Proof of Work mining, such as implemented for Bitcoin, Litecoin and Dogecoin, is an extremely competitive process by nature. In mining, miners are effectively racing to solve the same puzzle block after block. The miner that finds the correct solution is rewarded with new coins and transaction fees. Whether participating in this process can be profitable depends on two things, hashrate and energy consumption. Hashrate determines the chances of solving a puzzle, these are proportionally equal to the percentage of hashrate owned relative to the total network hashrate. This means profitability is mainly determined by the required investment per hashrate/s and energy costs. This has sparked a mining arms race, which has led to the development of Application-Specific Integrated Circuits (ASICs) to get maximum speeds at the lowest costs.
The most efficient ASIC miners can easily set you back $10,000 and are not affordable for just anyone. This is considered harmful to the decentralized nature of cryptocurrencies.
Consider a network of just two GPU miners with equal 500 KH/s hashrate. Both receive $500 per day and use $300 worth of energy. An ASIC miner with a 1 MH/s hashrate joins the network, and is able to mine at an energy cost of just $300 per day. The total network hashrate will go up to 2 MH/s, meaning the ASIC miner will receive $500 and the GPU miners will both receive $250 on average. As both GPU miners are now mining at a loss, at least one of them will be forced to leave the network.
In the end, only the biggest mining operations will be able to be efficient enough to generate a profit. Costs are generally decreasing with increasing scale. In economics, this is known as economies of scale. Hashrate will concentrate in the hands of these mining operations.
Different hash functions
It should be noted that not every PoW algorithm is the same, and therefore not every cryptocurrency using PoW is currently facing this threat (although this will likely change). Over time various PoW algorithms have appeared with different hash functions. SHA-256 was used for Bitcoin, while Scrypt was used for altcoins such as Litecoin and Dogecoin. Newer PoW mechanisms are X11 (Darkcoin), Scrypt-N and Scrypt-Jane. Bitcoin (SHA-256) was the first cryptocurrency to experience a mining arms race, but with the increased popularity of Scrypt-based cryptocurrencies (originally seen as “ASIC-resistant”) manufacturers have also started to invest in Scrypt-based ASICs. It is expected that other new algorithms will experience the same fate if their popularity increases, as ASICs can be designed to perform any hash function. The only thing that keeps this from happening is a lack of financial incentive to do so.