition for investment in bitcoin for institutional and retail investors. These products in aggregate surpassed $10 billion in assets under management in the first 20 days.
Corporate treasuries hedge inflation on a portion of their balance sheet once fair value accounting for bitcoin goes into effect mid-December 2024 (early adopters include Microstrategy, Marathon Digital Holdings, Tesla, Hut 8, and Block). Even if the allocation is only 2-5% of cash on the balance sheet, the impact could be material with wide adoption. Microstrategy is the extreme early adopter with over $11 billion of bitcoin versus $46 million of cash on its balance sheet after the market close on February 29, 2024.
Apple, Alphabet and Microsoft hold over $400 billion in cash and investments on their combined balance sheets. Berkshire Hathaway is holding $167 billion in cash on its balance sheet. All companies in the S&P 500 are holding over $2 trillion in cash and cash equivalents on their combined balance sheets.
If the price for bitcoin due to all these network effects increases significantly from where it is today, Bitcoin miners will raise abundant capital in the public markets to lower their cost of energy. Bitcoin miners and their energy partners will add more sustainable energy capacity and expand their fleet of Bitcoin mining machines to build out more High-Density Computing capacity.
One limitation of the new bitcoin ETFs is an SEC requirement to only settle transactions using cash. Most ETFs also allow in-kind settlements with the underlying asset(s) because these are more efficient and lower costs. This limitation could cause more selling pressure on bitcoin to raise cash when bitcoin’s price might already be under selling pressure during a period of market stress.
Key bitcoin features
Bitcoin has many favorable attributes, but its core features include:
Decentralized network around the world without a CEO, central bank or government control
Autonomous as an open-protocol that operates on all available nodes on a closed-network (the network only performs one task, operate the Bitcoin protocol to settle transactions)
Secure with scaled settlement of transactions across the network
Immutable without risk of validated blocks on the blockchain being changed
Scarce with only 21 million bitcoins mined
Divisible in up to 100 million units, or satoshis, per bitcoin
Censorship Resistant
Network Effects (already covered above)
Portable unlike many alternate Stores of Value like real estate property and large quantities of gold
Anonymous although transactions can be traced using keys on the blockchain
All of these bitcoin features help drive its value proposition across multiple use cases. Apex predators exist in many different ecosystems in nature. Orcas rule the seas. Polar bears rule the ice. Brown bears rule many northern lands. Lions rule the plains of Africa. And anacondas rule the Amazon river basin.
But no animal rules the ice, seas and Amazon. The ultimate role for bitcoin is to serve as an “apex asset” by consolidating multiple markets to become the equivalent of an orca in the sea, polar bear on the ice and anaconda within the Amazon river basin.
1. Bitcoin Layer-1 blockchain
Blockchain technology was first described in a whitepaper when Satoshi Nakamoto detailed a peer-to-peer electronic cash system using the Bitcoin protocol. The bitcoin feature that impacts High-Density Computing the most is its Proof of Work consensus mechanism to settle transactions across all operating network nodes. Each node is competing for the Bitcoin protocol reward, so this drives more nodes onto the network and demand for computing power behind each node.
As more aggregate computing power comes onto the network, the Bitcoin protocol increases the difficulty to mine bitcoin to self-regulate the protocol. When China banned Bitcoin mining several years ago, a large proportion of mining equipment was suddenly taken offline. This triggered a reduction in the difficulty and computing power needed to mine bitcoin to help self-regulate the Bitcoin protocol. This change was autonomous. No executive or government mandated this change. The Bitcoin protocol regulated itself.
SHA-256 hash function is the basis for Bitcoin’s Proof of Work
Hash function difficulty regulates the computing power needed to create a new block of transactions every 10 minutes
Short-term and expected long-term price appreciation for bitcoin drives the demand to mine bitcoin
Demand to mine bitcoin drives the amount of computing power on the Bitcoin mining network
Hash function difficulty is proportional to the computing power on the network
Bitcoin miners can join mining pools to aggregate their computing power and share the reward when won in proportion to the computing power they provided relative to the total computing power for the mining pool
Transactions are settled using Bitcoin mining
Hash validates a block of transactions
A new, validated block is added to the blockchain
2. Proof of Work consensus vs. alternatives
Open - Trustless, permissionless, blockchain-based
Proof of Work - proven, but energy-intensive
Battle-tested over more than 15 years
Semiconductor technology will continue to drive performance of High-Density Computing
Immersion cooling technology will improve reliability, performance and reduce noise compared to the air cooling fans used primarily today
Mining pools improve the take rate although diluting the reward proportionally across the pool
Proof of Stake - still in early phase, blockchain innovation
More energy efficient than Proof of Work
Nodes for Proof of Stake must stake an adequate amount of the asset to settle transactions
High transaction volumes are possible
Smart contracts are a key use case using higher transaction volumes and programming as a feature
Closed - Trusted counterparties settle transactions
Blockchain with access by permission
IBM Food Trust
Avaneer Health
Tokenization of assets like a piece of art by a trusted third party like JP Morgan Chase
Legacy financial services by Commercial Banks
Central Bank (monetary base, M0) uses 3 levers for monetary policy to regulate its network of Commercial Banks (bank money, M1/M2)
Open Market Operations
Central Bank expands/contracts monetary base to help regulate cash reserves at Commercial Banks
Central Bank buys and sells financial instruments called securities
Bonds
Mortgage-backed securities
Stocks (uncommon)
Cash Reserve (ratio) Requirement
Cash Reserves
Balance sheet
Checking accounts
Savings accounts
Outstanding loans
Discount Rate
Interest rate Central Bank charges for loans to Commercial Banks
Transaction settlement
SWIFT - interbank wire transfers
ACH - automated clearing house (direct deposits, bill payment, etc.)
Credit/debit cards
Visa network
Mastercard network
American Express network
3. Proof of Work drives High-Density Computing
As the price for bitcoin scales, High-Density Computing capacity (in kW) will also continue to scale to pursue the ever-increasing Bitcoin reward to settle transactions every 10 minutes. The Power Density for the semi-conductors used for PoW is at least 2x High-Performance Computing and 20x cloud computing.
Bitcoin mining equipment aims to drive computing efficiency with each new generation of the technology to help manage the operating cost. This translates into faster upgrade cycles for this equipment and higher Power Density over time. This ongoing upgrade cycle helps secure the Bitcoin network. It also aligns capital with the new versus maintaining the old. Legacy financial settlement systems also need to upgrade their technology using the same capital markets. This will become more competitive to capitalize the new and old over time.
Low-cost energy generation capacity eventually becomes the rate limiting step to scale and operate High-Density Computing to mine bitcoin. Buying more energy from the utility grid is possible under purchase power agreements (PPAs) with favorable terms during Off-Peak use. But the better long-term use of capital is to build out more low-cost sustainable energy capacity so energy can be sold to the utility grid during Peak use.
Thus, High-Density Computing becomes a lever to accelerate the transition to sustainable energy. Bitcoin mining is currently co-locating with excess sustainable energy, but the build out of more sustainable energy capacity will happen next. Texas will likely lead due its favorable energy marketplace. The Dallas-Fort Worth metropolitan area is one early adopter with with multiple bitcoin mining operations in surrounding rural areas with sustainable energy generation.
High-Density Computing can also be a positive catalyst for stationary battery deployments. Tesla is rapidly scaling Megapack stationary battery deployments to utility grid customers. A challenge is once deployed, it can take substantial time to connect the deployed battery to the utility grid. This delays recognition of the revenue from the project for Tesla. High-Density Computing however is co-located with sustainable energy generation. So, a Megapack battery deployment once installed can immediately connect to this microgrid and go into production. This is a win for Tesla and could be an opportunity for Tesla to act as a catalyst to jump start some projects in Texas.
Some Final Thoughts
Bitcoin is a risk-on, speculative digital asset with no cash flow. These attributes contribute to high price volatility. However, bitcoin is also demonstrating traits of an apex Store of Value when considering an adequate time horizon. Past performance and future prospects for the digital asset lead to risk capital chasing future returns. High-Density Computing focused on bitcoin mining through PoW consensus is one investment target for this risk capital.
PoW consensus is also energy intensive. Low-cost energy generation power must keep up with the demand to scale more computing power. This can be viewed as a negative if available energy is diverted towards PoW consensus to mine bitcoin.
But what if the need for energy to mine bitcoin drives the build out of more low-cost sustainable energy capacity using solar and other options. And when the market economics favor curtailment of bitcoin mining, this energy capacity is diverted towards the electrical utility grid. That is a win-win.
So the PoW consensus to mine bitcoin becomes a proxy for the amount energy required to carry out operations across the entire bitcoin network worldwide every 10 minutes. The more energy required, the more implied value bitcoin has because of this barrier to create more bitcoin. In other words, bitcoin is economic potential energy. And this energy can be transferred (while still conserved) at a later time to enable an economic activity using bitcoin to settle a transaction. Or this economic potential energy can be held to speculate on bitcoin’s future price (but with the risk its price can also drop significantly due to price volatility).
Best,
Stephen
I’m long BTC, HUT, SQ and TSLA mentioned in this post. Nothing in this Update is intended to serve as financial advice. Do your own research. The opinions and views expressed in this newsletter are those of the author. They do not purport to reflect the opinions, views or policies of any other organization, company or employer.