The Business of Blockchain 3 of 3: A 2020 Overview of the Crypto-mining Business

Updated: Mar 2, 2021



This is the third article in a series of three on the business of blockchain. In the first article, we discuss how there is potential long-term support for proof-of-work miners to function within the non-cash transaction market. Cryptocurrencies will likely push the existing non-cash transaction market participants (Visa, Mastercard, etc.) into a race to the bottom concerning revenue margins, which will, of course, erode their profit margins. Additionally, proof-of-stake cryptocurrencies are well on their way to solving the technical problems related to the transaction throughput required to become mainstream participants in the non-cash transaction market.


Our second article discussed how our global systems are ripe for secession and how bitcoin may play a role in the next global monetary system. Some rationale supporting the claim that bitcoin is a good store of value and how that could affect the price is presented.

This article will discuss existing risks to bitcoin, challenges for bitcoin mining operations and a review of several prominent publicly-traded bitcoin mining companies.


Risks to bitcoin

Investing directly in bitcoin or a nascent blockchain company is risky. Contrary to what most advocates believe, bitcoin does not solve a payment problem. It is labelled a coin, but it behaves like gold. Satoshi, it’s anonymous creator, called bitcoin an “electronic cash system” but this is far from what bitcoin has become. Developers are focusing on second layer chains or side chains to accomplish the cash element of bitcoin, further complicating the already difficult task of onboarding new users.


Creating a new monetary system is an exciting idea, but it requires mass adoption and confidence in the underlying market. We are nowhere near that yet, as there are estimated to be less than 6 million unique bitcoin users globally. A centralized blockchain solution, like the Telegram’s Gram, may have a better chance to reach mass adoption, given that they’ve raised $2 billion to fund development and Telegram has 200 million global users. Bitcoin has not reached mass adoption, and there are good reasons why; volatility, security and money laundering are prime examples.


Volatility



The volatility of bitcoin’s price remains a hindrance to mass adoption. When regular consumers buy bitcoin, many do not realize that bitcoin is not suitable as a cash-like system. This lack of understanding may lead to emotional trading, exacerbating volatile prices. In reality, it has turned into an inflation hedge. Most people don’t want the value of their cash to fall 20% overnight (the worst 24-hour change in bitcoin price to date). And traders don’t want to waste their coins on buying goods & services, which could mean potentially missing out on a huge run-up. More than half of all the bitcoins in circulation haven’t changed hands in at least six months. Bitcoin is held like gold, not spent like cash.


In rare cases, bitcoin demand increases in economically volatile regions such as Venezuela and Hong Kong. These unique instances are the only time in which bitcoin is used as the electronic cash for which it is claimed to be designed. There are, however, sizable exchange fees that one must pay when converting fiat into bitcoin and back into fiat. So, unless one’s value remains within bitcoin and slow transactions are acceptable, it is more economical to use the current banking system for daily transactions.


Security

The bitcoin ledger is only updated every 10 minutes, meaning one confirmation every 10 minutes. The table below, adapted from the bitcoin white paper, in section 11 (https://bitcoin.org/bitcoin.pdf), shows how many confirmations (z) are required to be 99.9% sure that a transaction is valid based on the percentage of the network used by an attacker (q).


If one assumed the bitcoin network was under attack using 45% of the network, you would not know that your transaction is valid until 340 blocks were solved (approximately 56 hours). Bitmain already owns two of the largest mining pools and has one-third ownership in the third-largest pool. These pools are BTC.com, ANTPool and investors in VIABTC with 38%. This means Bitmain controls over 45 percent of the network; therefore, 340 confirmations are required before a guarantee is secured. Bitmain is not far from controlling more than 50%, which threatens the whole system. They could attack the bitcoin network, and this should concern investors. The challenge for attackers is monetizing their assets before their actions are realized, causing a collapse in the price of bitcoin. This balance is programmed into bitcoin to prevent attacks.


More concerning is the mining hardware, which is likely preferentially distributed in self-dealing to mine more economically than competitors and mining pool software, which has the potential to apply preferences to individual pool participants over others.


Money laundering

Money laundering is a big problem for fiat currencies and bitcoin is another avenue for this type of illegal activity. Even if the portion is small, the fact that money launderers use bitcoin damages bitcoin’s reputation and delays mass adoption. Some miners are willing to mine at a loss, and the most plausible explanation is to launder illicit funds. If a legitimate miner were to mine and hold their coins, spending cash to cover operating expenses, they wouldn’t continue to mine at a loss; they would buy them on the open market with the money that would otherwise go to operating expenses. There is a cost to launder money, so there is always some shrinkage. Money laundering could explain why some are mining at a loss.


Also, bitcoin and other cryptocurrencies provide an avenue for subverting currency export restrictions. For example, China holds strict controls on cash entering and leaving China — Chinese Nationals are only permitted to take 20,000 yuan per year outside of China (Apx $15,000 USD). They do not, however, restrict people buying computer equipment and mining bitcoin. Mining can be a legitimate expense, and the newly minted coins can be exchanged anywhere in the world. Other countries trying to restrict currency movements have the same problem.


Because of the halving expected this May, one might believe the price of bitcoin to go up, but there is an argument to be made that it may not, and if it doesn’t, it would be catastrophic to investors in bitcoin and bitcoin mining companies. The bitcoin ecosystem has matured significantly since that last halving: crypto derivative markets have taken off, institutional investments have grown dramatically, and valuation frameworks have matured. This time there are a lot of reasons an investor might think, “this time, it’s different.”


Trends in cryptocurrency mining

It is noteworthy that market trend data is considerably challenging to establish, given how new, highly competitive, and dynamic the mining sector is. Below are some of the trends happening in the Bitcoin mining sphere.


  • In 2017, growth in the mining industry, as measured by full-time equivalent (FTE) employees, grew by 103 percent year-over-year. This growth was primarily driven by a dramatic increase in crypto prices in 2017, making mining more profitable before substantial increases in difficulty, before a price drop and growth retraction in the first quarter of 2018, where FTEs dropped by 67 percent. Since 2018 the job market appears to have reversed. Job search website Glassdoor states: “According to our data, the crypto and blockchain market is far from dead it’s still rapidly growing. From February 2018 to February 2019, we saw the share of US job postings related to crypto, blockchain and Bitcoin grow 90%.”

  • A disproportionate number of mining operations are in China. This centralization is likely a result of the availability of cheap power; however, miners have been looking to the United States and Canada primarily due to the availability of cheap hydroelectric power in combination with the real and perceived political stability and regulatory environments. The availability of fast internet and low temperatures (which reduce potential cooling costs) also factor into the decisions.

  • It is considerably more common for the legal headquarters of mining companies to be in the same country as their operations than not. This could be a result of the efficiencies gained by having management and operational staff near one another, and a sign that crypto friendly (or not heavily restricted) regulatory regimes also make available sufficient amounts of cheap electricity. Crypto mining companies based in North America tend to be “cross-regional” with offices and mining facilities in multiple regions.

  • Regulation of crypto asset mining is primarily overlooked or undefined around the globe. The most progress has been made concerning mining and anti-money laundering (AML) and terrorist activities. However, the creation of crypto assets, their designation as securities or commodities, and their taxability are all areas currently under intense scrutiny in some jurisdictions.

  • There is currently a new gold rush of miners entering the marketplace. If the price of bitcoin doesn’t increase, many miners will become unprofitable, and the network may run the risk of becoming increasingly centralized, which will lead to decreased security. Price is not always a function of supply; some things are available in virtually limitless amounts yet can be costly, as determined by demand (e.g. software). In the absence of a fundamental use-case for bitcoin, bitcoin and bitcoin mining will remain highly speculative.


Mining hardware developments


The first generation of bitcoin ASIC miners (computer hardware explicitly designed to mine bitcoin) required approximately 10 kW per TH/s. The most efficient miners today only need 40 Watts per TH/s, representing an efficiency gain of 250x over six years. ASIC efficiency gains are due to two main factors, design optimization and base component efficiency gains. The first ASIC miners used designs based on FPGA miners and had 110-nanometer (nm) semiconductors. Since their introduction, ASIC designs have gone through several optimization iterations, and the latest miners are using much more efficient 7-nm semiconductors, and 5-nm miners are on the near horizon.

The enormous efficiency gains between 2013 and 2018 have led to very short lifespans for mining machines. A machine bought during this time may have only been profitable for a few months before the difficulty would be so great that the cost to run them was higher than the reward likely to be generated by them. Fortunately for miners, the impact of Moore’s law, which states that “the number of transistors in a dense integrated circuit doubles about every two years,” is drawing to an end. This means that miners’ machines should remain profitable for longer. Whoever can get the latest tech machines into the market, the quickest will win this arms race. The Bitcoin network operates at approximately three times the power requirement of the most efficient state-of-the-art ASICs. At the current network hash rate, the network uses three times as much power than it would take if all the miners were state-of-the-art. Without a technological breakthrough, we are entering the flat part of the ASIC power requirement curve. Therefore as time progresses, if the hash rate increases, the power requirements would tend to increase at a nearly linear rate. There would be no considerable advantage to adding additional capacity as the returns would be linear with competition apart from variances in operating costs such as electricity.

The Bitcoin network hash rate has an upward trend. So if a miner doesn’t increase their hashes over time, they will mine fewer bitcoins over time. Mining operations with power prices above 5 US cents a kWh will probably not be profitable after the next halving.

Blockchain development impacts on mining

Debates over blockchain development paths have led to hard forks in several prominent blockchains, meaning the blockchain splits and becomes two separate networks. The Ethereum network split into Ethereum and Ethereum Classic. The Bitcoin network split into Bitcoin and Bitcoin Cash (BCH) in August 2017, BCH later split again into BCH and Bitcoin SV (BSV) in late 2018. The causes of these and other forks have been over a wide range of issues which do not have obvious answers but range from values to business models, to scaling strategies. The flexibility of blockchain mining can lead to very fluid development; if a network takes a development path which does not gain traction, miners can switch their mining software and mine another fork or cryptocurrency.

The BCH reward will be halved for the first time in April of 2020. The current block reward of mining bitcoin cash is 12.5 BCH, after halving miners will receive 6.25 for a block mined. For a currency to work, there needs to be a distribution of hashing and pools. There is not enough mining distribution present in BSV or BCH to make them feasible in the long run. BSV and BCH are vulnerable to so-called 51% attacks, in which a single miner or group of miners can gain control of more than half the network’s mining power and uses it to reorder old transactions.

When BCH split from BTC, it instigated a “hash war” when it was not clear which fork was going to gain the most support from miners. Today, given that the network hash rate for BTC is over 120 exa-hash and the combined network hash rate of BSV and BCH is around 5 exa-hash it is safe to say that BTC won the hash war. Therefore, BSV and BCH are vulnerable to attack. Bitcoin, BTC, has won the hash war, and without the support of miners, both BitcoinCash and BitcoinSV will eventually die, and the coins will be worthless.

In the short term, it is better to invest in bitcoin than invest in a mining company.

We forecast a price increase in bitcoin, but BSV and Bitcoin Cash are incredibly challenged and may not survive.

Most of the Bitcoin mining companies below are going to go bankrupt if the bitcoin price does not take off in the next 12 months. Right now, bitcoin mining profitability is exceptionally questionable as the volatility swings are deep and too unpredictable for most legitimate businesses to survive. If you like the space, it is better to buy bitcoin when it dips and sell on the FOMO run ups.

Winners and losers in crypto mining

Below is a list of publicly-traded crypto mining companies as well as Bitmain, which is seeking a listing for early 2020. They are in order of market capitalization (CAD and EUR values were converted to USD at the time of publishing). We have provided some high-level commentary on the mining side of their business, but this should not be used for stock trading advice. We are neither licensed nor qualified to provide investment advice, and stock trading involves substantial risk of loss and is not suitable for every investor. The content is for information only; you should not construe any such information or other material as legal, tax, investment, financial, or other advice.




Bitmain- Short term winner

Est Market Cap. $5B USD Bitmain still owns lots of bitcoin, which we predict will go up in value. We predict they will do well because of the mining ASIC arms race and their dominance in this field. Bitmain’s products market share by hash rate, however, continues to decline and now stands at around 66%. As a way to maintain market share, Bitmain has proposed to take on cash flow risk, bitcoin price volatility risk and the electricity costs. Bitmain has changed its sales strategy that forced customers to pay the full amount on ordering for mining hardware due to huge demand, with a new payment structure. Customers which order 100 to 999 miners can put down a 50% deposit while larger investors purchasing more than 5,000 units only put down a 20% deposit. The remaining cost needs to be cleared seven days prior to the shipment date. This shifts the short-term cash flow pressure away from customers toward Bitmain itself because of declining demand.

Bitmain plans to increase sales by targeting companies with unused power resources to help fill them to capacity. They will offer a co-mining agreement for one year for mining farm operators to rent its flagship AntMiner S17 or T17 products. Bitmain would cover the year-round electricity cost (up to $0.05 USD per kilowatt-hour) while mining farm operators remain responsible for maintenance and operations. Bitmain retains 75% of the mining profits to cover the rent of the miners, and the farm operators take the remaining 25%. The fine print, however, states that if the mining revenues are less than the electricity cost, then all the mined coins go to Bitmain. Bitmain will still own the machines and is only renting them out. This was recently done in central Texas, at the abandoned Alcoa aluminum smelting complex in Rockdale, which was a joint venture with investors and was going to use DMG as the operator. All of them will split revenues as above unless mining revenues are less than power costs. In early 2020 DMG pulled out of this partnership deal because they were last in line to get paid, and their share was too small. See write up on DMG below. Bitmain tried another similar deal a few years back in Newfoundland with Great North Data, which has filed for bankruptcy in November 2019. So far, this offer has not worked well in North America.

Through this plan, Bitmain will increase its mining capacity for itself — this marks a reversal from past trends of increased focus on sales. Bitmain’s hash power dropped down to just 237 PH/s in May of 2019 but rebounded back up to 903 PH/s as of December 2019. They have been removing their old machines and installing the latest technology.

In Washington State, in a town called East Wenatchee, Bitmain refitted an abandoned factory. They installed approximately 12 MWs of miners within the Wenatchee facility representing an investment of roughly $20 million. Bitmain has also built a facility to repair damaged Antminers in Malaga WA, about 11 kilometres from their mine in East Wenatchee.

Bitmain continues to be one of the largest crypto companies in the world. They reportedly have plans to open at least 17 mining centers in the USA. Bitmain has also decided to strengthen its presence in South and Central America. They have established a collaboration with Bit5ive and Fastblock for the distribution of Antminers to more than 30 countries across Central and South America.

Bitmain has also introduced a put option to ease mining investors’ concerns regarding bitcoin’s price volatility for those miners that make large orders. If they purchase over 1,000 units of AntMiner S17 Pro, valued at about $1.5 million, the firm will give them 62 put options, worth about one percent of the miner order. These put options would allow customers to sell bitcoin at $5,000 USD on March 27, 2020. If bitcoin’s price is higher than $5,000 by that date, the option will be useless. If it’s below that amount, then the customer would exercise the option to lock in the $5,000 price. Bitmain would then have to cover the cost difference. Sixty-two put options would guarantee a revenue of $310k USD on March 27, and would roughly cover the install cost for the 1000 miners.

The shifts in Bitmain’s business model are a sign of intensifying competition in the mining business. Bitmain’s new strategies aim to recover from a series of self-inflicted wounds caused by poor strategic decisions. Bitmain has suffered due to their failed Hong Kong IPO bid, failed tape-outs in their design process, overproduction of hardware, overaggressive hiring of staff, and perhaps worst of all, its captive BCH holdings. These factors have all contributed to balance sheet issues, which, according to a recently leaked internal memo by Bitmain chairman and co-founder Jihan Wu, almost sunk the company in early 2019.

Canaan Inc ADR

Symbol CAN — Market Cap. $950 M USD Canaan will have short term pain but will do well in an arms race (high output 7nm machine technology) due to new cash from their IPO. They will be hurt by the aggressive moves from Bitmain, as discussed above.

Hut 8 Mining Corp

Symbol T.HUT — Market Cap. $90.6 M USD Hut8 will do well because they hold more than 3500 bitcoin, which will go up in value. They will need to replace their ageing mining equipment, but they have variable competitive power rates locked in for ten years. They can share in any upside if power prices spike up by shutting down their miners.

Hive Blockchain Technologies Ltd.

Symbol V.HIVE — Market Cap. $43.2 M USD Hive Blockchain Technologies Ltd. mines mostly Ethereum (ETH). ETH is moving away from mining to a Proof of Stake verification process. ETH was never meant to be a volatile coin and there is no reason for its price to appreciate dramatically. This makes it very hard to mine for a profit. Hive does a lot of mining in Europe, which has high power prices. On top of that, Sweden is eliminating tax credits on electricity for miners, so their costs will increase.

Bitfarms Ltd.

Symbol V.BITF