One group of participants in the cryptocurrency ecosystem to whom financial derivatives may be particularly useful are miners. Miners are part of any Proof of Work algorithm as used in Bitcoin, Litecoin and Dogecoin, and they validate new transactions in so-called blocks. To validate a block, all miners in the network participate in a race to solve a computational puzzle of which the outcomes provides this validation. The first miner to solve the puzzle first gets a reward, currently equal to 25 coins per block in the case of Bitcoin.
The chance of solving a puzzle first and getting rewarded is proportional to the amount of computational power contributed to the total network hashrate. In the long run, the rewards miners get are equal to their chances of getting rewarded. For example, if a miner contributes 10 percent of the network total hashrate, the chance of being the first to solve a block is 10 percent per block. In the long run, this miner will have received 10 percent of all rewarded coins.
As a single miner normally only has a very small percentage of the total network hashrate, miners organize in mining pools to stabilize their payouts. Mining pools mine using the group’s combined computational power, and may therefore control a significant chunk of the network. The mining pool further distributes received rewards among its members in line with their proportional contribution.
Of course, a miner’s generated income is denominated in the mined cryptocurrency. This is why price fluctuations may pose a big risk to those who made a big initial investment in their mining equipment. A drop in prices can make earning an investment back very difficult, or even delay it long enough to make it impossible.
Proof of Work mining is an extremely competitive process by nature. Profitability depends mainly on efficiency, as it is not possible to get more rewards than the proportional contribution to the total network. This has sparked a mining arms race, which has for instance led to the development of Application-Specific Integrated Circuits (ASICs) in order to get the maximum hashrate at the lowest possible (power) costs. As miners become more efficient, driven by economies of scale, older miners will no longer get sufficient income to cover the costs. The electricity costs of running a miner remain equal, but as more (efficient) miners join the network the proportional income drops.
Due to the constant arms race, a new miner will typically mine the most coins during the early days of its lifetime. A drop in prices during this period can ruin a miner’s ability to earn itself back, which can be very painful as this equipment can sometimes cost up to $10,000.
Fortunately, miners can turn to financial derivatives to protect against (hedge) some of this risk. These derivatives are particularly useful to miners, as this group is capable of making a fairly accurate estimate of their income in Bitcoins. If this is known, the dollar value of this future income can be fixed before mining is started. To this purpose, miners can use Futures Contracts (Forwards would be even better if possible).
Consider the following mining rig: a Neptune Third Batch from KnCMiner priced at $6,000 running three TerraHash per second (TH/s) at 1950 Watts. This miner starts mining today while the price of one Bitcoin is at $475. The owner who wants to earn his mining rig back as fast as possible has two options, either sell Futures Contracts on cryptocurrency exchange OKCoin with maturity date on the 26th of December 2014 and price of $477 to fix the mining income, or sell received Bitcoins at the available market rates when received. For simplicity, assume that in both cases all coins received will be held until the 26th of December.
To determine the amount of coins that will be received in total during this period, an estimate can be made by extrapolating the growth in the total network hashrate. Today this is at 236,000,000 GH/s, and with steep linear increments of 2,183,333 GH/s per day this will be at 489,266,667 GH/s by the end of December. In reality, the network growth displays an exponential trend, hence a steep linear approximation is made. Doing so, it is revealed that the miner will start receiving 0.0458 Bitcoins per day and receive 0.0221 coins per day near the end of the year. Over the entire period, the miner will receive about 3.6404. To verify this, there are various online tools available that make similar approximations.
If the price of Bitcoin drops to $300 per coin, the miner could sell his 3.6404 Bitcoins for $1,092.11 on the 26th of December 2014. But if the miner sold 3.6404 Futures Contracts (a short position), then the total payout would be $1,736.47 in line with the $477 per coin agreed in the contract. Technically, given cash settlement the miner would receive $1,092.11 from selling the Bitcoins and $644.36 (3.6404 * ($477-$300)) profit on the Futures Contract. For the complete picture, power costs should still be deducted to get to the final profit but these costs are equal for both cases.
The example shows how the miner can successfully protect itself from a drop in price and secure its income. The reason why Forward contracts would be even better to this purpose is because they do not settle on a daily basis, although this brings additional counterparty risk. Also, miners still have counterparty risk on the exchange they are trading on. But even so, they remain a group to whom financial derivatives may provide significant benefits.