Interview transcript of Professor Xu Zhe (Part 3): How to avoid the risk of increasing mining difficulty?

The following article is from Deribit's Trading Class, author Sarah | Interview transcript

In the article "Interview with Mr. Xu Zhe (Part 2): How Miners Use Options to Increase Profits", Mr. Xu Zhe shared that Short Call (call option) is a better way. As long as the number of Short Calls is strictly controlled not to exceed the number of BTC produced by the mining machine, the risk is controllable. With this strategy, miners can Short Call a very high IV without worrying about being liquidated, because the mining machine is delivered.

So at this level, do we have the best of both worlds? Actually not. In addition to the risk of currency price fluctuations, there is another major risk - the increase in mining difficulty.

01
The risk of increasing mining difficulty

Another risk you can’t handle is the increase in mining difficulty, which is more troublesome because there is still the problem of yield convergence. Since you can use mining machines and futures to generate fixed income returns of legal currency (not risk-free returns), the calculated rate of return is much higher than the assets on the market. In fact, everyone knows that central banks around the world are now moving towards negative interest rates because the marginal rate of return on capital has declined.

So, under this premise, if you have something with positive returns, it will be easily snatched up by people. This combination of mining machines and futures will be discovered sooner or later (in fact, it has already been discovered). As the market matures (including several mining accidents) and the aggressive miners are eliminated, the returns of this thing will definitely converge. We have seen that the recent growth of Bitcoin derivatives has soared at the same time as the difficulty of mining, which is basically the fulfillment of this law.

I use a word called "yield hunger", which is not very literary, but it basically means the same thing. Now is an era of capital surplus. The central bank can release trillions of dollars of liquidity without any constraints, and through the mature effect of commercial bank monetary leverage, a large amount of capital can appear. Under the inevitable trend of declining capital margins in the market, funds will flow into all profitable places, and Bitcoin mining will definitely be targeted, and it is indeed targeted.

You can compare. Although Bitcoin is still far from its historical high (more than 20,000 US dollars), the difficulty of Bitcoin mining has actually been increasing very unstably.

02
How to avoid the risk of increasing mining difficulty

So is there any way to avoid the increase in the difficulty of Bitcoin mining?

1. Mining difficulty swap

I have seen an article that a foreign exchange said that we have Mining Difficulty Swap, called mining difficulty swap, where everyone can bet on mining difficulty. I have not seen the quotes for this thing, but based on my experience with financial derivatives, I can imagine that this contract should be a high premium contract. What does it mean? It is the same as the VIX product, because everyone knows that this thing has great potential for rising and little potential for falling. This means that if we want to swap it, the long side has to pay a lot of fees to the short side, and it is a very high premium thing.

If you want to build a mining difficulty contract, there is a way. Since there is a functional relationship between the amount of Bitcoin output and computing power (mining difficulty), we can build a synthetic position of mining difficulty through mining machine assets and Bitcoin futures. I don’t know if there will be any exchanges doing this in the future. If there are, I guess there will be arbitrage space. If everyone is gambling now, saying what the future mining difficulty will be, I guess people who bet more (betting on the future mining difficulty increase) will be overwhelmed, so there will be a super premium, and betting against these people can protect miners, because miners also need this protection.

2. Conservatively estimate future mining machine output

There is no such mature contract now, and our ability to protect against this risk (increase in mining difficulty) is relatively weak. The only thing we can do now is to be more conservative in estimating the output of future mining machines and be more pessimistic about the increase in mining difficulty, because there is also a halving, which makes this matter (prediction) difficult.

If the price is halved, if you only expect the revenue to be halved and our output will be halved, then it is relatively easy to predict. But the problem is that if the price is halved, many models of mining machines will lose money. In this case, even if they have futures for hedging, it will be useless because their output will be halved and they will face shutdown. The difficulty of mining will decrease, but you don’t know how many people will shut down their machines.

The increase in mining difficulty and the decrease in block rewards are a relatively large risk. To deal with this risk, the first way is to adjust the output estimate a little bit lower, thinking that I can't actually mine that many bitcoins, and don't be confident that you have already sold short in the futures market, but in the end, the mined coins are not that many, and then you can't deliver them. If you don't have coins to deliver, and the coin price still rises, you will lose money.

3. The number of short options is lower than the expected BTC output

Another way is to not sell all expected outputs when shorting options. After you have covered the electricity bill (since it is calculated in fiat currency, the electricity bill given to you by the power plant is relatively fixed), the remaining Bitcoin output, for example, if you have 10 BTC, you originally had to sell 10 Calls, but now you don’t have to sell 10 Calls, but only 7 Calls. In this way, if the number of Bitcoins mined is relatively small, you will not be unable to get them.

At this time, the biggest problem you face is that BTC is mined less than expected, and the price of the currency rises again, and is much higher than the execution price of your short position. If only 7.5BTC are mined in the end, but you still short 7BTC, you will be fine and you can still live until the day when the law of large numbers takes effect.

This is definitely an unsatisfactory solution because it is very bland. If you do the math, there are still 66 days until March. If you sell a $10,000 call, you can only get 0.066 BTC for each BTC, which is equivalent to a gain of only 6.6%. A 6.6% gain in two months is 46% compounded annually. However, because you want to be more conservative (that is, assuming that you can mine 10 BTC, but because you have to face the estimates of mining difficulty increase and block reward halving, you have to adjust the gain further), it is very bland. You have such a complicated option for a year, and the gain is only 20-30%, which is meaningless.

03
How to further enhance your benefits

If you want to increase your income a little bit, you have two options.

1. Sell near-term options

One is to sell near-term options. Because the output of mining machines is not all at once, it is not like I have a batch of mining machines now, and I will give you a batch of BTC on March 27. Now the mining pool generally returns coins to you every day, so you can sell the ones that are relatively close. For example, I sell a call that expires on January 31. If it is not exercised, when the contract on February 7 comes out, you can sell the call of the February 7 contract.

In this case, if you calculate, the accumulated option premium sold by March must be more than the premium you directly sold for forward options. Why? Because the recent Theta drops quickly. The principle of calendar spreads is actually the same, that is, we use the method of recent Theta dropping faster and forward Theta dropping slower to obtain the Theta difference. But the problem is that if you do this, it will definitely be a negative Gamma, but because you hold it to maturity, you will definitely use the currency for delivery in the end, so let it be negative Gamma, and the floating loss of tossing back and forth has nothing to do with you. It is better to make a closer Theta difference.

2. Reduce Strike Price

But if you really want to find a contract with a near expiration date and a high strike price, you will find that the premium is really pitiful. What should you do? Another way is to lower your strike price. For call, the lower your strike price, the higher the premium, and the higher your profit, but this means the higher the possibility of delivery. The higher the possibility of delivery, the higher the average selling price of the free premium.

How do we resolve this contradiction? Actually, there is a way to resolve it, but it is a more personal strategy.

Interview summary, stay tuned for the next episode.