Are Miners the Modern Hedgers?

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ErisX is a designated contract market (DCM) and derivatives clearing organization (DCO) for digital asset spot and futures trading. We have taken many of the familiar building blocks from traditional commodity markets and applied them to the digital asset space to bring conventionality to crypto.

While we believe all market participants will benefit from a transparent and regulated futures market for digital assets, for the purpose of this blog post we will focus on miners and their role in the ErisX marketplace. Similar to hedgers in traditional commodity markets, miners can leverage the ErisX suite of futures products to enable price discovery and risk transference. The success of mining is probabilistic, not deterministic, and no matter the outcome, miners incur costs that often must be paid for in legal tender. Below we provide a brief overview of mining, compare miners to traditional hedgers and discuss the specific aid futures contracts bring to the mining industry.

What is Mining?

In order for blockchain transactions to be validated and confirmed amongst the network participants, the network must reach a consensus before a group of transactions, or blocks, are added to the chain. The goal of the mechanism by which participants reach a consensus is to have a clear set of rules by which all can agree on the state of the distributed ledger and which transactions are legitimate.

In a “proof-of-work” consensus model, the computers on a network running a given blockchain software are also known as nodes. These nodes are competing to add blocks to the blockchain by finding a solution to a mathematical puzzle and getting a reward in return for their work. This process is also known as mining.

The process of mining has evolved to require specialized computing hardware capable of computing guesses at the solution to the puzzle in significant volumes at a high rate of speed (trillions of hashes per second). The mathematical puzzle these machines are attempting to solve involves a cryptographic hash algorithm. A hash is the output of a function that takes an input of indeterminate length and mathematically converts it into an output of fixed length. There are various hash algorithms used across blockchains today such as SHA-256 in Bitcoin, scrypt in Litecoin, and Ethash in Ethereum just to name a few.

The amount of time it takes, on average, to confirm a block is embedded in the blockchain software and designed to maintain the integrity of the network. This is regulated by a number known as the difficulty level which determines the difficulty of the puzzle that must be solved to mine a block. The challenge of adding one of these blocks to the blockchain involves finding a hash value with a numerical value below the difficulty level.

To add a block, a mining node, a.k.a. miner, will first create a candidate block that includes a set of transactions that it chooses from a pool of transactions that have accumulated throughout the network since the last block was created. The header of the new block includes information such as the last block header’s hash as well as administrative information and a hash of the current block’s transactions. All header data is fixed except the nonce. The nonce is a variable the miner incrementally changes such that the block header is passed through the hash function until it achieves a hash value below the difficulty level at which point the block can successfully be added to the chain (this is the guessing part of solving the puzzle, and the specialized mining hardware has been designed to more efficiently and quickly change the nonce and resubmit to the hash function). The nonce in Bitcoin for example is a 32-bit field and as such can include any whole number between 0 and 4,294,967,295.

Through these efforts, miners produce new blocks and earn block rewards as well as transaction fees. Mining, and specifically the computing power it takes, requires costly resources and machine-intensive operations such as electricity, labor, purchase, installation, and maintenance of computer hardware.

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Source: Ledger

Ethereum is another digital asset that is created through mining. It is in the process of transitioning from a “proof-of-work” consensus mechanism to a “proof of stake” consensus mechanism, where instead of miners there are validators and blocks are forged instead of mined. In order to validate transactions and create new blocks, the blockchain requires validators to “stake” their coins, i.e. lock them in a deposit. Validators are chosen to validate blocks and receive a portion of transaction fees for their service. If fraudulent transactions are validated, they lose their staked coins.

A more detailed description of proof-of-stake is outside the scope of this post, but under both protocols for the Ethereum Network, participants earn Ether for processing blocks.

Managing Risk

As stated, validating transactions and securing the network involves costs that often must be paid for with legal tender. Miner’s expenses may often be well understood, however, they may face multiple challenges as they are operating their nodes:

  • The success of mining is probabilistic and not deterministic, i.e. the actual reward could be above or below the expected reward.
  • The reward is deterministic, but winning the reward is like a lottery, determined by odds — over time these should converge around a standard distribution.
  • The fiat-converted price at which a reward is valued could be above or below current or expected value as prices fluctuate.

These challenges impact their mining output, i.e. production. Mining requires an upfront capital expenditure (CAPEX) plus an ongoing variable operating expenditure (OPEX). If miners are fully exposed to price, liquidity, and difficulty risks it makes it more challenging to predictably model their expected returns. As a result, miners may want to hedge the expected price at which they can sell their production using a futures contract. This will create revenue certainty and reduce volatility in their earnings versus their operating costs.

There are additional risks miners face that are similar to other commodities and assets that are not legal tender. For example, when seeking to sell their digital assets in exchange for legal tender, digital asset owners face market risk related to price volatility, and liquidity risk related to finding ready counter-parties with offsetting interest. These risks will fluctuate in proportion to the fluctuations of price volatility and liquidity supply/demand in each of the independent crypto/legal tender trading pairs. These risks are not unique to digital assets, but in the current fragmented global market structure of trading platforms and “exchanges” with significantly varying degrees of regulatory oversight and operational transparency and integrity, they may be exacerbated. For example, some markets may have thin liquidity at or beyond the top price levels in the crypto assets that trade there. There may be no, or limited, safety mechanisms, such as order and trade size/price limits, or trade suspension thresholds. The lack of transparency around fees, matching models, and internal operations related to, for example, segregation of duties, information barriers, and principal trading, may amplify these risks.

Owners of digital assets may also face settlement and counterparty risk. These two risks will vary depending on the nature of the conversion trade, e.g. on-chain settlement vs. off-chain legal tender settlement (via commercial/central banking system) in a peer-to-peer transaction. This risk also depends on the reliability of the exchange/broker in the case where both the digital asset and the legal tender have been deposited at the exchange/broker/custodian and trades are settled on a book-entry basis. These risks are also not unique to digital assets but may be exacerbated in the context of the various methods of conversion-trade settlement with few formal standards and controls. As noted in the Virtual Markets Integrity Initiative Report by the Office of the New York State Attorney General, quantity and quality of actions taken by markets to develop their operational reliability, safety, and transparency varies. For market participants, they do not know to what extent the market on which they are trading has implemented common policies and procedures governing, for example, risk disclosures AML/KYC, segregation of funds/assets, segregation of duties across employees, market surveillance, cybersecurity, and digital asset storage. In certain instances, once the digital asset has been converted into legal tender, it may be difficult for the seller to withdraw their legal tender to a commercial bank account they control. This depends on the policies and procedures of the receiving bank and how it views the source of the funds, both the sending entity and the beneficial owner, from a compliance standpoint. Though mostly anecdotal, there are a variety of examples of the challenges faced by people and companies engaged in business related to digital assets.

Conclusion

Miners, similar to traditional hedgers, are foundational elements of a well-functioning capital, commodity and commercial market. The act of mining is performed by high-powered computers that solve mathematical puzzles to produce digital assets such as bitcoin or Ether. Miners are rewarded with the respected coin and are similar to traditional hedgers in that they are looking to offset market risk of their production related to price volatility and offsetting counterparties. This is a nearly identical use case to a traditional physical commodities producer that uses futures contracts to lock a price at the present for the future sale of the commodity. The producer foregoes the potential upside if the commodity increases in price beyond the settlement price of the futures contract, but is also protected on the downside if the price falls.

Here at ErisX we believe that, similar to hedgers in traditional commodity markets, miners can leverage the ErisX suite of futures products to enable price discovery and risk transference. Our innovative and unified platform for spot and regulated futures will provide price transparency and collateral efficiencies. Finally, our adherence to the regulatory core principles underpinning our CFTC Designated Contract Market and Derivatives Clearing Organization licenses, enable us to protect investors and our markets from manipulation and abuse. As we gear up to launch our futures market, we are excited to welcome all market participants to our platform and help everyone manage their risk including the miners, which are the modern hedgers.

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