The Next Era of Bitcoin Requires A New Form of Risk Management
As Bitcoin heads into the halving, we enter a new phase. In the distant past (2011), mining could still take place on the desktops of a few hobbyists. They were smart, technically adept, and years ahead of most of us. But they did not need to plan for large scale spending and the attendant financial risks. Over the last decade, we have seen tremendous innovation in mining technology and methods.
But as the block reward is cut in half and as prices reach previously unseen levels, mining will require higher levels of capital and commitment. Whether in the form of new, well-capitalized players just entering the mining market or veterans whose budgets have grown through their block rewards, next phase miners will operate on a financial scale that calls for professional risk management.
And Bitcoin futures won’t be it.
Futures Are the Wrong Tool
Futures are wrong to hedge Bitcoin mining for two reasons. First, Bitcoin mining rewards are asymmetric. Second, futures are linear, margin is high and the leverage can be very harmful.
Asymmetry
Let’s look at the asymmetry first. Many productive processes appear linear, but are not. If the price of wheat goes down, the wheat farmer loses money on the wheat he’s grown. So far, so good. But if the price of wheat goes up, he makes more money from his wheat. Well, it depends on why wheat prices rose. If they rose because of a drought that killed off his crop, then no, he doesn’t profit from the price hike.
While analogous to the farmer described above, the Bitcoin equivalent requires a bit more explanation. As the price drops, the block reward drops in value. That’s the first order impact. Next, the value of all the mining rigs the miner owns could well be lower. Put differently, the expected value of future blocks received has dropped, so the mining equipment that generates the blocks drops in value. The miner takes a loss on a price drop.
What about a price increase? The value of the block reward is higher. That’s a win. But the higher price of Bitcoin brings in more miners. The supply of hardware limits this effect somewhat but, at a high enough price, more resources will enter mining. But the quantity of Bitcoin mined per day must remain fixed. The way this happens is that Difficulty is raised. So, the same equipment the miner owns will produce fewer block rewards as the price increases. Sure, she can buy more miners, but those aren’t free. That’s an additional cost. Or she can hold onto Bitcoin rewards longer, and many do. But this introduces more directional risk. In the end, the gain to the miner will not scale the same on way up as the loss does on the way down.
Linear and Limitless Loss
The risk and payout graph of futures is represented as a straight, diagonal line. If you are long you make exactly as much for a rally as you lose in an equal decline. If you are short, you make the same amount on every tick downtick in price as you would lose on every uptick. As we’ve already discussed, the natural position of the Bitcoin miner (and many others) is not as linear. So it is a mismatch.
People love the leverage of futures contracts, but that leverage is a bit of an illusion. The margin (and, therefore, level of leverage) remains the same, if the price does not move against you. What if the price does move against you, even on a hedge? More margin is required. What happens if the dollar value of that margin exceeds one’s financial resources? The hedge must be lifted. In that case, the hedger has sustained a loss, hopefully offset by a gain, but the original risk is back. There is no longer a hedge.
Bitcoin margins are very high, for good reason. At the time of this writing, the CME is requiring about 32% of the notional value of its Bitcoin contract as margin. Some brokers are requiring more than the notional value of the Bitcoin contract as margin on short positions. Literally, one broker was requiring $200,000 in margin to go short one $50,000 Bitcoin contract. Let’s just pause and think about that. The tool people like because of the leverage requires 4x the current notional value of the contract.
That broker’s action is perfectly reasonable, given the volatility of Bitcoin, but it makes it hard, if not impossible, to use the contract as a hedge.
Some will respond that if volatility is too high to use futures safely, just buy options. An options market is coming, after all. Unfortunately, buying options just passes the volatility and risk to a counterparty. And that counterparty very thoughtfully passes the costs of that volatility back to you in the form of very high premiums. You will not be buying cheap Bitcoin options any time soon.
So, at the moment, the tool for hedging is too expensive, potentially dangerous, and a fairly lousy match to the underlying risk.
Asymmetry and Boundaries
What is needed is a hedge that is more affordable and that can be customized to fit the risk profile being hedged. This will be achieved through instruments that are bounded by their innate structure, not by passing the unlimited risk to a counterparty. And it will be achieved by making customization a core feature.
With these components, a system for constructing a hedge can make an affordable hedge that will be usable for the sorts of advanced mining operations we’ll see in Bitcoin’s next phase…. assuming that phase comes to pass.
Perhaps, by this point, you’ve guessed that this is what we’ve been developing at Grey Swan. Perhaps not. But we have been working such a system. And it will find a range of users beyond miners.
