Bitcoin extraction is a demanding venture. When one contemplates allocating financial assets to extract conventional resources like gold, copper, or oil, surveying for those assets in the field occurs beforehand to guarantee that any funds directed into a mining endeavor will not be wasted. However, due to the inherent characteristics of Bitcoin’s security protocol, miners cannot survey for anything, as discovering a block is entirely a statistical and random occurrence. With only 144 blocks available each day, there is no assurance that a miner’s efforts will yield rewards promptly without considerable variability, unless the miner possesses a substantial amount of hash power. A miner needs approximately 1.2% of the total hashrate (around 10 Exahashes per second at the time of this writing) to ensure reliable payments and significantly reduce its revenue fluctuations. The capital expenditure necessary to achieve such a level of hashrate is on the order of hundreds of millions of dollars. Unless a miner represents a colossal entity with an immense array of ASICS, they will face significant challenges.
Pool mining was developed to remedy this challenge. Let’s examine a single miner with a modest but notable mining operation. Out of the 52560 annual blocks, he’s anticipated to discover one, as he possesses 1/52560th of the total hashrate of the network. In other words, he’s expected to find one block every year. However, his utility bill is due every 4 weeks, and if he were to wait a full year paying expenses before receiving any income, he would face bankruptcy. Given this discrepancy between ongoing expenses and revenues, an idea occurs to him. He embarks on a quest to locate 499 others with similar-sized operations, and they reach an agreement. Rather than each individual mining independently, the miner suggests that they mine collectively as if they belong to the same entity, distributing the mining rewards based on each miner’s contribution every time a block is discovered. If every miner has 1/52560th of the total hashrate of the network, the collective of 500 miners is expected to mine a block about two times per week. By adopting a pool mining strategy, each miner secures that their effort and hard work will be rewarded much more regularly. Consequently, everyone can settle their bills monthly and, by year’s end, effectively evade bankruptcy. Nonetheless, sources of variability remain within those very rewards.
Pool mining ensures miners receive payment much more regularly compared to solo mining. However, it does not guarantee predictable rewards based on the hashing capacity that each miner possesses. This dilemma is commonly referred to as the pool’s luck risk. Let’s revisit the previous illustration. 500 miners, each with 1/52560th of the total hashrate of the network, are expected to mine 500 blocks within a year. However, they may uncover 480, 497, or even 520. There is no guarantee that the pool will successfully mine exactly 500 blocks within the year. A pool’s luck is determined by dividing the number of blocks mined by the number of blocks that were anticipated to be found based on the pool’s overall hashrate. If a pool mines 480 blocks while expecting to extract 500, the pool’s luck stands at 95%. Pool luck can induce significant variances in earnings over short intervals. Nevertheless, luck tends to level out over time, and payments will ultimately correspond to the anticipated distribution based on the pool’s hash rate. Two additional elements contribute to the total variability in miners’ reward payments, with the first being more consequential than the latter. The first aspect is transaction fees, which vary significantly as evidenced in recent years. Transaction fees from blocks mined immediately after the last halving accounted for more than 50% of the overall block reward for the first time in Bitcoin’s history. As of the date of this article (block height 883208), there were multiple non-full blocks mined over the past week, given that the mempool cleared on several occasions during these past days. A remarkable surge in such a short span. The second aspect pertains to the variance associated with the duration between blocks mined by the network. When a block is found immediately following another, there is less time for transactions to accumulate in the mempool, leading to lower transaction fees for that block. In contrast, if an extended period transpires between blocks, more transactions will be broadcasted, causing transaction fees to escalate in the process.
Uncertainty is distressing, particularly when considerable capital is at stake. Consequently, most miners find value in attaining more predictable, stable, and less volatile payments to recuperate the significant capital invested. This is where a Full Pay Per Share (FPPS) payout scheme offered by pools becomes relevant. FPPS functions as a conventional insurance product—a pure risk transfer. Regardless of the number of blocks the pool miners collectively extract and the transaction fees associated with them, miners receive payment from the pool based on the estimated value of their hashing power. The pool assumes all that risk. The predictability that FPPS offers to miners is unparalleled by any other method. Therefore, it should not be surprising that FPPS has become the standard in pool payouts today, albeit not without a considerable cost.
FPPS is far from a free handout. To endure periods of unfortunate luck and all risks associated with an FPPS payout model, pools require substantial financial reserves. These elevated capital demands incur expenses. And pools are not charitable entities. These heightened costs ultimately get passed on to miners through increased pool fees. As previously stated, miners need to bear in mind that an FPPS payout system operates like an insurance policy. And insurance policies depend on counterparties. Yet sometimes, counterparties fail to uphold their responsibilities when most needed, as evident during the 2008 Global Financial Crisis. The miner must place their trust in the pool fulfilling their insurance contract commitments. Certainly, if the pool is very large in size, that risk becomes considerably small. Pools can also find strategies to mitigate this risk from their operations. Nevertheless, isn’t Bitcoin fundamentally about minimizing trust, counterparty risk, and eradicating it whenever possible? It appears the Bitcoin ethos has yet to reach the pool mining aspect of the protocol.
Moreover, any miner that receives FPPS rewards for their efforts must relinquish any benefits associated with transaction fee spikes. The FPPS payout calculation determines miner rewards by assessing transaction fees from the preceding n blocks and estimating an “expected value” for transaction fees. The pool then employs this assessment to decide how much to remit to miners for the transaction fee segment of their shares. Consequently, when transaction fees surge, the payout is calculated based on historical data where no transaction fee spike occurred. One does not need a PhD in mathematics to understand that all those profits end up in the pool’s hands rather than in those of the miners in this case. Furthermore, even if a recent spike in transactions was observed, pools cannot incorporate this into payout computations. The likelihood of such a spike not being an anomaly is virtually negligible. In essence, pools cannot ensure that fee spikes will remain consistent and frequent in the future. Therefore, they cannot factor it into miner payouts without risking insolvency.
The unsustainability of the FPPS payout model
Examining closely how the FPPS payout scheme operates…
Once the scheme is established, it becomes clear that it resembles the contemporary pension frameworks of numerous governments, inherently unsustainable. The FPPS as it exists presently is poised to collapse soon under its own mass. As time progresses, transaction fees will account for a larger share of the total disbursement to miners. This interaction, together with their intrinsic fluctuations, will result in a considerable escalation of the total payout variability, thereby amplifying the insurance expenses of FPPS pools indefinitely. In other terms, as the Coinbase reward continues to diminish, the variability of the rewards within the block will escalate significantly. If the variability increases, the accompanying risk of providing this insurance servicing for miners will also heighten. Consequently, policy rates for the insured must rise accordingly. This implies that FPPS pools will be assuming added risk when committing to a fixed payment to miners. With increased risks come elevated capital expenses. The level to which pool fees must increase for pools to persist in delivering an FPPS insurance product remains uncertain. Only insurance actuaries can ascertain the exact figure. One aspect we already know for certain: it won’t be inexpensive, because it already isn’t.
A substantially higher pool fee for stable and predictable payouts provided by FPPS will render a PPLNS reward strategy significantly more appealing for any miners aiming to optimize their profitability, as the previously mentioned dynamic of the shifting composition of blocks unfolds. In this arrangement, miners receive payment upon the discovery of a block by the pool. When a block is located, the pool evaluates how many valid shares each miner contributed during a timeframe consisting of the last N blocks found by the pool and allocates payouts accordingly. This interval is commonly known as the PPLNS window. The primary drawback of this compensation system is, of course, the risk linked to the pool’s luck being below 100%, as well as the chance that there may be times when the pool fails to find any blocks, resulting in miners not receiving their payments. Nonetheless, a pool with only 1% of the hash rate has merely a 0.0042% probability of not discovering a block within a week, while the likelihood of the pool’s luck falling below 90% in a year is around 1.09%.
Will a viable market emerge soon for FPPS pool services at a sufficiently high rate that compensates the pool for all the variability related to the overall block rewards? No one can predict with certainty. One thing we know: Pool fees will have to be substantial. The earnings that miners will need to surrender will simply be too large to justify eliminating the risk related to not receiving payments consistently and promptly. As other more experienced players venture into the bitcoin mining sector, such as energy firms, one should anticipate other risk management solutions becoming readily available in the market for miners to hedge various types of risks. New innovative pool compensation schemes will likely arise as these instruments become more accessible to all.
Miners’ revenues and profits will be significantly affected by the dynamics outlined in this discussion. Exploring alternative pool compensation methods and risk mitigation strategies will be essential for any miner looking to enhance the profitability of their operations. The FPPS payout design may still be beneficial for miners today. However, as previously mentioned, FPPS will soon be relegated to the annals of bitcoin’s past.
This is a guest piece by Francisco Quadrio Monteiro. The views expressed are solely their own and do not necessarily represent those of BTC Inc or Bitcoin Magazine.