The Breakdown - Why Bitcoin’s Bear Market Hashrate Surge May Not Be Bullish

Episode Date: October 28, 2022

This episode is sponsored by Nexo.io, Circle and FTX US.   On today’s episode, NLW catches up on the bitcoin mining industry, and why soaring hashrate and mining difficulty represent something very different in a bear market than they did during the bull.  - Nexo Pro allows you to trade on the spot and futures markets with a 50% discount on fees. You always get the best possible prices from all the available liquidity sources and can earn interest or borrow funds as you wait for your next trade. Get started today on pro.nexo.io. - Circle, the sole issuer of the trusted and reliable stablecoin USDC, is our sponsor for today’s show. USDC is a fast, cost-effective solution for global payments at internet speeds. Learn how businesses are taking advantage of these opportunities at Circle’s USDC Hub for Businesses. - FTX US is the safe, regulated way to buy Bitcoin, ETH, SOL and other digital assets. Trade crypto with up to 85% lower fees than top competitors and trade ETH and SOL NFTs with no gas fees and subsidized gas on withdrawals. Sign up at FTX.US today. - “The Breakdown” is written, produced by and features Nathaniel Whittemore aka NLW, with editing by Rob Mitchell and research by Scott Hill. Jared Schwartz is our executive producer and our theme music is “Countdown” by Neon Beach. Music behind our sponsors today is “War” by Enoch Yang. Image credit: Yuichiro Chino/Getty Images, modified by CoinDesk. Join the discussion at discord.gg/VrKRrfKCz8.

Welcome back to The Breakdown with me, NLW. It's a daily podcast on macro, Bitcoin, and the big picture power shifts remaking our world. The breakdown is sponsored by nexo.io, Circle, and FtX, and produced and distributed by CoinDes. What's going on, guys? It is Thursday, October 27th, and today we are talking Bitcoin mining. Before we get into that, however, if you are enjoying the breakdown, please go subscribe to it, give it a rating, give it a review, or if you want to dive deeper in, at the conversation. Come join us on the Breakers Discord. You can find a link in the show notes or go to bit.ly slash breakdown pod. Also a disclosure as always, in addition to them being a sponsor of the show,

I also work with FTX. All right, folks, so as I said, today we are catching up on the Bitcoin mining space. There is a lot happening here that I think is worth some deeper consideration. Since the crash in Bitcoin's price during the first half of this year, something unintuitive has been going on in Bitcoin mining. Hash rate has been going up, and not just by a little. Hash rate is currently sitting at around 260 X a hash per second. Those are at all-time high levels and 45% higher than the 2021 peak, just before the Chinese mining ban at the beginning of the summer. This year, there was one small dip around 13% over the summer, as the Texas electrical grid exercised its right to curtail mining activity. And we got news that miners had sold 27% of their

Bitcoin stacks on aggregate amid rumors of financial stress and pending bankruptcies within the industry. Since then, hash rate has been to quote, sue up only. It added 10% in August, 4% in September, and a massive 13% so far this month. Now, in a bull market, additional hash rate is a positive indicator. It means more miners are adding to network security and operations are highly profitable. Bare market hash rate increases can tell a whole different story. Additional hash rate forces the network to adjust its difficulty upwards. This month saw one of the largest difficulty adjustments in the history of the Bitcoin network, up 17% between the two adjustments in October. We now find ourselves with difficulty at all-time highs, hash rate at all-time

highs, and minor profitability highly questionable. Because of that, analysts are starting to get concerned about the state of the industry. Dylan LeClair, an on-chain analyst at Bitcoin magazine, writes, some juicy rumors flying around about some big-name Bitcoin miners being in trouble here. You can see it in the skyrocketing hash rate. Pressure is absolutely building for some industry participants. Glassnote around the same time wrote the Bitcoin hash price has reached an all-time low of 66,500 per XA hash. This means that Bitcoin miners are earning the smallest reward relative to hash power applied in history and likely puts the industry under extreme income stress. So what's going on? One of the reasons that analysts are so concerned

is that we've actually been here before. The current dynamic is eerily similar to the state of the network in late 2018. Bitcoin price had dumped from a high of almost 20,000 in December 2017 to $6,500 by mid-September 2018. Bitcoin then traded within a $200 range for two months. Now, throughout this entire drawdown, hash rate steadily climbed, almost quadrupling over the course of 2018. In November 2018, both hash rate and price dropped like a rock. In the last six weeks of 2018, Bitcoin nearly halved in price to 3,300. At the same time, 35% of the hash rate disappeared from the network. We saw then what was unmistakably minor capitulation, as insolvent Bitcoin miners sold their coins into an illiquid market in high volumes and thus dumped the price. Now, a sub-theme of the 2018 minor capitulation was companies operating at a loss to capture market share.

At the time, Bitcoin mining was a much less developed industry with more limited access to debt funding. So for most, once mining became unprofitable, it was time to turn off the machines and wind up the company. There were some large-scale corporate miners, though, with the balance sheet and efficiencies of scale to withstand a period of unprofitable mining. In November 2018, the estimated average cost of mining of Bitcoin was around $7,000, a 7% loss. The miners that could keep the lights on kept mining, but the smaller-scale miners exited the industry. So have we seen anything similar this year? We have already seen one round of minor capitulation over the summer. This culminated with Compute North, the second largest Bitcoin mining hosting provider in the U.S.

filing for bankruptcy in September. They had debts of over 500 million owed to more than 200 creditors. There were also reports of mining companies of all sizes dumping huge quantities of Bitcoin onto the market to stay afloat. With their main competitor going through bankruptcy, the operation of U.S. hosted mining facilities has now consolidated on core scientific, the largest Bitcoin mining company in the world. In recent months, the company, which hosts Bitcoin mining rigs for other operators within their facilities, has raised their prices by 20 to 25% according to industry sources. Last week, sources said that Core Scientific would be raising the hosting rates to just under

10 cents per kilowatt hour of electricity used. That is a big problem for operators of older mining rigs. Ethan Vera, the chief operating officer at mining services firm Luxor Technologies, commented on the reported price change. He said, all units outside of the Bitmain Antminer S19 XP go into negative gross margin territory above $0.9 per kilowatt hour. Now, the S19 XP is the most recently delivered top-of-the-line mining rig. If hash price, a measure of mining profitability, trends down, we expected to hit some resistance points as the high-cost operators and low efficiency miners turn off. Now, there are, of course, a lot of assumptions baked into these numbers, especially

the effects on any volume discount. But the concept directionally is that miners are being squeezed and it's likely that a large portion of the hash rate is currently mining unprofitably. Prior to the most recent difficulty adjustment, Glassnode put the cost of production for Bitcoin at around 12,000, with a level of 17,000 representing acute financial stress for miners. The pressure of negative cash flows is starting to show up as financial stress for miners as well. Early in October, Argo blockchain hit liquidity issues. The firm has agreed to issue 87 million shares around 15% of the company's equity to a single strategic investor to raise $27 million.

It also decided to sell 3,400 ant-miner S-19 pro miners an older model for $7 million. CEO Peter Wall said, quote, our profitability has been squeezed from both sides, from higher energy prices to lower Bitcoin price. That's resulted in a cash crunch for Argo. Wall was confident that these measures would provide sufficient short-term liquidity to make it through the bare market. Quote, assuming all our transactions close, we're confident we have the liquidity and balance sheet to get us through the next 12 months.

Now, one of the things that Peter Wall mentioned was the increased price of electricity. This is obviously causing a squeeze on miners globally. In late September, reports surfaced that European mining was migrating north. hash rate, which had previously been located across Europe, was relocating to northern Scandinavia. Northern Scandinavia sees almost 100% of its energy generated from renewable sources, and available at one-tenth the price elsewhere in Europe. Fiorenzo Mangienello, founder of the Switzerland-based Kawa Energy, which is a mining company that also provides venture funding, said that in southern Norway it had become, quote,

impossible to mine given high energy prices. He called the situation a macroeconomic disaster for the industry in Europe. On top of high energy prices that have, admittedly, eased off dramatically as the European winter gets off to a warm start, the political climate is growing more icy. Last week, the European Council issued a warning to its member states that, quote, in case there is a need for load shredding in the electricity systems, the EU member states must also be ready to stop crypto assets mining. While the amount of mining that hasn't been driven out already by high energy prices seems

likely to be minimal, the escalating tension between the crypto mining industry and the European and executive branch, seems likely to cause some companies to consider relocating permanently out of the reach of EU bureaucrats. Want to keep more profits when trading? Get the best possible prices and trade with 50% lower fees on Nexo Pro. The new Spot and Futures trading platform uses aggregated liquidity of over 3,000 order books collected from multiple sources. Utilizing the complete Nexo Suite allows you to earn interest and borrow funds as you

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Now what about consolidation? One of the key features of the 2018 hash rate collapse was the consolidation of the mining industry and some are positioning to take advantage of a similar dynamic. In late September, Jihon Wu, the founder of miner manufacturer Bitmain, and who now leads spin-off company BitDeer, announced that he was raising $250 million to purchase distressed assets from insolvent mining companies. The fund would be partially funded internally with $200 million to be raised from outside investors. BitDeer CEO Matt Kong said, quote, we can buy the cheaper machines and run them in our existing facilities with stable and

cost-effective power purchase agreements. Binance are taking a slightly different approach, launching a $500 million credit facility for public and private miners. This is interesting because one of the big changes in the mining industry in 2020 and 2021 was the availability of credit. With interest rates on the floor and the corporate debt market implicitly backed by the Federal Reserve, many large miners took the opportunity to sell bonds into the market. It's a reasonable assumption that smaller players took on debt from other sources to fund expansion as well. While some were able to access longer-term loans, other miners are coming under pressure as their loans come up for renewal.

The credit market is nowhere near as freely accessible as it was last year, and the terms are much more restrictive, to the point of being un-economical for some. That's where the Binance facility comes into play. The lending will be operated through Binance's Mining Services arm Binance Pool. It will offer collateralized loans over a duration of 18 to 24 months. While this loan availability might help some miners hang on a little longer, it also seems likely that the facility will be structured with high interest rates which do not allow a company to easily recover to profitability without a turn in the broader crypto markets. At least part of the calculus seems to be that Binance will make the loans against the collateral

of mining rigs and digital assets both at heavily depressed prices, and which can be seized if loans default. Other organizations are also providing emergency credit to the mining industry. Defi Platform Maple Finance announced in mid-September that it would be establishing a $300 million lending pool, which would allow users to lend funds to miners. The platform initially said it would charge between 15 and 20 percent interest rates over a 12 to 18-month term on a fully collateralized basis. Glyn Jones, the CEO and founder of Icebreaker Finance, who are managing the lending pool, said back in September that, the case for investing in Bitcoin miners right now is quite compelling, as borrowers still need capital and are, quote, willing to agree to different

terms than they would have agreed to nine months ago because they don't have many choices. Whatever their precise terms are, it seems they were quite compelling. Maple Finance now has a pipeline of six to ten mining companies in place to form the first cohort of borrowers and another 25 on the wait list, according to CEO Sidney Powell. The terms have also become more stringent since the original announcement. The interest rate will now be 18 to 20%, and loans will be on a full recourse basis. That means that borrowers will need to provide a guarantee over all assets, of the company, not just mining rigs and Bitcoin as collateral, so that all company assets can be seized if a minor defaults or enters bankruptcy. Powell told CoinDest this week, quote,

The sector needs liquidity, so we are figuring out creative ways to assist. Typically, the firms you would want to underwrite are those with low levels of debt on their balance sheet, and who have things like power purchase agreements in place, so effectively a longer line of sight on what their electricity will cost. End quote. Until now, mining industry loans are typically non-recourse, meaning that in the case of the default, the company could walk away, forfeiting the Bitcoin or mining rigs put up as collateral. The concern is that Bitcoin miners have been falling in price faster than Bitcoin itself, making them unstable collateral. This is particularly true of older miners which have become unprofitable recently following the release of the new ant miner model.

The lending pool has received its first $10 to $12 million of commitments to loans, and Powell expects this to grow to the full $300 million by the middle of next year. The borrowers include a range of companies, from large publicly listed miners to smaller private miners with locked-in power agreements. Now, it is not a universal story that the industry is suffering. Some companies are still well capitalized and taking the opportunity to expand. CleanSpark, for example, has been on a buying spree for the last few months. In September, the company bought out competitor Moss and Infrastructure Group for a reported $42.5 million. The deal included a mining facility in Sandersville, Georgia, and around 6,500 latest generation mining rigs. The deal came on the back of announcements that

CleanSpark had also purchased 10,000 new Bickmain Antminer S-19J-Pro's for $28 million after credits and discount, a significant markdown from the manufacturer's list price. But let's turn now to the question of how Wall Street is viewing all of this. Jared Mellarood, an analyst at Hash Rate Index, says, if you invested $100,000 in a basket of the five biggest Bitcoin mining stocks at their all-time highs, you would have $11,000 left. So clearly, Wall Street analysts are taking note of the troubles within the industry. Last week, Chris Brenler and analysts at Wall Street Investment Bank, D.A. Davidson, downgraded both Core Scientific and Arco Blockchain from buy to neutral. He wrote, Quote, persistent inflation and rising pessimism around interest rates have pushed back the eagerly

anticipated federal interest rate pivot, and now it's clear that less advantaged miners are already starting to run out of time. Brenler added that he is still positive on Bitcoin's long-term potential, but that he is, quote, pulling the plug for now on the miners as higher power costs, increasing network competition and debt burdens have further strained profitability and liquidity. Brenler had previously been optimistic about publicly listed miners, predicting that lower Bitcoin prices and higher costs would weed out the competition and lower the network's hash rate. Obviously, as is the whole point of this show, this hasn't played out as both mining

difficulty and hash rate currently sit near all-time highs. Publicly traded miners in general have been totally beaten up this year. Shares are down 70% on aggregate and signs of financial stress have flared. In this context, riot blockchain and Marathon Digital are Brenler's favorites in the sector. Quote, as both have low-cost power, funded growth plans, and ample liquidity to capitalize on the impending shakeout. So as we wrap up with all of the stresses on the industry, why is hash rate continuing to rise so strongly? Some recent stories set out the case that large miners are continuing to commit as much hash rate as possible to squeeze out smaller unprofitable miners, thus consolidating the industry. But is there anything else that could be going on?

Some analysts are taking the simplistic greed, that miners are long-term bullish, so they're mining as many Bitcoin as they can. The CEO at CryptoQuant tweets, Bitcoin miners are extremely bullish now. Hashrate to mining revenue ratio hit an all-time high, meaning they keep investing in infrastructure despite very small Bitcoin mining revenue. Historically, miners were underwater in the short term, but never failed in the long term. Another possibility is that increased efficiency of the latest model rigs, combined with advances in immersion cooling installations, are dramatically throwing off profitability models, meaning that some large operations with access to the most efficient setups could be maintaining

profitability as electricity prices begin to squeeze. On top of that, large miners typically operate on longer-term electricity pricing contracts, as well as longer-term debt funding. We could simply be seeing some operators continue to mine with these longer-term cost structures in place. meaning they haven't seen significant drops in profitability yet. Now it seems unlikely that this could account for such a dramatic increase in hash rate, but it could be contributing on the margins. Another possibility, although admittedly an optimistic one,

is that the migration to mining using renewables and waste energy could be going much faster than anticipated. Throughout the year, reporting has shown that co-locating Bitcoin mining facilities with wind farms in Texas has been a popular mode of expansion. There has also been a significant push to deploy miners next to oil wells, utilizing natural gas that was previously flared to power mining rigs. While it's still in its early stages, there's also been a push to use other waste energy like harvested methane from landfills. In the long run, this could mean that hash rate

isn't as exposed to fluctuations in energy costs as it once was, but it seems unlikely to explain it all now. And then finally, there is the argument that this is about Russia. Steve Barbour of upstream data, who is hardly a conspiracy theorist says, Guys, it is Russia. Russia's where the hash rate is going. Manufacturers have admitted to selling more ASICs to Russia than the U.S. recently. And guess what happens when you blow up pipelines in bottleneck energy? Bitcoin fixes it. Russia did not destroy their reliable baseload energy in the name of ESG and carbon cultism. Russia has huge excess of natural gas they cannot export at good prices.

Russia is economically sanctioned by the entire West. What do you think Bitcoin is designed to do? Now, it's hard to say this with any confidence, but there are some indications. In early October, the Russian Ministry of Finance discussed plans to allow any industry to settle international trade in Bitcoin. The director of the financial policy department for the ministry said, quote, we believe that we need local crypto infrastructure. First of all, to protect the interests of citizens, because now those who trade their digital currencies on crypto exchanges are limited. Secondly, to control when digital currency is used legally and when not.

Whatever the case, most people are still bullish long term. Checkmatey, the lead-on-chain analyst at GlassNode says, Bitcoin thrives in an adversarial monetary environment. It's kidding pretty damn adversarial out there. So that is the update on Bitcoin mining. I hope this was helpful. I think it's a super fascinating moment. And one that's unlikely to leave the industry looking exactly as it looks now. But for now, I want to say thanks again to my sponsors, nexus.com, circle and FTX. And thanks to you guys for listening. Until tomorrow, be safe and take care of each other. Peace.