Is the mining market collapsing?

Yes! Bitcoin miners are shutting down. No! This is not causing a “death spiral”

This article is translated from Medium by Caijing.com Chain Finance and does not represent the position of Caijing.com Chain Finance.

Author: Christopher Bendiksen Translator: LornaQ

Original link: https://medium.com/coinshares/an-honest-explanation-of-price-hashrate-bitcoin-mining-network-dynamics-f820d6218bdf

Yes! Bitcoin miners are shut down.

No! This will not lead to a "death spiral"

Since the beginning of 2018, the price of Bitcoin has fallen 80% from a peak of nearly $20,000 to about $4,000. Miners are usually paid in Bitcoin, so they need to rely on exchanges and exchange prices to cover their costs and make a profit in ideal circumstances.

What does this mean for the web?

Mining CAPEX, OPEX and ROI

Capital expenditure (CAPEX) refers to all expenditures related to acquiring assets, including mining equipment, racks, real estate, etc.

Operating expenses (OPEX) are the ongoing, consumable expenses for running a business, such as wages, electricity bills, rent, etc.

Return on investment (ROI) is the percentage of the income obtained after investment and the cost. The calculation formula is: Return on investment (ROI) = annual profit or average annual profit/total investment × 100%. If ROI is a positive number, it is profitable, if it is a negative number, it will result in a loss.

When mining, there are two extreme situations:

In one case , miners lease mining machines, sites, maintenance equipment, etc., and pay for electricity on demand. In this case, all expenditures are Opex and the operation does not own any capital. If no contract is entered into, the result is neither assets nor liabilities.

Another scenario is to purchase all the required equipment, buy the property, pay the fixed electricity bill and sign the labor contract. In this case, all the expenditures are upfront capital expenditures, and the operation not only owns the capital (asset) but also needs to fulfill the contractual obligations.

In fact, many mining farms operate between these two models, combining OPEX and CAPEX. For example, some miners own their own mining machines, but rent the site and pay for the electricity they use; others rent mining machines, own the site where the mining machines are placed, and sign a short-term electricity contract.

It is worth noting that the costs of many miners include OPEX and CAPEX, which we assume are 50% each (ignoring the crossover).

Like most other productive capital, mining machines have a limited lifespan and their productivity diminishes over time, becoming worn out or obsolete after a period of time, which includes the concept of depreciation. In practice, this means that to be profitable, a mining machine must generate cash flows in excess of its acquisition cost plus ongoing capital costs during its limited working life. Therefore, the value of a mining machine changes from acquisition cost to scrap cost, or even to zero when it is scrapped.

If the mining machine maintains efficient operation for a long time, its depreciation period is long; on the contrary, if it is used for a short time, its depreciation period is short. If the mining machine has a long service life, it is helpful to amortize the consumption of fixed assets.

Depreciation is the transfer value of fixed assets that is included in the cost of expenses on a regular basis, but does not affect the actual cash flow. Cash flow here refers to cash flow in excess of all operating expenses. Cash cost or capital cost refers to putting money into US Treasury bills, such as "risk-free" investments, not investing in the mining industry, which has never received returns.

For miners, there are two important thresholds for Bitcoin price:

The first is the break-even point. When the income is higher than the break-even point, the miner makes a profit. Otherwise, the miner loses money.

The second is their cash breakeven point, above which cash flow is positive, but this can still result in losses (if miners never have enough cash to cover their mining equipment purchases, ROI can still be negative); below this point cash flow is negative. And, based on industry views, i.e. risk appetite and capital levels, the likelihood of shutdowns is high.

It is worth noting that even if miners realize that ROI is negative and cannot cover CAPEX, they will continue to mine as long as the cash flow is positive to cover CAPEX as much as possible. Once OPEX exceeds revenue, the mining machine becomes a negative cash flow, and it makes no sense to shut it down, because it is just burning money.

Just because miners remove mining machines from the network does not mean that the ROI is negative.

In our report, we calculated the market average break-even point for mining one Bitcoin. This is the best approximation of the cost of mining Bitcoin. If the value obtained is above the market average, the miner will get a positive ROI. Below this point, the miner will not shut down. However, below this point, the miner will lose the principal of the investment, which makes them unable to become participants in the mining industry for a long time unless they have a steady stream of investment capital.

The cost of mining one Bitcoin

Average 'all-in' cost: $6800/BTC; Average cash cost: $3400/BTC.

In our June report, we estimated the market average cost of each Bitcoin to be around $6,500. We estimated the market average CAPEX based on all available information, electricity costs of ¢5/kWh, and an 18-month depreciation period.

It’s important to emphasize that this is an average. Not all miners operate based on these hypothetical numbers. Some operate well, some operate poorly.

This value means that if our assumption holds true, the ROI is positive in June 2018 when the Bitcoin price is above $6,500. In fact, the Bitcoin price on the market at that time was about $8,500.

Under the same assumptions, we estimate the cost to be about $6,800, with an error of $300. The current price of Bitcoin on digital asset exchanges is $4,000, which is inconsistent with the assumption.

For reference, we estimate (using 18 months as the depreciation period) that OPEX accounts for 50% of the total cost. This means that the market average cash cost is about $3,400, which is very close to the current price of Bitcoin.

What does this mean?

Either our hypothetical scenario is foolish, or many miners will likely be forced to shut down due to inefficient mining machines and expensive electricity.

What does the data show?

The hashrate peaked at an average of nearly 55 Exahash per second (EH/s) at the end of September 2018. The hashrate has since decreased to 40 EH/s, resulting in the largest drop in difficulty in five years since the last difficulty adjustment.

At the time of writing, the Bitcoinwisdom project predicts that the next difficulty adjustment is more likely to be downward. This difficulty adjustment is one of the largest adjustments in Bitcoin's history. The largest difficulty adjustment occurred in 2014 when large-scale professional mining machines were launched.

Clearly, some miners are struggling. Their machines are running for less than their cash cost and may be forced to shut down.

The error could be that we assumed the average market electricity cost was too high, or that we assumed the cooling cost was too high.

Coin price and dynamic computing power

The computing power of Bitcoin changes mainly with the price, and is also affected by the efficiency of the mining machine, but this has little effect. When the price rises, the computing power increases, and when the price falls, the computing power decreases.

The cost of mining is expressed as the price of Bitcoin minus a slightly competitive profit margin. However, these changes are not instantaneous and there is an asymmetric delay in the long tail effect.

As with other capital-driven industries, delays are caused by the time lag between making investment decisions and actual start-up.

For most participants in Bitcoin mining, the delay is about a few months, depending on the miner's familiarity with the mining machine manufacturer. However, even for mining machine manufacturers, there is a significant delay. Mining machine manufacturers need to order chips from foundries and go through procedures such as assembly, shipment, and installation. Through this series of procedures, the computing power can be increased. In the meantime, the price of Bitcoin may rise, and the speed of increase may be much faster than the launch of new mining machines.

There is nothing stopping miners from shutting down immediately when cash costs fall below the breakeven point, meaning miners can respond to price drops by shutting down immediately. (A notable exception to this is that some miners operate on a regular basis with electricity contracts, thus forcing them to mine until they have no liquidation power.)

Therefore, the growth of computing power may be delayed by several months in the case of rising Bitcoin prices, but the computing power will react much faster to falling Bitcoin prices.

“But I thought the price of the coin changes with the change of computing power?”

No. Besides, how could this happen?

Miners receive rewards in the form of Bitcoin, but pay all expenses in local fiat currency. With a stable computing power market share, the price of Bitcoin is proportional to the fees paid.

Under equal playing field and in a downward market trend, increasing hashrate will only result in losing money, as mining costs increase as the difficulty increases due to the increase in hashrate.

Only when the price of the coin rises will the hashrate increase – outstripping the efficiency gains – to compensate for the increased difficulty and cost.

In fact, I can only think of one scenario where hashrate could somehow serve as a "floor" for the price of a coin. In this highly unlikely scenario, miners are so well-funded that they could refuse to sell their Bitcoin at the market price and cover their costs with liquidity from their balance sheet while continuing to mine at a loss. It's up to you whether you take this approach or not.

Has the mining market completely collapsed?

Is the mining market completely collapsed? No.

The effect of the price crash is that the miners with the highest marginal costs withdraw from the market, while the most efficient miners remain. The difficulty is reset to a lower level, and the cost of mining is reduced to a level that is lower than the price of Bitcoin again.

The remaining miners restart a new round of competition - both against each other and against a new group of entrants who believe they can profit under the new conditions. Through this series of procedures, miners will mine under the conditions that tend to be the cheapest.

Unlike other commodities, where the amount of output is affected by price changes, the amount of Bitcoin issued is constant. For example, if the price of gold rises, the output of gold will also increase until the marginal production cost is equal to the market price again (minus transportation costs). If the price of gold falls, the output will also decrease. This is to stabilize the price of commodities by controlling the relationship between supply and demand.

This does not happen with Bitcoin. Issuance is predefined and market dynamics have no significant impact on it.

What happens next?

The hash rate changes with the price of Bitcoin and adapts to any new market conditions.

Old, inefficient mining machines will be eliminated, and mining machine manufacturers with high costs will be eliminated; until the price of Bitcoin rises again, computing power will only increase if miners reduce OPEX.

Reducing OPEX can be achieved through cheaper electricity, more efficient mining machines, or cost cutting.

Dynamic difficulty adjustment is accounted for by periodic resets so that the cost of mining is in line with the price of Bitcoin.

In the event of a mining collapse, the price of Bitcoin would immediately plummet to near zero; thus shutting down almost the entire network; thus preventing the necessary blocks from being mined for months or even years to reach the next difficulty reset. This scenario is possible, but we think it is unlikely.

Bitcoin is not dead.