: Proof of Work Currencies as Scarce Commodities Summary Given the relatively low adoption rate of Bitcoin as a means of exchange (~ 250,000 transactions per day for Bitcoin on 1/25/2018) and the rapid appreciation of its price during Q2 & Q3 of 2017, some market observers have argued that Bitcoin (and Ethereum by association) is simply an instrument of irrational speculative demand in virtual markets. However, proof-of-work cryptocurrencies should also be considered as intrinsically scarce commodities whose production is spurred by participants allocating significant computational resources to maintain an immutable chain of records (i.e Blockchain). Mining represents a unique attribute of crypto-assets and the mining pools involved in securing the Ethereum and Bitcoin blockchains are actors whose activities could be important to movements within cryptocurrency markets. This article is intended to offers investors and fund managers a brief overview of mining and explores the causal tie price plays in determining the quantity of computational power allocated to the blockchains of the two of the leading proof-of-work cryptocurrencies, Bitcoin and Ethereum. It argues that while both cryptocurrencies resemble scarce commodities, the price of each currency is also determined by variables primarily external to mining. Ethereum differs from Bitcoin in that its associated turing complete platform provides functionality for a broad array of disruptive applications. Overview of Mining Many managers are familiar with ‘mining,’ the process by which new coins enter circulation for proof-of-work blockchains. Miners verify transactions across the distributed ledger preventing double-spending and false replication of the main blockchain by malicious actors. In exchange for validating transactions, successful miners are rewarded with coins produced by the block found and appended to the existing blockchain. Mining is a highly competitive process, requiring participants to allocate computational resources in a race to solve cryptographic puzzles and find the next block. The aggregate amount of computational power deployed by miners across the network is measured in Gigahashes-per-second (GH/s) . The supply of new bitcoins entering into circulation is maintained at a predetermined rate by a ‘difficulty’ variable defined on blockchain.info as a relative measure of ‘how difficult it is to find a new block.’ Once 2,016 blocks have been found (approximately every two weeks), the network verifies whether the average time to create a new block was ten minutes. If the average time between each new block was more than ten minutes, difficulty decreases; conversely, if the average interval between blocks found is less than ten minutes, difficulty increases. Given the time lag for difficulty adjustments, there is a strong but not perfect correlation between hashrate and difficulty (.964) since the genesis block was mined. Price vs HashRate Analysis Participation in the mining process is tied to the market price of associated cryptocurrencies. Specifically, the amount of computational power allocated to a proof-of-work blockchain is a function of how profitable it is for a miner to lend resources that network. In this sense, mining Bitcoin or Ether is just like mining a scarce commodity such as gold or oil. The higher the price for such commodities at a given moment, the more resources will be dedicated to unearthing and reselling them in a competitive market. To verify the tie between hashrate and market price for Bitcoin and Ethereum, we run a regression test between these variables. Figure I — Data from Blockchain.info Figure II — Data from Etherscan For Bitcoin we find an R Squared of .81 between price and hash power for the period beginning on January 1st 2017. Price is assumed to be the leading indicator in this model. If price falls, and a miner’s marginal cost exceeds their marginal revenue, that miner will cease operations leading to lower hash power in the network. Conversely, as price rises, and mining becomes a profitable endeavor, more miners contribute their hashing power to the network. This will lead to a surge in the supply of bitcoin as blocks are mined at faster pace, until difficulty adjusts. The price of Bitcoin Cash and other altcoins is another variable the Fund Manager may consider. As miners can easily move their hardware between Bitcoin and Bitcoin Cash, whenever a price increase renders one network more profitable, mining pools transition their hash power to that network. Following a flood of hash power, mining difficulty for the associated network will increase overtime, rewards diminish, and the rate of change in price between Bitcoin and Bitcoin Cash should reach parity assuming no other variables at play. However, if a sudden change in market price occurs for one currency relative to the other, a similarly abrupt depreciation in hash power might ensue for the rival cryptocurrency. For example in November, the surge in Bitcoin Cash’s value relative to Bitcoin caused the quantity of hash power allocated to Bitcoin to drop precipitously and led to longer confirmation times for transactions on the network. Ultimately the listing of Bitcoin Cash on Coinbase in December of 2017 led to a further downward spiral in Bitcoin’s price. It is important for Fund Managers monitor network activity and market sentiment for both currencies to anticipate price changes for either. The ease by which a miner may move from Bitcoin to Bitcoin Cash could explain why the R Squared for Ethereum’s hashrate relative to its price is slightly lower than that of Bitcoin’s over the same period. As demonstrated in the previous figure, the R Squared for these variables is only .754. Yet, Ethereum’s price increase may also reflect broader adoption of its platform for a range of applications. Notably, in 2017, more than $3 billion was raised in Ether by early stage ventures through Initial Coin Offerings and novel apps like Cryptokitties brought blockchain closer than ever before to mainstream adoption. Conclusion This write-up intended to provide a very brief summary of the underlying economics of mining . We recommend the reader refer to sources listed below to gain a further understanding of mining as it pertains to price movement of Ethereum and Bitcoin. Bitcoin’s inherent volatility renders it unsuitable as a currency and thus more closely resembles a scarce commodity like a diamond with little intrinsic utility. Ethereum’s platform on the other hand has become widely used by early stage venture to raise capital, and holds more promise for widespread adoption. Other key variables to consider underlying these cryptocurrencies’ market prices include 1) government regulation 2) investor sentiment 3) broader acceptance of protocols for uses other than speculation. Regulation from the PBOC and the Korean government preceded the most significant changes in prices of these two proof-of-work cryptocurrencies this past year. References Blockchain.info “ ” Franco, Pedro, October, 2014. Wiley. Understanding Bitcoin: Cryptography, Engineering and Economics Polasik, Michal, et al. Available at SSRN 2516754 (2014). “Price Fluctuations and the Use of Bitcoin: An Empirical Inquiry.” Zhang, Yiteng, and Guangyan Song. (2014). “Economics of Competing Crypto Currencies: Monetary Policy, Miner Reward and Historical Evolution.”

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