As The Bitcoin Bubble Bursts, Digital Currencies Have A Dilution Problem

There was a time when people followed every gyration of bitcoin with pathological curiosity, peaking roughly five months ago when after having generated an epic return for 2013 as more and more momentum chasers got on board, the digital currency flirted with the $1000 (in USD terms) level on a daily basis. Then it peaked, almost to the day when this article came out, and ever since then it has been a slow, painful grind lower both for its holders and for its proponents, as can be seen on the chart below.

Needless to say, now that the bitcoin bubble popped, both the interest, and the momentum has been lost, as has the desire to "mine" bitcoin, which as we profiled previously, requires massive, expensive computer workstations. Or rather required. Because as Bloomberg reports, the Bitcoin mining bubble has also burst.

Speculators, known as miners, use powerful computers to solve complex software problems and verify transactions to unlock new bitcoins. They’re finding that the enterprise isn’t as profitable as it once was.

Drawn by the virtual currency’s jump in value last year, digital prospectors have turned the mining industry into an arms race as they buy expensive computing equipment and gobble up electricity. While that worked well as long as bitcoin’s value kept rising, smaller players are now being crowded out by bigger competition, high utility bills and declining prices.

If you mine at the moment, you have to be very lucky to get anything,”said Mehmet Vatansever, who bought $16,000 worth of mining computers in February to chase after new bitcoins. “It’s a very difficult business.”

End result: Ebay is suddenly flooded with supercomputers whose only purpose was to create more bitcoins, and whose upkeep now that the price of bitcoin has tumbled, costs more than the profit from selling mined bitcoins.

While he has been able to create new bitcoins, Vatansever soon discovered that his equipment was on track to earn less than his monthly utility bill of $480. After selling his computers on EBay Inc. in April, Vatansever estimates that he lost a total of about $6,000 on his mining adventure.

In the past week, miners made $14.9 million in revenue, compared with a weekly average of $25.2 million in December, according to Blockchain.info, an bitcoin-data aggregator. The figures represent the number of bitcoins mined plus transaction fees, multiplied by the dollar-based market price.

EBay now features more than 1,600 listings for mining computers, many of them used.

To be sure, while smaller operators have thrown in the flag, mining is still profitable for the scale operators who are crowding out minor players.

While individuals give up prospecting, at least two other larger mining companies, KnCMiner and Cloud Hashing, are still generating profits. By scaling up operations, they’ve been able to save costs on cooling and power, making their computers more efficient and cost-effective. KnCMiner also sells mining computers to other miners.

KnCMiner, based in Stockholm, operates about 7,000 machines. While the mining company’s electric bill in March came to $450,000, the computers mined 21,000 bitcoins, according to co-founder Sam Cole.

However, the biggest losers are not the miners, especially if they can take the accelerated tax depreciation write off on their supercomputers (unless these can somehow be converted into HFT trading machines), but the sellers of these same machines.

Mining-equipment suppliers are feeling the cool-down firsthand. CoinTerra Inc.,a manufacturer of the powerful computers used to crunch numbers for new bitcoins, has seen new sales shrink by 30 percent in the past three weeks from the preceding period, according to CEO Ravi Iyengar.

Mining-equipment suppliers are also detecting early signs of a shift to new virtual currencies. Approximately 250 KnCMiner customers switched their orders from $10,000 computers to similarly priced alternative-currency mining machines in the past three weeks, according to Cole.

And there is of course AMD, whose Radeon video cards experienced a dramatic surge in popularity as a cheaper alternative to self contained workstations, only to feel the sudden pullback in demand now (and if it hasn't yet, it will soon).

But the biggest irony is the following:

Because they are newer, designed differently and currently mined by fewer people, currencies such as Litecoin can be more profitable, according to CoinWarz, which tracks mining activity. “The new rush right now is Litecoin,” Colin Lusk, a network engineer in Portland, Oregon, said in an interview.

While he once mined only bitcoins, Lusk now uses five of his eight machines to produce Litecoins and other virtual currencies. Created in 2011, Litecoin is similar in design to bitcoin yet requires less computing power. A $3,500 computer can produce $25 worth of Litecoins a day for $3 in electricity, while producing $20 worth of bitcoins would cost $17, Lusk said.

Spot the irony yet? As the bitcoin bubble bursts, the residual price momentum and "mining" bubbles remain only in those currencies where the "mining" of bitcoin is easier. This explains the shift from bitcoin to litecoin. In other words, where it is easier to create digital currencies out of thin air and where there is still a momentum-based surge in popularity. In yet other words - to permit a faster dilution of the existing currency pool.

But what is it that those who oppose fiar rage against? Why the eagerness and desire of central bankers to dilute said fiat at the first deflationary whim in order to protect their banking "custodians."

Who would have though that the digital currency crew would so promptly fall for the same "dangling carrot" incentives that all the fiat proponents are so tempted by on a daily basis...

Then again, monetary alchemy is nothing new - after all people were trying to convert lead into gold centuries before the US Dollar was the reserve currency. Luckily, they failed.