The Bitcoin Halving: Miner Economics and Institutional Mining

At 5:55 PM EST on May 11, 2020, the third Bitcoin Halving will occur. Over the last several weeks, the price of Bitcoin has soared nearly 30% as speculators and long-term hodlers are accumulating ahead of the highly anticipated event.

The two previous Halvings, in 2012 and 2016, were followed by massive bull markets and new all-time-highs, and market participants are entranced by the possibility of another post-Halving rally.

For an overview of what the Bitcoin Halving is, check out our Bitcoin Halving, Explained (Disclaimer: The author works at Ryze Financial) article. The bottom-line takeaway is that the Halving cuts the block reward in half from 12.5 BTC every block to 6.25 BTC every block.

While all eyes are on the price of Bitcoin, significant shifts will occur in a part of the ecosystem often overlooked by price speculators — the mining industry.

The group most directly affected by the block reward Halving are the miners who validate transactions and secure the Bitcoin network, in return for the block reward.

Miners: The Original Permabulls

Miners are the most bullish of all participants in the Bitcoin ecosystem, compared to long-term hodlers and speculative traders. Miners are inherently the most bullish because they have to buy mining rigs, which are physical assets with 3–5 year depreciation cycles.

Mining equipment can only be used to mine Bitcoin (and some other crypto-assets). Miners have to rent or buy space to place these machines and pay the electricity cost of operating them, which is their main expense.

Traders and hodlers can theoretically exit their Bitcoin positions at any time by selling their Bitcoin on an exchange. For miners, exiting isn’t as simple.

Not only would they have to get rid of their physical assets at a depreciated value, they’d also have to renegotiate long-term contracts with hosting facilities and utility providers.

When you’re locked into a multi-year electricity contract to get cheap power at high usage, exiting your position isn’t as simple as just powering down machines.

Thus, miners are natural “permabulls” who are perpetually long Bitcoin. They HODL as much as they can and only sell Bitcoin when they need to pay for operating expenses such as lease payments and electricity.

In the context of competition, miners with larger BTC reserves have an edge because they can sell this Bitcoin after a bull run and expand operations, with the goal of securing a larger share of newly minted BTC.

Mining Economics and Pro-Cyclic Behavior

Miner revenue comes in the form of block rewards for validating transactions and securing the Bitcoin network. This revenue is potential sell pressure to the market, since miners generally have to sell at least some of their Bitcoin to cover their operational costs.

Their profit margin, or efficiency, is determined by three main factors: their electricity costs, the type of mining equipment being used, and the price of Bitcoin. The first two are relatively static over time for any miner.

Electricity costs vary greatly depending on the miner’s location as well as the size of the mining operation. Since utility companies often provide cheap power to those who consume a large amount of it, miners benefit from economies of scale.

Mining equipment can be simplified into old generation and new generation equipment. New equipment and cheap power generally result in far more efficient mining. In fact, new generation equipment is so much more efficient, that an old-gen S9 mining rig at $0.03/KwHr electricity cost is less efficient than a new-gen S17 miner at $0.07KwHr, more than double the electricity cost.

Since miner costs are dollar-denominated and their revenue comes in Bitcoin, mining is pro-cyclic to the price of Bitcoin. This means that miners amplify both dips and spikes in the market.

As Bitcoin’s price decreases, a miner’s net profitability decreases, and margins are compressed. Thus, they have to sell more Bitcoin, which increases selling pressure. Inefficient miners have to sell more, and this accelerates sell-offs.

When the price is increasing, miners can hold on to more Bitcoin and don’t have to sell as much, which decreases sell pressure and can cause the price to spike further.

The Halving’s Effect on Miners: Predictable Revenue Drop

Halving events in Bitcoin, which occur roughly every four years, are ultimately bullish for a number of reasons, among which are a 50% reduction in daily available mining selling pressure and a cleanse of inefficient miners.

Currently, 12.5 Bitcoin is released every block (roughly every 10 minutes), equivalent to 1800 BTC released daily and 54,000 monthly. All of this is released to miners as potential sell pressure. This is being cut to ~900 BTC/day as a result of the Halving.

When the block reward is halved, Bitcoin-denominated revenue for miners is cut in half. As a result, a significant portion of miners will become unprofitable and shut off.

Some estimates state that up to 40% of miners will become inefficient post-Halving. Almost all old-gen equipment, roughly 35–40% of the network, will shut off. Inefficient miners shutting down acts as a healthy cleansing of the network. The Bitcoin they would’ve earned will be allocated to the surviving miners, potentially increasing their revenue and margins.

The decrease in gross Bitcoin-denominated revenue is counterbalanced by fewer participants taking a share of that gross revenue.

In anticipation of a decrease in revenue, miners are already taking action to try and establish an edge over competitors. In a quest for efficiency, mining operations are looking to upgrade their equipment and cut power costs.

Some miners are replacing older equipment with new-gen mining rigs, while others are repurposing old-gen tech through firmware upgrades. Others are taking more drastic measures by relocating their equipment to places with incredibly cheap 1–2 cent electricity such as Kazakhstan and Uzbekistan.

In the US, some miners are seeking more direct access to power to lower their electricity costs. Companies like Great American Mining are partnering with oil and gas providers to power their mining rigs with resources that would have otherwise been wastefully burned off.

Others are leaning towards renewable energy sources such as wind farms, which can be less stable but more cost-efficient when there is excess capacity.

What’s Different This Halving: Institutional Mining

One key difference between the 2020 Halving and previous Halvings is the dominance of institutional mining. The days of profitably mining Bitcoin with your at-home rig are long gone.

Retail miners in the US pay 13.3 cents/KwHr on average, and can’t compete with warehouses full of next-gen rigs supplied with power at half the cost, or lower. The institutionalization of mining will lead to more treasury management and less irrational sell pressure, or “miner capitulation.”

Bitcoin mining behaves similarly to the production of commodities such as natural gas or oil. Commodities are inherently volatile in nature because they’re highly sensitive to supply and demand fluctuations.

As an example, look no further than the price of crude oil over the last 3 years. Suppliers have to hedge against this volatility to ensure profits in the face of price risk.

Derivative instruments such as futures, options, and swaps are key to risk management in traditional commodities. This allows for a more mature industry in which suppliers don’t have to be perpetually long-only, and have more controls in terms of risk.

During previous Halvings, Bitcoin mining wasn’t as institutional as it is now. The industry was dominated by retail miners, who generally have poor risk management and only sell Bitcoin when their hand is forced.

Since then, funds, energy providers, and public companies have all entered the space. Institutions behave and react to market events differently than retail miners. Institutions have more stakeholders and a lower risk appetite, thus they employ more risk controls and treasury management.

Since the last halving, regulated derivative instruments such as futures and options have become available to miners. These instruments are used to hedge against price risk, just as they are in traditional commodities markets.

Institutional miners also have more access to capital and can borrow against their future cash flows. These hedging activities will lead to decreased Bitcoin volatility in the long run because miners won’t have to sell as much during downturns. Overall, miners will become less pro-cyclic and won’t exacerbate moves.

After the 2020 Halving, institutional mining will have the bulk of the market since smaller inefficient miners will shut down. We’ll see tighter risk controls, which leads to less miner capitulation, and less long-term volatility. Less volatility leads to a strengthening of the digital gold narrative and will enable Bitcoin to become further established as a store of value

Mining in Context: The Global Picture

The “digital gold” and “deflationary store of value” narratives for Bitcoin will be tested in the coming months. As we discuss in Helicopter Money, Inflation, and the Bitcoin Standard, the macroeconomic effects of COVID-19 set the stage for Bitcoin to shine as a hedge against inflation and store of value.

Many market participants disapprove of central banks injecting money into their economies at will. Bitcoin is being viewed as an “out,” as an alternative financial system to fiat money. Unlike fiat money, Bitcoin has a fixed inflation rate and rate of supply.

These functions, controlled by code, cannot be manipulated. Quantitative easing in fiat currencies is juxtaposed with quantitative tightening in Bitcoin as a result of the Halving.

The Halving may also have long-term geopolitical effects. As of Dec 2019, 65% of mining power (measured as hashrate) comes from China. The US, however, is currently the most energy abundant country in the world. US mining operations are seeking creative ways to harness this energy abundance in a post-Halving world, which could lead to an increase in US-generated hashrate.

Increased competition between Chinese and American miners for greater control of a global financial network could compound existing tensions between the two economic superpowers.

In addition to China, Iran is yet another foe of the US that seeks to shift the power balance through Bitcoin mining. As a way to subvert US sanctions and stir international trade, Iran has ramped up its use of crypto-assets including Bitcoin.

Government-subsidized electricity rates in Iran, which holds ~10% of the world’s oil, can be under 1 cent/KwHr. This opportunity is being seized by Bitcoin miners, which has become a legalized, regulated industry under Iranian Law. In 2020 alone, Iran plans to license 1000 mining operations.

Irrespective of pandemics, trade wars, and economic sanctions, the Bitcoin blockchain churns out blocks, every 10 minutes. As a result of the Halving, those blocks will reward miners with 50% less Bitcoin than they currently do.

This drop in revenue may have profound effects in the mining industry and wipe out large swaths of mining operations.

However, since every single miner expects this to happen and can predict, up to the second, when it’ll happen, the Halving very well may have an insignificant impact on the mining industry.

At the end of the day, it’s impossible to know, but we’ll be watching closely and reporting back to you as this plays out with more research.

(Disclaimer: The author works at Ryze Financial)

Sources:

Coinmetrics State of the Network E18

GSR and Interhash to Create Hedging Solutions for Bitcoin Miners

Blockware Solutions: 2020 Halving Analysis

Iran Has a Bitcoin Strategy to Beat Trump

Marty Bent’s TFTC Issue 717

Pomp Podcast #256 — Matt D’Souza

“On the Brink With Castle Island” Podcast Ep 22 with Dan Matuszewski

Coindesk Bitcoin Halving Podcast Ep 2