A Hashhiker’s Guide to Mining Derivatives
Mining’s Financialization
Mining lies at the heart of Bitcoin’s monetary policy, consensus, and security. In terms of market infrastructure, though, the mining ecosystem lags behind the rest of the industry. In part, this is due to the technical complexity of constructing financial products for miners; these instruments must account for several interrelated factors, so are more complex than derivatives on the price of Bitcoin.
Financial instruments for miners are still in their infancy and are not yet employed by most miners. That said, there is a clear trend of increasing financialization in mining. Today, mining-related financial arrangements range from pooled mining to cloud mining contracts, and from hashrate tokens to network hashrate futures.
In this article, we’ll take a look at the different types of hashrate instruments available today, and discuss why the development of two-sided marketplaces for virtualized hashrate appears to be the next natural step in the evolution of mining.
Virtualizing Mining
Like many capital-intensive industries, the history of mining is broadly captured in the interaction between two competing forces: specialization and financialization.
Specialization is a natural side effect of competition: dedicated market participants typically outcompete generalists, ultimately increasing the capital required to participate in the industry. Because mining is a commodity industry, specialization in the sector typically manifests in efficiency increases rather than product differentiation.
Historically, specialization was most evident in changes in the type of hardware used to mine, with the network’s dominant hardware progressing from CPUs to GPUs to ASICs. Today, it’s most visible in the continued development of energy-efficient ASICs and in the increasing scale of mining operations.
Financialization, on the other hand, emerges to address high capital intensity and minimize operational risk. By using specialized financial products, miners can become more capital-efficient, allowing them to remain competitive in an increasingly capital-intensive industry. Financialization also serves a dual purpose in allowing them to offload some of their risk onto speculators through the issuance of financial instruments.
In most cases, the two forces are at odds: specialization results in financialization, which lowers barriers to entry and dampens further specialization.
This trend holds true for pooled mining, in which miners share hashpower and revenues through the assistance of a pool operator. Pooled mining reduces the variance with which miners are paid, allowing small miners to continue to operate. Most pools today offer payouts based on expected returns, offloading the risk of finding blocks entirely onto the mining pool.
Pooled mining is the most primitive example of hashpower virtualization, or the process by which hashpower is abstracted from a physical commodity into a synthetic one.
Within Bitcoin’s protocol, the network itself is the exclusive buyer of hashpower: the miner who correctly solves the proof of work for the next block receives the block reward. In pooled mining, the miner instead sells hashpower to the pool operator in exchange for steady cash flows; the pool operator then resells this hashpower to the network when a block’s proof of work is solved.
Other virtualized hashrate instruments allow their users to get exposure to the returns from hashpower without purchasing and setting up machines. The simplest of these is a cloud mining contract, in which the buyer rents a machine’s hashrate from the seller for a specified period of time.
Many cloud mining services, like Bitdeer, work with a small set of miners to guarantee the hashrate sold on the platform. Other platforms like Nicehash allow miners to sell to purchasers peer-to-peer; for the most part, these marketplaces offer a primitive order book, but not automated order-matching or contract reselling.
The internal workings of cloud mining contracts are often opaque. Most cloud mining contracts are physically-delivered, meaning the buyer controls where the hashrate is directed. Others are cash-settled, meaning the buyer receives the financial returns from the hashpower but cannot choose which pool or network to mine on.
In some cases, specialization and financialization are procyclical. Under these circumstances, specialization leads to financialization, which in turn facilitates further specialization.
In their current state, lending products fall under this category. While miner financing reduces the up-front capital needed to start a mining operation, in practice most lenders will only finance large, creditworthy miners. These industrial miners then benefit from leverage unavailable to their smaller counterparts, which allows them to further scale and improve the efficiency of their operations.
Most analysts see mining’s high capital intensity as good for the network’s security. While reducing the minimum capital expenditure leads to greater decentralization at this layer, it also leads to misaligned incentives by actors without skin in the game. The most prominent examples of this misalignment to date have been the multitude of 51% attacks on minority-hashpower chains, which typically leveraged cloud mining marketplaces.
For better or worse, though, there’s clear demand for the reduction in capital expenditure provided by financialization. Mining will continue to financialize for the foreseeable future, and virtualization is one of the primary vectors through which this shift will occur.
Hashrate Tokens
Recently, a type of virtualized hashrate instrument known as a hashrate token has received a considerable amount of attention. In late 2020, Poolin and Binance Pool, two of the largest Bitcoin mining pools, independently launched tokens representing a cash-settled claim to the revenues from a fixed amount of hashpower.These hashrate tokens can be staked to receive the daily rewards from mining with 1 TH/s and 0.1 TH/s of computing power, respectively.
Poolin’s hashrate token, called pBTC35a, was launched on Ethereum as part of the MARS Project. Binance’s token, BTCST, was issued by 1-b.tc on Binance Smart Chain, with Binance Pool acting as a guarantor for the collateral hashrate provided by Power360. Both projects advertise DeFi integrations and must be staked in order to receive yield.
On the surface, these tokens are attractive to investors for several reasons. The tokens allow their buyers convenient access to virtualized hashpower without setting. As standard tokens on Ethereum and Binance Smart Chain, the tokens can be exchanged on decentralized markets on these platforms and can take advantage of existing liquidity. The tokens are also perpetual, entitling the user to the revenues from that hashpower so long as the token is staked, irrespective of depreciation in the underlying hashpower-generating machines.
Securitized hashrate tokens have proven to be very popular, and more pools are likely to launch their own tokens. As perpetuities, the tokens lend themselves well to a discounted cash flows (DCF) analysis, but a public valuation of these assets has not been conducted.
Poolin’s token factors in an electricity price of $0.0583/kWh, an efficiency of 35 J/TH, and Poolin’s standard pool fee of 2.5%. At time of writing, the token has a market price of $120.19 on UniSwap. For simplicity, we assume a 10-minute block time based on the network’s idealized behavior. We also assume that the current Bitcoin price of $49,634, difficulty of about 21.72 trillion, block subsidy of 6.25 BTC, and 30-day average fees per block of 0.98 BTC are all sustained, based on data from Coin Metrics.
Under these assumptions, a token buyer breaks even on their initial investment in 15 months. The monthly IRR of the purchase is 4.53%.
Binance Pool’s token models an efficiency of 60 J/TH with an additional efficiency loss of 3%, an electricity price of $0.058/kWh, and a pool fee of 2.5%. The token also allows for up to 10% provider downtime. The token’s current market price is $335 on Binance.
Assuming the current network parameters are sustained and downtime averages to 10%, a token buyer breaks even on their initial investment in about 45 years. The monthly IRR of the purchase is 0.03%.
Against the backdrop of the current hashpower market, the market price of Poolin’s token appears to be roughly appropriate relative to the value of its underlying hashrate. On the other hand, BTCST seems to be exceptionally overbought. In light of current demand for hashrate tokens and the convenient financing they offer, companies will likely continue to issue these instruments.
Network Hashrate Futures
Hashrate tokens aren’t the first attempt at porting hashrate into existing cryptocurrency market infrastructure. Several exchanges, most notably FTX, have rolled out futures trading on network hashrate and difficulty. While these network hashrate derivatives garnered significant attention when they first launched on the platform in mid-2020, they’ve failed to attract meaningful volume: at time of writing, the FTX quarterly network hashrate future contract’s daily trading volume is only $4,511.
The limited adoption of network hashrate futures has led to skepticism that hashrate as an asset class will ever develop robust markets. There are, however, fundamental differences between network hashrate derivatives and virtualized hashrate that weaken this argument.
The primary issue with network hashrate futures is that total network hashpower is only one component in the value of a miner’s hashpower. In expectation, a miner’s Bitcoin-denominated daily revenue is equal to the sum of all block rewards that day times the miner’s share of the network hashrate. Each block reward can further be decomposed into issuance, which is generally stable, and fees, which are volatile.
Although the long-term goal of many miners is to accumulate Bitcoin, miners’ expenses are fiat-denominated. As a result, properly hedging their operations also entails accounting for the price of Bitcoin.
In summary, then, a miner’s dollar-denominated revenue depends on issuance, fees, network hashrate, and the price of Bitcoin. Network hashrate derivatives account for only one of these interrelated variables, so cannot completely hedge mining risk.
Network hashrate futures also suffer from several other deficiencies affecting their adoption. In particular, their settlement value is very predictable close to expiry, since hashrate is calculated over a backward-looking window. Network hashrate is also manipulable by miners and pools, who can adjust hashrate production according to their futures positions.
Finally, the market conditions into which hashrate futures were released were less than ideal for adoption as a hedging instrument. Given the ongoing shortages of latest-generation hardware and Bitcoin’s appreciating price, miners have had even less reason than normal to hedge out network hashrate as an independent component.
In light of their shortcomings, the failure of network hashrate futures should not be interpreted as proof of a lack of demand for virtualized hashrate products. While conceptually interesting, these contracts have little to do with virtualized hashrate instruments and don’t actually help miners hedge out their risks. They do, however, help point to the next step in the evolution of financial products for miners: two-sided marketplaces for virtualized hashrate instruments.
OTC Hashrate and Fee Derivatives
In predicting the future of miner financialization, one final family of instruments also merits attention: traditional derivatives on fees and hashrate. Because the market is nascent, these instruments are not yet traded on a centralized exchange, but rather orchestrated between two counterparties through a broker: this type of transaction is referred to as over-the-counter, or OTC. The most prominent broker for hashrate and fee products today is BitOoda.
Broadly speaking, hashrate derivatives are contracts based on the economic value of a miner’s hashrate. Today, these instruments typically take the form of futures or swaps, and can be cash-settled or physically-delivered.
These contracts share deep structural similarities with cloud mining contracts, differing primarily in the sophistication of their target users. Whereas cloud mining contracts are typically sold to retail consumers online, OTC hashrate derivatives are generally targeted toward institutional clients and require considerably more personalization.
Fee swaps, on the other hand, are a type of agreement in which two counterparties exchange fee exposure, with one party receiving fixed payment and the other receiving payment based on the average transaction fee on the network. An agreement like this could be reached between an exchange operator, who makes frequent on-chain transactions and wants insulation from potentially high fees, and a miner or pool operator, who needs fixed revenues to ensure they can cover their operating costs.
These two parties could instead choose to enter into an out-of-band agreement in which the exchange operator pre-pays the miner for a set number of transactions per month and the miner includes these transactions in their blocks at below-market fee rates. Because transaction inclusion must be physically-delivered, though, the set of potential miner counterparties is limited to those who order their own transactions and mine blocks frequently. For this same reason, it’s difficult for market makers to provide liquidity on out-of-band contracts. In short, fee swaps scale better than out-of-band payments.
Fee swaps can be structured in fiat or BTC terms, and are most attractive to both parties when future demand for blockspace is highly uncertain.
Fee swaps have the potential to be mutually beneficial arrangements, especially when fee volatility is high, and hashrate derivatives are useful tools for hedging mining risk. In their current form, though, both types of contracts suffer from poor liquidity due to a shortage of qualified buyers and sellers and an inefficient settlement process. As long-term, over-the-counter engagements, counterparty risk is also a concern.
Nonetheless, the existence of hashrate and fee derivatives is a sign of market maturation. As the market continues to evolve and attract sophisticated players, OTC derivatives will likely be supplemented or supplanted by their exchange-traded counterparts.
The Next Episode
Existing OTC derivatives on hashrate and fees offer a convenient way for users to gain exposure to hashrate and for miners to derisk their operations, but their growth is fundamentally hampered by their lack of liquidity. Existing OTC derivatives are non-fungible and are not easily resold, limiting their potential. Despite their differing clientele, existing cloud mining contracts suffer from similar faults.
Hashrate tokens, on the other hand, seem to have solved this issue: through their tokenized structure, they’ve successfully co-opted existing market infrastructure and attracted enough liquidity to be interesting.
That said, the structure of hashrate tokens as perpetuities is unrealistic and does not mirror the reality of physical hashrate production. It limits their scalability, since the token issuer must be confident that the guarantor will be able to generate the required amount of hashrate in perpetuity. It also reduces their usefulness as a hedging instrument, since sellers would need to buy back tokens to cancel out their liabilities. Today’s hashrate tokens are also cash-settled, lacking the option for physical delivery.
In spite of their shortcomings, both cloud mining contracts and hashrate tokens tend to carry substantial premiums, indicating that speculative demand for exposure to hashrate exists. The fixed cash flows afforded by both these products are also attractive to miners, especially in light of the industry’s increasing competitiveness.
The future of virtualized mining lies somewhere in between these three instruments: in resellable, fixed-term agreements brokered through a centralized clearing house or exchange. These derivatives will likely mirror those available in traditional markets: including swaps, options, and futures.
Both cash-settled and physically-delivered hashrate derivatives are likely to emerge, with the two types of products playing complementary roles.
Because cash-settled products do not require miners to supply hashrate, they’re likely to be more liquid than their physically-delivered counterparts. Like cash-settled derivatives in traditional markets, they’ll likely be traded on leverage, and will accordingly be a more capital-efficient tool for hedging. Due to the derivatives’ technical complexity, constructing indexes for these products will be challenging.
Physically-delivered derivatives are likely to play a more niche role, since their liquidity is limited by supply of physical hashrate. Their primary function will likely be in facilitating price discovery for cash-settled products.
Physically-delivered instruments may also service ideological users and those looking to defensively mine to secure their on-chain holdings. These instruments would also be made more valuable by Stratum V2, which would allow purchasers of these products to order their own transactions more easily. Because of these desirable traits, they may come to command a premium to cash-settled products.
Two companies, Braiins and Luxor, have already announced their intention to build out hashrate exchanges. Crucially, both companies operate mining pools, allowing them to act as credible guarantors of the hashpower exchanged on their respective platforms. If these early entrants are successful in attracting volume, more teams will likely enter the market.
Bitcoin mining has evolved considerably since the network’s inception, in particular through increasing technological sophistication and financialization. After several experiments in different types of abstraction, hashrate derivatives represent the next step in mining virtualization.
Thanks to Amanda Fabiano, Brian Wright, and Drew Armstrong for suggestions and comments.
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