Small mining companies save themselves: using financial derivatives to hedge against hash rate fluctuations

Original: Reuters, original author: Tom Wilson

Source: Odaily Planet Daily Translator: Nian Yin Si Tang

The old image of bitcoin miners, young techies hunched over their bedrooms, solving math problems on their laptops to earn bitcoins, has morphed into savvy startups with superfast chips and massive, specialized mining machines.

Now these miners have a new idea - they are looking for financial derivatives to hedge against the sharp fluctuations in electricity demand. The reason for this is obvious, because such fluctuations may cause miners to lose all their money.

The growth of the market for such tools could accelerate investment in cryptocurrency mining, which was once a niche hobby but has evolved into a capital-intensive industry with demand for digital currencies expected to grow.

Crypto miners must harness increasing amounts of computing power as they compete with others to solve complex mathematical equations to build blockchains and earn new digital currency as a reward.

Startups have little defense against changes in the so-called “hash rate,” a volatile measure of the overall bitcoin network’s processing power that determines how much power miners need to produce new bitcoins.

A surge in hash rate means more electricity is needed, which will undoubtedly increase production costs and eat into the ultimate profit when the cryptocurrency is sold. This unknown situation may become a major obstacle for startups to attract imminent investment from institutions and markets.

To deal with this dilemma, miners also have their own solutions. Seven cryptocurrency miners and industry insiders told Reuters that derivatives that allow miners to hedge computing power can help solve this problem. In theory, this will provide clearer forecasts for cash flow - a prerequisite for potential investors.

The miners and crypto traders who responded came from all over the world, including the United States, Canada, the United Kingdom and Hong Kong, and all said that the market for such products, while in a very early form, is emerging and will become increasingly important.

“The trend in hash rate is upwards. Unless miners increase their output, they will receive fewer bitcoins for the same power,” explained Michel Rauchs, author of a study on cryptocurrency miners at the University of Cambridge.

“Using hash rate derivatives, they can price in the risk.”

London-based DAG Global, which describes itself as a cryptocurrency merchant bank, said miners have shown strong interest in its products for hedging hash rate.

“As hash rate changes, you can go from profit to loss very quickly,” said Robert Andersen, head of digital asset sales at DAG. “(We offer) contracts that protect against that risk, which is like an insurance policy for which you pay a premium.”

Another crypto exchange, GSR, said it has been working on similar products but is not ready to offer them yet due to the nascent stage of the market.

"We're building products around hash rate and mining difficulty," said GSR co-founder Richard Rosenblum. "It's going to take more than a few months before there's a lot of liquidity." He was also cautious about this, believing that it could take several years for the market to form.

Clearly, this market is still in its very early stages, and while exact figures are hard to come by, some in the crypto space estimate that the market could be worth around $50 million to $100 million a year.

To win over investors

For traditional investors looking for high-yield returns in an era of ultra-low interest rates, the proposition offered by cryptocurrency miners is an alluring one.

Bitcoin is currently trading at around $7,500, and 1,800 bitcoins can be mined every day, which gives it an annual market value of around $5 billion.

No wonder many investors want to get a piece of the pie.

As an important example of a crypto mining company going public, Chinese mining giant Canaan Creative went public on the Nasdaq last month, raising $90 million in its initial public offering and valuing the company at approximately $2 billion.

While that suggests capital market appetite, Canaan is one of only a handful of large miners left in the world. Many others are smaller companies that may have to work hard to convince investors they can manage risk.

The mining market is still competing for hundreds of millions of dollars in investment, said Marco Krohn, co-founder of Hong Kong-based Genesis Mining, which mines bitcoin from Iceland to Kazakhstan.

“You need to tap into traditional financial markets — these are people with a lot of problems, they tend to be risk averse,” Krohn said.

To attract such investors, mining companies told Reuters they are looking more closely at controlling hash rate and price risk through financial instruments.

The adoption of derivatives in the mining community has definitely increased in recent months,” said Kevin Shao, manager of Canaan’s blockchain department.

Crypto mining hedging tools may still be in their early days, but change is undeniably coming, according to BitOoda, a U.S. company that has been facilitating a product called a “difficulty swap” since April.

Sam Doctor, the firm's chief strategist, said the market for such products was becoming increasingly liquid and contract terms were increasing.

“There are more players waiting to see how these trades perform before taking the step to trade,” Doctor added.