Interview transcript of Professor Xu Zhe (Part 1): How do miners use cryptocurrency derivatives to increase their profits?

In the article "【Live Preview】How Miners Use Cryptocurrency Derivatives to Increase Profits", Xu Zhe shared the core elements of mining , the different mindsets of miners , and the risks that currency price fluctuations bring to miners .

In a live interview held by German Swiss University and Zhikuang University on January 20, Xu Zhe continued to share: the risks that miners may face and futures hedging .

The following is the transcript of Xu Zhe’s interview:

01
Risks that miners may face

The biggest risk faced by miners is the fluctuation of the currency price. If you pay attention to the mining industry, when do miners have a better life? When Bitcoin (or other currencies mined by miners) rises particularly well, life is better; when the currency price falls, miners have a harder time. The currency price is the biggest risk factor that determines the miners' income.

The second more troublesome problem is the increase in mining difficulty. The Bitcoin protocol is open and has no threshold. Anyone who is willing to buy a mining machine can participate in mining. This will lead to the fact that if the mining behavior itself is profitable, it will conform to the principle of decreasing profit gradient, and other people will continue to participate, making mining more difficult. Because the block reward of BTC is fixed every ten minutes on average, it means that the total reward is certain. When the total reward is determined, the more people participate, the less profit each person will get on average. Your expenditure is fixed, and your income may become less, which is another relatively large risk.

These two risks are the main risks faced by miners, and there are other risks. For example, there are natural disasters in the mine; the power supply machine suddenly loses power, or some power failure occurs; some mining machines are not of good quality, and they may not be used or are old and broken, and the waiting time for repair is relatively long; the transportation in the managed mine is not convenient, and there are problems in entering and exiting, etc. These risks are all there, but they are not the most core, because the mining industry is now quite mature, and related services are fully competitive. Unreliable mining pools, mines, and operation and maintenance companies will be eliminated by the market.

Therefore, the biggest problem that miners must face is still the fluctuation of currency prices and the fluctuation of mining difficulty.

02
The simplest strategy is futures hedging

Now that there are financial derivatives related to Bitcoin, there are ways to avoid price fluctuations. The simplest way is to use futures .

A futures contract is a forward contract. We agree to trade at an agreed price in the future, which is very reliable. If there is no problem with the exchange, futures contracts can help you lock in the price of the currency you will sell in the future. In this way, you don't have to worry about a sudden drop in the price of the currency. For example, if you now have a batch of mining machines, and you expect these mining machines to produce 50 bitcoins by June, you can short 50 bitcoin futures. Now the bitcoin futures premium is $8,925. Not only is the future selling price of the currency guaranteed, but you can also earn a little premium. Futures premium refers to the premium of the futures quotation over the current price.

This approach is better than shorting Bitcoin with leverage. If you use leverage to short, the problem you face is that leverage is not free. Whether you borrow Bitcoin to short or use perpetual swaps to short, you will face the problem of fee uncertainty. Let's not discuss borrowing coins to short, which is definitely not cost-effective because you have to pay interest if you borrow coins.

The principle of perpetual is similar, but the design of perpetual is better. It is designed based on the principle of simulated foreign exchange contracts (multi-currency swaps). The long and short positions are balanced by using the funding rate to converge to the normal mode, but it is uncertain. When you use perpetual to go short, sometimes it is better than futures, and sometimes it is worse than futures.

In finance, there is no assumption that there is no risk-free arbitrage. We can basically say that in the long run, the final effect of perpetual long and short positions will converge with futures in a very small range, but you can't survive in the long run, and it will bring uncertainty. The premium of futures is certain. From this perspective, futures contracts are generally the best.

This is also true in other markets, such as the rubber contract of the Singapore Exchange. At the beginning, the mainstream rubber contract provided by the Singapore Futures Exchange to Southeast Asian countries was swaps. After the rubber swap contract was issued, many spot traders, traders and plantations used swaps for hedging. Later, the exchange issued standard futures contracts, and the trading volume of futures contracts increased immediately, overshadowing swaps. Because futures contracts do not face the problem of price uncertainty, they can make the expiration price relatively fixed, which makes financial forecasting easier.

In principle, it is impossible to make risk-free arbitrage by going long on perpetuals and short on futures, as the price of perpetuals is definitely lower than that of futures. The current situation is that futures are in premium, so if you go long on perpetuals, short on futures, and hold until maturity, if you can generate risk-free returns, this part of the money cannot exceed the risk-free rate. This is a principle of finance. If we can build a portfolio whose returns can be higher than the risk-free rate, then the returns of this portfolio will definitely converge to the risk-free rate. Because there is no reason not to take the free money, and if too many people take it, there will be no arbitrage space.

So , I don’t like to do this, because many years ago I was a trader whose main business was arbitrage trading. This industry has a tendency to slowly kill itself. Although it is not as strong as the assumption of financial engineering, in fact, this principle is still quite tenable. The financial engineering theory says that "no risk will be wiped out instantly", which is wrong. It will be wiped out slowly, but in the end its trend will be wiped out, there is no problem with this.

In the long run, perpetual contracts should be equivalent to futures contracts. But since they seem to be equivalent in the long run, and there is uncertainty in perpetual contracts in the short term, it is actually not as good as futures contracts. Futures contracts have certainty. Miners, as natural Bitcoin sellers, certainly hope to sell at a better premium. Futures have certainty of selling at a premium, so there is no need to be the risk bearer of uncertainty on the fee side of perpetual contracts. Because perpetual contracts are based on supply and demand, when the market is enthusiastic, such as when the market falls more fiercely, the shorts need to pay a higher rate to the longs. And as a long-term seller, it is not cost-effective to pay a wronged amount of money. But futures contracts will protect you. Even if the futures contract is temporarily discounted, it will still converge to the Index on the day of delivery, because this futures contract is cash-delivered.

Of course, some exchanges also have physical delivery, which is more certain. In the end, you need to deliver the BTC you actually mined to the exchange address. However, cash delivery is easier. As long as the Index Engine is safe and there are no problems, the two are equivalent.

03
If you choose hedging, how much BTC should you short?

The first type: Fiat currency standard/non-Bitcoin believers

Fiat-based miners can use futures to short BTC equivalent to the "expected BTC output".

The specific method is to estimate the output of Bitcoin and then short the corresponding amount of Bitcoin in futures, so that your future income is certain. For example, if your mining machines can mine 50 BTC by June, then short 50 BTC. Then in June, you can deliver the 50 mined Bitcoins at the futures price, and the cash flow is predictable.

This approach is based on the premise that the mining difficulty remains unchanged (coin price is no longer relevant), the electricity cost does not change dramatically, and the mining farm is basically stable. It is similar to fixed income, that is, the future cash flow is certain. Since the future cash flow is certain, it can be discounted to present value. If we can earn 50 * $9000 in the future, most mining machines will be sold as scrap metal by weight, then this risk must be prevented, but we are unwilling to lose the room for Bitcoin to rise in the future. If you use the full set of futures, you will not be able to enjoy the surge in Bitcoin.

The second type: non-pure fiat currency standard/Bitcoin believers

To avoid shutting down the coin price, you can use futures to short BTC equivalent to the "electricity cost".

Is there a way to have the best of both worlds (prevent shutdown risks while enjoying the benefits of Bitcoin's surge)? Yes, there is. The biggest obstacle faced by miners is the so-called shutdown coin price. If all the Bitcoins produced by the mining machine every month are sold, it is still not enough to pay the electricity bill, then mining becomes a pure negative profit. If pure negative profit continues, the time to pay back the investment will be longer and longer, and everyone will give up. The decline in mining difficulty is also caused by these things.

Therefore, the risk exposure faced by miners can be further subdivided into another level. In addition to the decline in currency prices leading to a decline in revenue, plus our rigid expenditure, that is, electricity expenditure, you can first lock in the cash flow of future legal currency expenditures for electricity bills with futures.

For example, if you have to pay $100,000 in electricity bills this month, and you estimate that you can produce $150,000 in Bitcoin (valued at the beginning of the month), then you should not short $150,000 in Bitcoin, because then you are equivalent to handing over all the Bitcoin (this should be the practice of fiat currency), and the rise in the price of the currency has nothing to do with you. You should only short $100,000 in futures equivalent to the electricity bill, so that by the end of the month, you can hand over $100,000 in BTC, and your electricity bill will be settled. If your electricity bill is settled, the remaining BTC is something extra for you. It can bring profits if it rises, and of course it will also lose money if it falls, but you don’t have to worry about shutting down the power because you have already arranged the electricity bill at the beginning of the month.

Take a specific number as an example. The current futures contract price for March is $8732/BTC. There are still more than 70 days until March. Calculate the total electricity bill for more than 70 days in US dollars. If you calculate more carefully, you may also need to do RMB-USD futures. But if we assume that the fluctuation of the exchange rate between the US dollar and the RMB is not so drastic, then you can first calculate the electricity bill to be paid by the end of March, denominated in US dollars, and divide it by 8723. The number of coins you calculate should be less than the number of BTC that the mining machine can produce during this period, otherwise it means that your mining is already in a loss-making state.

Hedging must be done when there is still room for profit. You can't say I won't hedge now, and I will hedge later, this is wrong. Hedging should be done when mining is still profitable. After you have hedged, you will find that on the day of March 27, the futures delivery day, the electricity bill has been settled, and you can still have those extra bitcoins. These bitcoins are risk-free for you, and you don't have to worry about shutting down if the price of the currency plummets. In this case, you have a compromise. You don't have to worry about the price of the currency falling to the point of shutting down, and you can enjoy the extra benefits brought by the rise of Bitcoin.

When we study it to a certain point, we will find it very interesting. What does this combination mean? It means that you have the right to obtain a certain amount of BTC in the future. Does it sound familiar? This is very similar to the definition of a call option. After we lock the electricity bill through futures, we will find that if the risk of not being able to pay the electricity bill has been covered, with the investment of mining machines, we have the right to obtain some BTC in a certain period of time in the future. If BTC experiences a historic surge, we can enjoy all the benefits of the rise in BTC. This combination of electricity bill futures cover is very similar to a call option.

Is there a combination that can further determine the return? Yes, there is. Now we have to introduce the powerful tool of " options ".

Stay tuned for the next episode!