Should we all start mining crypto currencies? Thoughts from a VC focused on Financial Markets Tech

Just over 6 months ago, as an experiment, I built a cryptocurrency mining rig at Illuminate Financial (a financial markets tech focused VC fund that I helped to launch). I have a few key leanings from this experiment:

1. DON’T MINE PROOF OF WORK COINS, THE ECONOMICS DON’T STACK UP — To-date the liquidated IRR is 8% (inc. power costs), which isn’t great….and made worse by the fact that the reward to risk (Sharpe Ratio) is terrible and future prospects aren’t looking any better! I will dig into more detail below.
2. AT A SMALL (DECENTRALIZED) SCALE IT IS NOT WORTHWHILE — which puts the whole concept of a decentralised blockchain into question…(specifically using Proof of Work consensus — used by the majority of crypto currencies: BitCoin, Ethereum, BitCoin Cash, etc)
3. IT WASTES A LOT OF ENERGY!! — you probably already knew that…but I was surprised by how much!

If you don’t have time to read the full article, skip to the summary at the bottom.

At Illuminate we have eight large ($10Bn+ Market Cap) financial markets institutions as investors/strategics partners. We work with these large and heavily regulated institutions to identify, adopt, fund and grow relevant innovative solutions.

We have been looking at Blockchain businesses and Crypto Assets since March 2015 and given the incredible growth in this market I was keen to get a better understanding of the underlying infrastructure, so I built a rig.

Digging into each of the learnings in more detail…

1. THE ECONOMICS DON’T STACK UP

Figure 1: Total Hardware Costs for a Mining Rig

Figure 2: Liquidated cash flows from mining rig (25th May 2018)

The above charts show the breakdown of the total cost of the mining rig (£1755.02), the liquidated mining revenues (£751.85), the corresponding power costs (£364.43) and the residual value of the rig (£1437.67), assuming a 33% depreciation rate per year (generous given one of the five cards has already broken) representing an 8% IRR.

Even if an 8% IRR was acceptable, the uncertainty/volatility of each of the variables is incredibly high and the forward looking prospects are not good:

• Ethereum Price (EthPrice)= the average daily price of Ethereum since November 2017 was $686 (see Figure 3), the 60-day average daily volatility is 4.35%, the highest price since November 2017 was $1400 and the lowest $380… this is an insane level of volatility!!

Figure 3: ETH/USD price since Nov 2017

• Ethereum Network Block Difficulty (NetworkDifficulty)(see Figure 4) this is the difficulty of mining one block on the Ethereum network and has increased from 1500TH to 3200TH.

Figure 4: Ethereum Network Block Difficulty

• Ethereum reward per block (BlockReward) — approximately 3.7 ETH including transaction fess and “uncle” rewards. This is expected to drop by 80% to 0.6 ETH as the Ethereum network transitions to Proof of Stake.
• Mining Rig Capacity (RigCapacity) (e.g. number of GPU cards) = 5 Cards @ 21 MH/s= 105 MH/s. It is possible to increase this by overclocking through changing the BIOS memory straps, but this variable is pretty constant.
• Number of Blocks per day (BlocksPerDay) — constant, but has dropped from ~6200 to ~5600 since November 2017.

The daily profit equation looks like this:

Daily Profit = Mining Revenue — Power costs = £3.35 — £2.10 = £1.25

Current Mining Revenue = BlockReward * EthPrice * (RigCapacity/NetworkDifficulty) * BlocksPerDay = 3.7 ETH * $680* (105 MH/3200 TH)*5600 Blocks/day= $4.62 = £3.35

Power Costs = Rig Power Requirement * hours of mining per day* cost of electricity = 730 Watts * 24 hours * £0.12/kWh = £2.10

To give you an idea of the volatility the profit per day has fluctuated between minus -£0.12 (loss making) and £8.41.

With a decrease in the reward per block to 0.6 ETH (and assuming no change in network difficulty), the daily mining profit would drop to minus -£1.62 per day. If the returns dropped this low the mining capacity in the network (and therefore the difficulty) would drop… in this scenario the market gets flooded with second hand GPU Cards, which would decrease the residual value of the rig, suppressing the IRR!!

2. AT A SMALL SCALE IT DOESN’T MAKE SENSE

Beyond the reward vs. the hassle of building and maintaining the rig…including mining software updates, operating system updates, switching between mining currencies to increase profitability, opening wallets, storing wallets, liquidating crypto positions, transferring fiat to bank account, NiceHash mining wallet getting hacked, one of the GPUs breaking etc….

The more FUNDAMENTAL point is that I did not mine the ethereum blockchain directly. What? Why?

I am too small…If I mined the Ethereum blockchain directly the cash flow would be very lumpy….on average I would need to wait 544 days to solve a block and get the ~3.7 ETH reward.

So I have to mine via a more CENTRALISED mining pool, which eats away at the return (mining pool fee), but MORE IMPORTANTLY goes against the whole point of a blockchain…which is to be DECENTRALISED!! The mining pools ultimately decide how to use your hashing power, which coins to support and more than 50% of the Ethereum network’s hashing power is controlled by 2-3 mining pools which is more centralised than the institutional FX markets!!

Distribution of hashing power for Ethereum: Source: Etherchain.org

3. WASTES A LOT OF ENERGY!!

Since I started mining 6 months ago, I have used ~3400 kWh… which is the same amount of electricity the average UK house uses PER YEAR!!

The Ethereum network currently uses ~56,000,000kWh per day (higher for BitCoin), which is equal to approximately 6.8% of the UKs daily electricity consumption!!

WHAT IS THE POINT OF USING ALL THIS ENERGY?? There are CURRENTLY very few genuine value add applications running on the Ethereum network! This electricity could be better used to purify water, recycle plastics, heat people that are cold, cool people that are hot…

IN SUMMARY

Contrary to the more negative sentiment above, I am a huge fan of cryptocurrencies, distributed ledger technologies and their potential to…

• Standardize contracts and data structures on a global scale removing all the human energy wasted on reconciliation
• Create auditability and trust in complex/cross boarder supply chains
• Give individuals control of their own data
• Level the playing fields through decentralisation

So what is the answer:

• Don’t mine Proof of Work Crypto Currencies…especially not on a small scale… unless you have cheap hardware and near free electricity
• Move away from Proof of Work (as there are clearly a lot of problems) to Proof of Stake, which Ethereum is doing or other protocols that waste less energy (e.g. Stellar Dynamic Trust).
• Get excited about cryptocurrencies and distributed ledger technologies, because they are here to stay and will have a significant (positive) impact on the world.
• As an entrepreneur or investor…identify the use cases that genuinely benefit from being on a public blockchain, this is where you will make money ...at Illuminate we see many companies building solutions on a public blockchain, that really don’t need to be (other than if you mention blockchain it is like sprinkling pixie dust on your valuation)! In Financial markets you already have a number of trusted intermediaries (with enough competitive pressure to compress margins) that can be trusted nodes running synchronised/distributed ledgers, without having to run a proof of work or proof of stake consensus mechanism.
• Proceed with caution as despite the recent dip, valuations are still very high… how can EOS, a pre-product network that found a critical bug right before mainnet launch be worth $12B when GitHub, 10-year old application with 30 million monthly active users, awesome UX, and extremely strong network effect is worth $7B…

Thanks for reading. If you have questions/comments, let me know ar@illuminatefinancial.com