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How Miners Can Hedge Their Inventory to Increase Return on Investment

how-miners-can-hedge-their-inventory-to-increase-return-on-investment

Strategies from the world of traditional finance could offer promise for miners who want to lower the risk associated with holding inventory.

To a newcomer, crypto mining may sound deceptively easy — essentially, a way to switch on a machine, walk away and watch the lucrative crypto rewards roll in. But the reality is a little more complicated.

The oldest and most powerful crypto out there, Bitcoin (BTC), uses a proof-of-work algorithm to ensure it’s blockchain’s security, and plenty of other influential cryptos have followed suit. Miners in PoW protocols receive a crypto reward whenever they’re the first to submit a correct answer to the cryptographic math problem that seals each new block of data on the blockchain. The more miners there are operating on one blockchain network, the stiffer the competition becomes to solve this problem and win a crypto reward. 

To improve their chances, miners generally use hardware rigs that demand more and more hardware components and electricity to become more powerful. Crypto miners need to make significant rig investments and pay high monthly electricity bills if they want any chance of earning a mining reward more than once or twice in a blue moon.

Regions with cheaper electricity tend to attract more miners, but even among these operations, profit margins tend to be tight. As a result, miners generally sell off their mined crypto as soon as they can. Selling their earnings for fiat not only helps them keep their rigs turned on but also lowers the risk of wiping out their profits or even having their capital sunk into mining equipment if market prices drop. That cautious business model also makes it harder for miners to earn a high return on investment, which is enjoyed by more institutional crypto traders — especially when they have access to sophisticated strategies borrowed from the world of derivatives and traditional finance.

But as crypto markets continue to mature, more and more asset classes become available to miners and can help them earn a higher ROI on their mining investment — without risking huge losses in a volatile crypto market.

Interest-bearing accounts

High-interest accounts are an ideal low-risk solution for any crypto owners who feel bullish about their assets and prefer to hold. Miners can deposit their inventory with account providers, who use those held assets to provide loans to vetted crypto users looking for extra capital. 

The borrowers repay their loans to the account providers over time with interest, and the account provider shares that interest with the account holder. These accounts tend to generate more interest the longer account owners agree to lock up their funds. Typical accounts with popular services such as Compound, BlockFi, Celsius and DeFiner offer 5%–10% annualized returns.

Futures contracts

Crypto experiences market volatility like any other commodity — and futures contracts can help miners turn that volatility into a revenue generator. Futures contracts are securitized agreements to sell and buy an asset at a price and time agreed upon when the future is created. Crypto miners can lock up some of their crypto inventory in a futures contract and sell that contract for more than the crypto’s current marketplace value.

During periods of a market condition called contango, futures contracts are priced higher than their current “spot price” — the market price traders pay to immediately acquire the asset. The difference between futures prices and spot prices is also referred to as the premium to spot pricing. Instead of selling their newly mined crypto for the current spot prices, miners can sell a dated futures contract to lock in that premium.

While exploring futures contracts, miners should be aware that they’re often cash-settled, meaning upon expiration, the futures seller will transfer the cash equivalent of the buyer’s promised position in the underlying asset’s market rather than the asset itself. Cash settlement is of limited use to crypto miners who actually own and eventually want to transfer their tokens, so miners should focus on physically settled futures contracts to ensure that their inventory actually changes owners.

Options contracts

Someone selling an option isn’t selling an asset itself — rather, they’re selling the right, but not the obligation, to buy that asset at a set price (called a strike price) at a later, agreed-upon time. Miners can sell options on their existing inventory and future inventory. 

After selling options on future inventory, they can use revenue from the sale to increase their mining operation’s output per day, setting them on the right track to meet future obligations created by the options. Traders can also sell options that are “in the money,” which means that their eventual strike price is lower than the crypto asset’s current price. 

If the market price is still above the strike price when the contract expires, the option holder is likely to exercise it, and the miner sells their inventory at the agreed-upon strike price as indicated in the options contract. If the market price is below the strike price, then the holder won’t exercise it because they could get the same amount of crypto for cheaper going directly through the market. With the option expired and unused, the crypto miner gets to keep both the original crypto inventory and the premium they made selling the option in the first place.

Contracts are key to implementing a “Collar,” one of the most common hedging strategies for crypto inventory. To use a Collar, miners buy two kinds of options simultaneously. They would buy a put option below the market price of the asset, which is the right to sell the token at a set time and price. However, they would sell a call option above the market price of the asset, which is the right to buy the token at a set time and price. 

Sale of the call option generates the revenue needed to cover purchasing the put and only cuts into the trader’s profit if the token’s spot price eventually increases above the price delineated in the call option. If the token’s market price drops below a certain benchmark, miners can exercise their put option at its expiration and sell off their inventory at the put’s price rather than actual, lower market prices. The Collar thus keeps the miner from experiencing huge losses or huge gains even in a volatile market.

In this example, the miner has asset protection in the event the price drops below $220, however, the profit is limited if the asset price rises past $260 due to the sale of the call option. The net cost of protection is a profit here due to the difference between the sale and purchase of the call and put, respectively. The maximum profit is limited to $23 and the maximum loss at $17, given the current ETH/USD price of $239.

Over-the-counter negotiations

Over-the-counter negotiations go through avenues outside of exchanges and other public venues, happening instead mostly through brokerages and private transactions. Most crypto miners who use OTC services sell forward contracts. Forward contracts, much like futures contracts, consist of agreements to sell an asset at an agreed-upon time and price. But while futures contracts are standardized to be bought and sold in trading venues, forward contracts tend to be customized to meet the needs of each buyer and seller. 

Some customizable aspects include the amount of the asset and the agreed-upon date but can generally include any terms, given all parties involved agree to them. Miners can sell forward contracts on inventory they don’t even own yet through OTC negotiations and use the sale revenue to expand their mining operation, which makes it more likely they’ll end the contract both meeting its inventory terms and possessing a more powerful mining rig.

Conclusion

The aforementioned strategies are from the world of traditional finance, and they can offer some promise for miners who want to increase their ROI without increasing the risk associated with holding inventory. In addition to immediate ROI increases and higher inventory retention, these strategies could also make overall market conditions better for market participants as a whole. Without the constant supply pressure of miners trying to offload their mining rewards immediately, crypto prices are likely to go up, making rewards more valuable and mining more profitable.

In practice, sophisticated miners will likely use a combination of these strategies. For example, miners may opt to hold the majority of their inventory in interest-bearing accounts and a smaller portion on a derivatives trading venue where traders buy and sell options and contracts to hedge their overall position. 

Derivative platforms typically provide leverage on the collateral posted at the venue, and miners will benefit from the time duration associated with the derivative contracts. Executing this strategy will undoubtedly both increase the return on the investment for the mine operators and improve market pricing as a whole.

This article does not contain investment advice or recommendations. Every investment and trading move involves risk, readers should conduct their own research when making a decision.

The views, thoughts and opinions expressed here are the authors’ alone and do not necessarily reflect or represent the views and opinions of Cointelegraph.

This article was co-authored by Warren Lorenz and Aly Madhavji.

Warren Lorenz is the chief strategy officer of Pipefold — a non-custodial clearinghouse for digital assets that eliminates counterparty risk, liquidity risk and hacking risk, helping institutions to efficiently allocate capital across crypto markets. Warren is also a limited partner at Weave Markets — a digital asset hedge fund — and was the previous managing director of trading operations at Amplify Exchange. As an entrepreneur, Warren has built multiple products that were licensed and sold to hedge funds, proprietary trading offices and family offices.

Aly Madhavji is the managing partner at Blockchain Founders Fund, which invests in and builds top-tier venture startups. He is a limited partner at Loyal VC. Aly consults organizations on emerging technologies, such as INSEAD and the United Nations, on solutions to help alleviate poverty. He is a senior blockchain fellow at INSEAD and was recognized as a “Blockchain 100” Global Leaders of 2019 by Lattice80. Aly has served on various advisory boards, including the University of Toronto’s Governing Council.

Written by btcethereumadmin

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