Cryptocurrency Mining as a Financial Instrument in 2021

31.08.2021

Cryptocurrency Mining as a Financial Instrument in 2021

Cryptocurrency mining is a novel profit-making activity. With the Bitcoin technological breakthrough, a new industry emerged in 2009. Since that time, many things have changed, and cryptocurrency mining has become a huge industry with huge money in it.

Compared to many classical financial instruments like government-issued bonds and stocks, cryptocurrency mining promises higher rewards and a comparable amount of risk. Presently, you can invest about $3,000 in mining equipment and get it back within 100 -- 120 days, with profits accumulating ever since.

The huge money issuance done by the world’s richest countries in 2020 has increased inflation and devalued the U.S. dollar. In that time, cryptocurrencies grew in value as investors urgently needed a safe haven asset to hedge their capital against the growing inflation. The choice investors made to invest in Bitcoin is not least accounted for by the security that it offers.

Let us now look at some popular investment options and see how they compare to cryptocurrency mining risk wise.

Stock Investing Risks

2020 was the worst year for the U.S. economy since the Second World War: the American GDP shrank by 3.5%. This means that demand fell in 2020 and many companies had a bad financial year, especially services companies, as retail demand was hit worst. This would in turn suggest that companies’ shares should follow suit and go down vastly.

And what we saw was a complete opposite: the stock market was continually setting new all-time highs. What could explain such a contrarity?

From March to April 2020, the U.S. authorized three COVID-19 relief packages that totalled almost $2.8 trillion. Later on, close to the end of then-President Donald Trump’s tenure in White House, the Congress passed another $900 billion bill, which brought 2020’s total of stimulus spendings to some $3.7 trillion. However extraordinary that figure might have looked, it was still less than needed for America’s economy, as at least the Democrats and then-President-elect Joe Biden proposed so.

Having won the presidential election, Joe Biden proposed a fifth economic stimulus bill nicknamed American Rescue Plan worth $1.9 trillion that he signed into law on March 11, 2021. The American Rescue Plan brought the entire COVID-19 relief spendings to a mind-boggling $5.6 trillion.

This entire emergency stimulus is the main if not only reason why the stock market was showing such extraordinary growth amid economic decline. The stock market is a pivotal financial institution that is a cornerstone for the American financial system that a vast majority of American households rely upon. And keeping this institution intact was a crucial goal of the U.S. government.

However, such monumental spendings come at a cost. They push inflation and devaluate the national currency. And that was the case with the U.S. dollar: the U.S. dollar index fell almost 12% since May 2020 to the year end. 

Here we come to a situation where we see an obvious contradiction between an economic downfall and rapidly rising stock shares. However, money printing cannot go forever as it would default the currency. And yet if the money boost does not fully restore the economy and the discrepancy between economic performance and the stock market continues to grow, the stock market will be prone to crash. 

Once investors start to notice that the financial performance of the companies is far worse than that of their stock shares. And that can easily trigger a market crash. And that should not come as a surprise as we saw a very similar thing happen in 2008. These risks are very real and, with the stock market being pumped with free money, they only get bigger.

Bitcoin Investing Risks

The most alluring property of Bitcoin is its immense return over investment that it has shown over the years. Bitcoin grew more than three-fold since December 2020 until April 2021: from around $18,000 to $64,000 at the top. However, such extreme volatility entails the risk of a comparable downfall. 

So, if you want to invest your money wisely, you should not ignore the colossal downfalls that Bitcoin has gone through in its market history. Let us bring to light some of the biggest Bitcoin crashes.

1. November 2011: -94%

In 2011 Bitcoin peaked from $2 to $32, but a rapid crash followed afterwards as the then biggest cryptocurrency exchange Mt. Gox announced that hackers had stolen millions of dollars from its users’ accounts. The fall led to a price reduction of Bitcoin from $32 to $2 or 94% over the course of five months.

2. November 2013: -87%

On 19th November 2013, the Bitcoin price tumbed from $755 to $378 and continued on a downtrend for the next 411 days. At its end in January 2015, the Bitcoin valuation was at $150 with a price reduction of 87% throughout the corrective span.

3. December 2017: -84%

In December 2017, the Bitcoin price peaked to $19,666, a new historical high at the time, with mass attention drawn to the flagship cryptocurrency. But on December 18, subsequent to the start of CME Bitcoin futures launch, the BTC/USD trading pair came crashing down, plunging below 12,000 in one day. As the downtrend went on until December 2018, the asset found a bottom of $3,122, losing 84% of its valuation along the way.

4. March 2020: -63%

In the time of the COVID-19 pandemic unraveling, Bitcoin was not spared and lost a big chunk of its value as many assets of other classes did. From February 13 to March 20, Bitcoin fell from $10,500 to $3,850, losing 63% of its market value.

5. May 2021: -53%

In May 2021, Bitcoin rose to a colossal $64,000 on the back of institutional demand and backing from highly influential businessmen. One of the biggest instances was Elon Musk’s Tesla investing $1.5 billion and Elon promising to accept Bitcoin as payment for Tesla cars in February 2021. However, a couple of months later, Elon backtracked on his words and said that Bitcoin mining was too harmful for the environment and said that Tesla would not accept Bitcoin until it became eco-friendly. This instantly set the asset crashing down to $31,000 in a matter of less than two weeks.

This is proof enough of the high investment risk associated with Bitcoin.

Bitcoin mining vs. Bitcoin investing

Let us consider a simple example. Suppose you have $10,000 you can invest in Bitcoin or in Bitcoin mining. When you invest in Bitcoin, you can only get the profit that Bitcoin makes on the market. It can be 10 or 20 or even more than 50 percent over a year. However, you might as well lose a good portion of invested capital over that same period of time as Bitcoin is prone to downside reversals as it is prone to bullish swings.

If you invest that same $10,000 in Bitcoin mining, you would have to buy ASICs. For a better estimation, you can look at the prices in our Iron Store. The biggest advantage of Bitcoin mining over investing in Bitcoin is that you would be making profit if the price of Bitcoin were at $100,000, $60,000, $30,000 or $20,000. The payback would only differ, and you would get your investment back in around 1 year or less. Then you will still have mining hardware on your hands that you would be able to sell on the secondary market for a profit or just continue mining for profit. Thus you can make profit both ways

According to our estimate, the buyback period for a Bitcoin ASIC miner is on the average 10 months, and it is prone to reduce to less than months if Bitcoin’s price is at $60,000 or more.  And we estimate that the average annual ROI will be 40% a year with much lower risks that you would be dealing with on the stock market.

These are the options, and the choice is always yours.

Hashrate

The hash is the number that is produced by the hashing function of the blockchain. For a block to be added to the blockchain, the hash should conform to the target hash, i.e. be equal to it or less than it. 

Speaking of Bitcoin, its hashing function produces a hash from the sum of a nonce and the hash of the previous block. Therefore, miners are searching for the nonce that being appended to the previous block’s hash will produce a hash that will conform to the target hash of the current block that should be mined. And the number of those nonce searches per second creates the blockchain’s hashrate, i.e. the number of nonce searches per second to find the right hash.

And the important thing is that a higher hashrate increases the chances of finding the right nonce and mining the block as the ability to produce more nonces per second increases the chances of finding the right nonce. However, there is a downside to this as a higher hashrate increases mining difficulty. Therefore, miners are raising the level of mining difficulty, trying to increase their reward, and consequently raise mining difficulty across the network. Therefore, hashrate and mining difficulty are in a direct relation.

Mining Difficulty

Mining difficulty is a key element of Bitcoin’s architecture that makes it such an efficient network. It allows the Bitcoin protocol to efficiently control the miners’ chase for profits and ensure that the block time (the time between two neighbouring blocks) remains at around 10 minutes.

The financial incentive also plays a big role in this. When the block reward grows due to the growth of the market price of Bitcoin, all miners are incentivised to ramp up their mining power to grab a bigger piece of a bigger pie. In response to that, the protocol accordingly raises the mining difficulty. When the block reward considerably drops, miners may reduce their engagement with the network, then its hashrate will fall. In response to that, the protocol will decrease the mining difficulty.

The Bitcoin protocol adjusts mining difficulty every 2014 blocks, which is around two weeks’ time. As a matter of fact, Bitcoin block times differ substantially from the ideal 10 minutes – from 1 minute to half an hour – but on average the 10-minute block time is quite effectively maintained.

Constituents of Block Reward

The block reward in every cryptocurrency consists of the new coins mined with the block and transaction commissions. The amount of newly mined cryptocurrency is automatically set by the protocol of its blockchain; the amount of commissions comes from the congestion of the blockchain and its throughput.

On Bitcoin’s network, the number of coins mined per single block was halved on May 11, 2020 from 12.5 to 6.25 BTC. Halving happens in Bitcoin’s network every four years. And that might look upsetting to some. However, there is a big counterweight to that, which is transaction fees. Bitcoin transaction fees are large already and it will likely grow in the future as more demand is present for Bitcoin.

What makes transaction commissions so lucrative is that the throughput of Bitcoin is the lowest among all large cryptocurrencies: 3 transactions per second. However, it is still one of the most used cryptocurrency blockchains. The low throughput guarantees that miners will be giving priority to transactions with higher commissions. Therefore, the senders will have to offer higher commissions to the miners if they want their transactions to be processed within a reasonable timeframe. 

An average commission per Bitcoin transaction rarely drops below $0.5 and can easily exceed $20. Actually, a new record was set in April 2021 when the average Bitcoin transaction commission reached $58.42. According to the on-chain data, transaction commissions often account for over 10% in Bitcoin’s monthly miner revenue. Given the financial potential that Bitcoin has, this can be a massive income opportunity that can only get bigger in the years to come.

How to Start Making First Profit?

There are two basic approaches to cryptocurrency mining: mining a large cryptocurrency like Bitcoin or mining low-capitalisation cryptocurrencies. In the first case, you will be more likely to make immediate profit; in the second, your profits will be less guaranteed, but potential rewards may many times exceed the profits of the first option.

Some low-profile miners intentionally prefer to mine lower-capitalization cryptos with lower network hashrates, expecting their prices to grow many times in the future. But this approach requires certain expertise and knowledge to make the right choice and not invest your mining power in a cryptocurrency that will fail.

Given that cryptocurrency mining equipment costs thousands of U.S. dollars, the safest option for the novice miner will be cloud mining: it allows to loan a small amount of hashrate from a hashrate provider and get first-hand experience, without running big financial risks.

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