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Original source: Blockware Compiled by: Shared Finance Neo Editor’s Note: The original title is “Understanding Bitcoin Market Participants — The Fragility of Miners Driving Bitcoin Prices” Many analysts believe that there is a price floor for Bitcoin, created by the breakeven point of Bitcoin miners' production costs. This assertion is inaccurate. In fact, as the price of Bitcoin gets closer to the cost of production for miners, the sell-off in Bitcoin tends to accelerate. The price of Bitcoin has always been under selling pressure, which originates from miners. Price support is actually built on miner capitulation and a net reduction in hash power on the network - a favorable difficulty adjustment. Understanding the game theory as it applies to miners is critical. The cost for miners to produce Bitcoin is determined by their electricity costs, as 95% of a miner's operating expenses are electricity costs. Miners need Bitcoin to reach a certain price so that the Bitcoin revenue they earn exceeds the electricity costs. Miners with the lowest electricity prices have a significant comparative advantage. We will analyze the following: The Bitcoin Network: Who are the market participants and how do they affect the price of Bitcoin? Peeling back the layers of the mining network How a new generation of mining equipment is leveling the playing field — keeping miners in the race to keep electricity prices high Debunking the myth that the miner’s breakeven price is a price floor The impact of the 2020 halving on the Bitcoin industry — a three-pronged approach Difficulty: Satoshi Nakamoto’s ingenious network stabilization mechanism — understanding its gravity How Miner Capitulation Could Accelerate Bitcoin’s Bottom
The three main types of Bitcoin market participants 1. Investment funds: hedge funds, venture capital funds, family offices and other institutional investors. They almost exclusively adopt a "long only" strategy and rarely go short. They usually have a long-term bullish tendency, but if their beliefs are tested, they have the ability to exit their positions at any time and walk away. 2. Holders: Long-term accumulators who seek to maximize their Bitcoin holdings. Holders have a long-term bullish bias and are less sensitive to price fluctuations than investment funds. However, like investment funds, holders can exit their entire position and leave at any time. 3. Miners: The backbone of the Bitcoin network. Miners have higher confidence in Bitcoin than investment funds and coin holders. They have a long-term vision. The assets they invest in have a long life cycle and can neither be repurposed nor quickly liquidated at fair market value. ASIC mining equipment has a life cycle of more than 3 years and can only be used to mine the Sha-256 protocol (almost exclusively Bitcoin). Bitcoin mining facilities have a life cycle of more than 5 years and are usually reorganized warehouses designed specifically for cooling mining equipment. On average, it takes miners 18 months to break even after investing money in mining equipment, facility construction, and electricity expenses. Miners are the main driver of selling pressure on the Bitcoin network. They receive all newly issued Bitcoins, and they must sell Bitcoins to fund capital expenditures and operating expenses for mining operations. Selling pressure from miners Approximately 54,000 new Bitcoins are mined each month. If Bitcoin is trading at $10,000, that equates to $540 million in new Bitcoin supply available to miners each month. A large portion of those 54,000 Bitcoins must be sold by miners to pay for electricity. Miners with higher electricity prices must sell a larger percentage of their Bitcoins to pay for electricity. Most of the capital outflow on the Bitcoin network is driven by miners. How the new generation of mining equipment can compete fairly The dynamic has changed over the past eight months due to the release of a new generation of mining rigs. Bitmain’s S17 Pro 50T consumes 50% more energy than the S9 13.5T but produces 300% more hashing power. Each S17 Pro 50T deploys the equivalent hashing power of four S9 13.5T mining rigs. Tier 1 and Tier 2 miners once accounted for a larger share of the network hashrate, but due to their low electricity prices, they have little incentive to upgrade to the next generation of mining equipment. The older generation S9 13.5T uses 16nm chips, while the S17 Pro 50T uses 7nm chips. Chip innovations have made electricity less important because computing power consumes less electricity. Newer generations of mining equipment reduce the financial impact of high electricity prices. Conversely, lower electricity prices reduce the impact of the relative disadvantage of inefficient older generation mining equipment. For both Layer 1 and Layer 2, the opportunity cost of Bitcoin/balance sheet loss is not conducive to upgrading their mining equipment in exchange for lower production costs, based on the current ratio of older mining equipment still on the network. As long as other layers use old mining equipment, layers 1 and 2 will remain competitive with old mining equipment. And because future hash derived from next generation mining equipment is close to 100% in layers 3-8, layers 1-2 will be forced to upgrade. Bitcoin halving is likely the first of this event. As your electricity prices rise, the opportunity cost of depleting Bitcoin reserves/balance sheet to deploy capital to purchase next generation mining equipment quickly becomes more favorable. In May 2019, forward-thinking miners began predicting that the S9 would be at risk of being discontinued due to the 2020 halving. As a result, over the past 8 months, Tiers 3-8 have aggressively led a hardware upgrade cycle to next generation mining equipment, while Tiers 1 and 2 continue to run their older generation S9s. The next generation miner upgrade cycle has increased the network hashrate by 80%, increasing the percentage of network hashrate represented by Tiers 3-8 - diluting Tiers 1 and 2's share of the total network hashrate. This therefore overturns the predictions of environmentalists about the Bitcoin network, many of which predict that the Bitcoin network's energy consumption will become excessive as it exceeds a certain hash rate. Understanding Bitcoin Miner Behavior The analysis below illustrates the selling pressure from miners operating at different electricity prices as their margins are compressed, and the subsequent relief once unprofitable miners cease production (the effect of difficulty). We provide a game theory-based simulation to illustrate miners' behavior and decision-making under different scenarios. These are not price targets for Bitcoin, but rather the impact on the mining network of Bitcoin at specific price levels, before and after the halving. In this simulation, all miners within a “mining tier” use a single average kWh rate. This simplification consolidates the number of mining rigs that “shut down” at each Bitcoin breakeven price threshold. As miners shut down, this creates a waterfall — amplifying the subsequent adjustments in network difficulty and profitability for the surviving miners. Because of these assumptions, this model creates a “step chart,” an illustration that helps conceptualize reality, but a smoother, more linear progression would better reflect real-world applications. For consistency, this analysis makes the following assertions: S17 represents the new generation of mining equipment, and S9 represents the old generation of mining equipment. The ratio of new generation hashrate to old generation hashrate is currently 61.38% and 38.63% respectively. The electricity price for each miner in layer 1 is uniform, based on the average kWh price of electricity across all miners in layer 1. Therefore, in this analysis, the breakeven production cost for each miner in each layer is equal, and when this price is violated, all miners will stop production. During the analysis period, no new miners joined the network. According to the distribution in the table below, the proportion of S17 and S9 mining machines in each layer is different: Why we are confident in these assertions: Blockware Solutions, LLC is one of the largest distributors of Bitcoin mining rigs in North America. Our customers and partners include: United States, Canada, Mexico, Venezuela, Paraguay, South Africa, Iceland, Sweden, Norway, British Columbia, Germany, Eastern Europe, Kazakhstan, Russia, UAE, Iran, Mongolia, China, Japan and Australia. Our extensive reach: customer base, strategic partners, business associates and network representatives represent more than 20% of the total network hash rate. We have conducted working meetings and peer reviews with the top mining pools and the largest ASIC manufacturers to gain insight into the distribution of hashrate percentages, electricity prices, and mining machine models in each region. We visited a 30-megawatt-plus mining farm in Chengdu, China, as well as hydropower-rich regions in upstate New York and the Pacific Northwest. Customers and partners in Sichuan Province, China, Venezuela, Kazakhstan, West Texas, Upstate New York, and the Pacific Northwest have sub-3c electricity, but most are mining almost exclusively with older generation mining equipment. They have little incentive to upgrade to next generation mining equipment because their low electricity prices reduce the benefits of more efficient mining equipment and cannot justify the significant cost of upgrading to next generation mining equipment. $10K Bitcoin: Significant Profit Margins at Every Tier When Bitcoin was trading at $10,000, every miner layer enjoyed a healthy profit margin, especially the S17 miner rigs. However, for Layer 8 miners, the price of the S9 miners is close to the shutdown price. Even if Bitcoin is worth $10,000, 96.3% of the Bitcoin generated by the S9 on Layer 8 needs to be sold to pay for electricity. Based on the above assumptions, miners must sell at least 39.12% of their Bitcoin (equivalent to $211,225,815) per month to pay their electricity bills. This means that new cash deployed by investment funds and holders must reach $211,225,815 per month to match the fiat outflows generated by mining companies to fund their operations. The selling pressure from miners is consistent, while the new funds raised by investment funds and holders are driven by market sentiment and vary according to the different stages of the market cycle. $7,500 Bitcoin: Debunking the Myth That Miners’ Breakeven Price Is the Price Floor As the price of Bitcoin falls, miners’ profit margins are squeezed. As a result, they are forced to sell a larger percentage of their block rewards to cover electricity costs (revenue is decreasing, but expenses remain the same). Let's look at miners operating S9s in Layer 6, Layer 7, and Layer 8: As the price of Bitcoin approaches and penetrates the breakeven price for miners, miners are now operating at a loss. They must sell all the Bitcoin they mine, plus they have to sell their Bitcoin reserves to pay for electricity. This puts additional selling pressure on the market in addition to the newly mined Bitcoin, which is the opposite of support. Understand actual operational results vs. paper results Many people believe that when miners reach breakeven, they can simply shut down and never run a loss. This is a misconception that is severely misunderstood. Contractual obligations and failed financial management often cause miners to operate at a loss. This forces miners to sell more Bitcoin than they mine; depleting their inventory of Bitcoin and putting additional selling pressure on the market: 1. Miners have negotiated contracts with utility companies for lower electricity prices, but these prices are dependent on minimum electricity usage thresholds. Therefore, some miners will find themselves losing money for a certain period of time because they must continue mining to meet the minimum usage requirements; otherwise they will lose long-term interest. They cannot simply shut down for a week or a month (when it is unprofitable) and wait for Bitcoin to rebound. 2. Many miners send their mining equipment to hosting facilities. These hosting contracts lock miners into a fixed mining rig for 1 to 2 years for a fixed monthly fee (determined by the price of electricity). If the miner defaults on these monthly payments, the hosting facility can confiscate the mining equipment. As a result, many miners will mine at a loss for several months to avoid defaulting and risk losing their expensive mining equipment. 4. Miners become speculators. Miners are human, so there is an effect on human psychology. Many miners try to implement guidelines for when and how much Bitcoin to sell. Many miners may sell all of their Bitcoins after receiving them, weekly, monthly, or just enough to pay for electricity. Unfortunately, when Bitcoin goes up, miners often turn into speculators, hoping to take advantage of the rise. We shared analysis with one of the largest OTC desks in the crypto space. In September 2019, we discussed how some of the OTC desk’s mining clients deviated from their liquidation plans and chose to hold mined Bitcoin in July and August — believing that Bitcoin would continue to run. Bitcoin peaked in late June, and these miners had to sell Bitcoin at much lower prices in late September and October. This situation accelerated the sell-off of Bitcoin because liquidating Bitcoin vaults created more selling pressure in addition to newly mined Bitcoin. In short: When the Bitcoin price was $10,000, only 39.12% of the Bitcoin mined each month needed to be sold to cover electricity costs. Once Bitcoin dropped to $7,500, profit margins for all miners dropped, causing S9 miners to lose money on layers 6, 7, and 8. As a result, 53.18% of the Bitcoin mined each month needed to be sold to cover electricity costs. Miner Capitulation Roadmap Bitcoin price at $7,500 — before halving There are many inefficient, older generation mining rigs mining Bitcoin (Tier 3-8 running S9's). These miners have the most pressure to sell Bitcoin, as most of the Bitcoin they mine needs to be sold to cover electricity costs. Tier 3-8 miners, running S9's also have the highest breakeven prices. They represent the pressure point in the current mining network that is putting downward pressure on Bitcoin's price. Bitcoin worth $5,000 — before halving In the event that Bitcoin continues to fall to $5,000, Tier 6, 7, and 8 S9 miners will be forced to shut down. This results in a favorable difficulty adjustment, raising the breakeven price for all surviving miners. However, despite the benefit of the difficulty adjustment, with Bitcoin worth $5,000, Tier 4 and 5 miners operating S9s will be operating at a loss. Tier 4 and 5 S9s represent new pressure points in the mining network, which makes Bitcoin's price more vulnerable. These S9s will follow the miner capitulation roadmap discussed earlier: they will begin to run out of Bitcoin funds to pay for electricity costs until they become bankrupt and are forced to shut down - which will increase the selling pressure on Bitcoin until the shutdown. Bitcoin is worth $5,000 after inefficient miners shut down After operating at a loss for long enough, miners in Tier 4 and Tier 5 shut down their S9s, which results in a favorable difficulty adjustment for the surviving miners. The shut down S9s in Tier 4 and Tier 5 account for 14.5% of the total network hashrate. This means that after the shutdowns, 14.5% of the newly mined Bitcoins previously collected by Tier 4 and Tier 5 S9s will be redistributed to the surviving miners. This redistribution will increase the breakeven price for the surviving miners and reduce selling pressure on Bitcoin as profit margins for the surviving miners will increase. Newly mined Bitcoins are now being accumulated by the powerful (more efficient miners). Minimum selling pressure from miners has dropped from 69.60% to 51.49% Bitcoin at $5,000 — After Halving In the case of Bitcoin reaching $5,000 via the halving, the network will have undergone a healthy cleanup, putting Bitcoin in the sweet spot of reaching new highs again (even a Bitcoin price of $8,000 would bring substantial cleanup). Mining revenue denominated in Bitcoin will be reduced by 50%. In order to stabilize mining profitability, the price of Bitcoin must increase so miners can earn the same mining revenue denominated in USD. This is critical so miners can fund their electricity expenses. There will be extreme miner capitulation as all S9s above 2.5c (Tiers 2-8) will operate at a loss, and miners running S17s at 6.5c and above (Tiers 7-8) will operate at a loss - forcing them to shut down. Bitcoin Drops to $5,000 After Inefficient Miners Shut Down — Post-Halving Satoshi Nakamoto’s ingenious network stability mechanism: understanding the appeal of difficulty to miners’ profit margins If Bitcoin remains at a lower price level for 2-4 months after the halving, many miners operating at a loss will be forced to shut down. After all the miners operating at a loss have shut down, the profit margins of the surviving miners will drop significantly. We will see a network that is in chaos in the short term, but once the inefficient miners shut down, the difficulty adjustment will return to stability. Difficulty: The Bitcoin protocol has a self-correcting mechanism that stabilizes the profitability of the mining network, ensuring that sufficient incentives are provided to miners to continue to secure the network. Miners are the backbone and security layer of the Bitcoin blockchain. The difficulty mechanism ensures that efficient miners are incentivized to perform. This is one of the most underestimated and poorly understood phenomena in Bitcoin mining. If the mining network experiences margin compression, the least efficient miners will be removed layer by layer. As inefficient miners are shut down, the network now takes more time to mine a block because there are fewer hashes that can solve blocks on the network in a timely manner. If the network does not solve blocks within 10 minutes, there will be a favorable difficulty adjustment. The share of rewards that were once earned by miners that were shut down from the network is now distributed to miners that are still on the network. This is considered a favorable difficulty adjustment. This process will continue until profit margins return to normal or even become very profitable for the surviving/most efficient miners. Mining is all about survival. Difficulty adjustments will reduce the impact of Bitcoin price adjustments on miners that are operating efficiently. The shock before the breakthrough 1. Supply-side economics improved by half Many market participants are speculating about the future of Bitcoin. What is certain is that by mid-May, the selling pressure that Bitcoin may face will be reduced by 50% as the newly issued block reward is halved. A 50% reduction in supply will reduce the modest but sustained downward trend in Bitcoin supply, which is entirely determined by the Bitcoin protocol code. This is a positive catalyst for Bitcoin's price. 2. Improvement in economic conditions on the demand side (due to halving of demand) sparked positive sentiment An economist might say that Bitcoin is worthless because it is currently too unstable to be an effective store of value and too slow to be an effective payment platform. A Bitcoin maximalist might say that Bitcoin is digital gold because it has scarcity. Ultimately, the market determines the price of Bitcoin. Historically, Bitcoin has fallen to the halving and continued the uptrend/bull cycle (always with multiple severe pullbacks along the way). Most market participants deeply understand these historical trends. People can claim that the halving is priced in, but unless you can confirm with the majority of market participants that they have deployed cash positions and reached their price targets, this is unprovable. Opinions differ, and most market participants hold a certain amount of cash positions. Everyone is thinking about the halving, and it creates positive sentiment on the demand side. This psychological positive sentiment will make market participants anticipate and prepare to deploy cash positions into the upward momentum. Everyone saw the trend of Bitcoin halving, and at some point, everyone missed the significant rebound of Bitcoin - this is why Bitcoin is more attractive than any other asset. This is a market, and markets are driven by human psychology. The psychology of Bitcoin market participants is that before the halving, they tend to be bullish. This creates positive sentiment on the demand side of Bitcoin. 3. An opportunistic environment for obtaining capital through debt After the Bitcoin network experiences a significant or sustained favorable difficulty adjustment, the likelihood of a Bitcoin price bottom increases. This is because newly mined Bitcoin is now being distributed and accumulated by the most efficient miners with healthy assets. The amount of Bitcoin (denominated in Bitcoin) received by the surviving miners is proportional to the amount of Bitcoin received by the shut down miners. These rare opportunities to earn money allow the surviving miners to accumulate a large amount of Bitcoin. Many market participants are quickly gaining access to a new stimulus. Through centralized lenders and decentralized lending platforms, miners can obtain debt by using mined Bitcoin as collateral in exchange for cash or stablecoins. Instead of selling Bitcoin, miners can now hold Bitcoin but still be obligated to pay for electricity, configure contracts, purchase more mining equipment, or further expand infrastructure. This dynamic reduces selling pressure from the network, and we believe it will be an important catalyst for Bitcoin prices to rise. As more Bitcoin accumulates through strong hands, it is likely to be held for the long term and build up the equivalent of removing supply from the network. These experienced miners have witnessed capitulation from miners before, with large amounts of Bitcoin on their balance sheets. Many believe that Bitcoin will choose to hold when the price is lower. For miners holding a large amount of Bitcoin, obtaining debt on the market will be another tool for them to hold Bitcoin during price pullbacks, which will reduce selling pressure and accelerate the bottom during pullbacks. Although this may be a source of stimulus for the network, it is worth being cautious about how it will end, as debt usually ends in a bad way when accompanied by excessive speculation. Combining the above three forces, we can expect a strong multiplier effect as the economics of both the supply and demand sides of Bitcoin prices improve dramatically. This is why the post-halving is bullish for Bitcoin prices. Bitcoin bounces to $7,500 after halving - miner capitulation accelerates bottom After miners shut down (capitulation), newly mined Bitcoin is distributed to the most efficient miners, which will minimize selling pressure in the Bitcoin market as these miners are well above the breakeven point. Just like when Bitcoin is sold off, mining companies will shut down to create friction, and when Bitcoin rises, mining companies will reopen to create friction. Many miners may be months behind on electricity, hosting or land lease payments and cannot restart without paying multiple months of rent. This makes it easier for the price of Bitcoin to rise, and as the price rises, a smaller fraction of newly mined Bitcoin will need to be sold to cover the cost of electricity (which remains constant) because the surviving miners have healthy profit margins. Shutdown miners are unable to mine while the price of Bitcoin rises. This is similar to the friction experienced when the price falls and miners operating at a loss cannot immediately shut down production. When the price of Bitcoin rebounds after a major difficulty adjustment, it creates a favorable environment for efficient miners who do not need to shut down to accumulate a larger piece of the pie. Bitcoin price rebounds to $10,000 – post-halving – miner capitulation accelerates Bitcoin price decline Friction prevents inefficient miners from resuming production in a timely manner. As a result, newly mined Bitcoin rewards are accumulated by efficient miners, so the minimum selling pressure of newly mined Bitcoin continues to decrease. With a Bitcoin price of $10,000, the minimum percentage of miner selling pressure drops to 23.33%. The following comparison nicely illustrates how healthy cleanup can be by removing inefficient miners and reducing potential selling pressure on the network: The cycle repeats itself: Bitcoin rises to $10,000 — after the halving — then rebounds after a tough correction After the Bitcoin price has been rising for long enough, inefficient miners are finally able to start over. This leads to an unfavorable difficulty adjustment as more miners compete for the same amount of Bitcoin. This causes the minimum selling pressure from miners to increase from 23.33% to 51.49%. This is a great example of the gravitational pull of difficulty, but what we are seeing is profit compression as miners joining the network adjust difficulty unfavorably. Difficulty stabilizes the mining network and provides sufficient incentive to maintain Bitcoin's security layer. Over time, the profit margins remain high enough to keep determined, efficient miners profitable despite Bitcoin price fluctuations. Eventually, difficulty will eliminate those with inefficient operations, but when Bitcoin prices rise sharply in the short term, even inefficient miners can enjoy healthy profit margins. Many people fear the halving, but if you understand miner psychology, and how game theory will drive behavior, efficient miners should welcome it before and after the halving. Miners with the most efficient mining equipment (6.3c) will feel the pain, but they will survive. Bitcoin will naturally face selling pressure from miners, which drives down the price of Bitcoin. New fiat will be required after the halving to offset the selling pressure from miners. Therefore, by injecting enough fiat into the financial system to achieve long-term price increases, investment funds and coin holders will be more able to stabilize downward pressure.
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