Generally Accepted Accounting Principles

One thing that has been true since the first GPU hit the market is that a better one is close behind. The same has been true since the first mining ASIC hit the market. I first wrote about this in 2018's ASICs and Mining Centralization. Recently, Alex de Vries and Christian Stoll estimated that:

The average time to become unprofitable sums up to less than 1.29 years.

This of course causes Bitcoin's massive e-waste problem. But David Gerard links to a fascinating blog post entitled The problem with bitcoin miners in which Paul Butler describes a more immediate problem it causes. The explanation is below the fold.

Butler writes:

Bitcoin miners have a relatively simple businesses to model. They spend a bunch of money up front on mining equipment (dominated by the cost of the actual mining hardware), and then have recurring costs of operations (dominated by electricity costs).

Generally, miners use straight-line depreciation over five years to account for purchases of mining hardware. At face value, this is a defensible decision. Mining machines turn electricity into hash computations, and the rate at which miners turn electricity into hashes is mostly constant until the machine goes kaput. Five years straight-line depreciation is standard for computer hardware under GAAP, the accounting standards that US-listed miners are bound to.

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Butler uses historical hash rate data to compute the actual depreciation curves for mining hardware, plotting the percentage of the initial bitcoin production rate against time in quarters for each quarter since Bitcoin's inception. The graph shows that initially (bluest lines), when GPUs were introduced, they stopped producing after about 5 quarters. Recently (magenta-est lines), ASICs last longer, stopping producing after about 4 years. But for the whole of Bitcoin's existence the hardware has depreciated far faster than the GAAP's five year straight line.

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Under GAAP, the value of the mining hardware in the company's reports is much higher that its value in terms of generating Bitcoin. Butler plots the rate of Bitcoin generation per million dollars of reported assets against time and explains:

If it’s true that miners are sitting on a bunch of overvalued assets, we should see a downward trajectory when we plot revenue over assets. Here’s the ratio for two big public miners, Riot Blockchain (RIOT) and Marathon Digital Assets (MARA). I’ve annualized the monthly amounts to account for differences in month length, and linearly interpolated their reported property, plant, and equipment (PP&E) asset book value between filing dates.

In simple terms, this excess depreciation means that the company's real cost for creating income is much higher than they report, and thus their real profit as a continuing business is much less than they report, because they are not putting aside the money they will need to replace obsolete hardware.

So far, so interesting, but expressed in terms of Bitcoin per million dollars of assets. What really matters is million dollars of income per million dollars of assets. Over the year in that graph, the Bitcoin price dropped from about $49K to $39K, and is now down below $30K. So if Butler had drawn the graph in dollar terms the drop would have been far faster.

Butler suggests that investors simply look on these mining companies as a bet on the future moonwards progress of Bitcoin:

In Q1 2022, miners collectively earned approximately 82,000 bitcoin, of which ~81,000 came from the block reward and the remaining ~1,000 (1.2%) came from mining fees. RIOT earned 1,405 of these, or 1.7%.

As of writing, there are 1,960,775 bitcoin remaining to be mined. If RIOT could sustain their 1.7% share of the mining market, they would earn 33,333 of those bitcoin. At today’s cost of $30,000 market price, all of those bitcoin would be worth just under $1B. RIOT’s market cap is currently just above $1B. Even in a fantasy world where RIOT could sustain its market share and never pay for electricity, hardware, staff, etc., it would still be a more expensive way to own a stake in the pool of unmined bitcoin than just spending the same money on bitcoin today. All that’s left for miners after the new bitcoin are all mined is that sliver of transaction costs that currently represents 1.2% of miners’ revenue.

MARA’s numbers look similar. They earned 1,258.5 bitcoin in Q1, or 1.5% of the market. 1.5% represents remaining 29,411 bitcoin, or $882mm worth at today’s cost. Their market cap is $1.2B.

Butler makes a strong case against the miners, but in two respects it should have been much stronger. First, he estimates the miners' effective income by multiplying the number of Bitcoin they mine by the current "price". This assumes that they can sell all the Bitcoin they mine at the current "price". This is a significant over-estimate, as David Gerard has been pointing out for some time, most recently here:

"Bitcoin miner Riot Blockchain (RIOT) produced 511 BTC in March and holds 6,062 BTC. ... HIVE Blockchain Technologies produced 278.6 BTC and over 2,400 ETH in March. As of 3 April, HIVE held 2,568 BTC and 16,196 ETH. ... Miners just love holding cryptos, see. It’s not that they can’t sell them for fear of crashing the market, because number can only ever go up."

That is, these miners have not sold an entire year's production. HODL-ing like this has been a losing game. In mid-April Bitcoin was around $40K. Even if they had sold all their rewards since, the Bitcoin stashes of those two miners alone would have lost more than $86M, or about 110 days' notional income in 45 days. Bitcoin miners in aggregate can't sell the notional $9.86B/year of their rewards because there isn't $9.86B/year coming in to the system from "greater fools". So their actual income in dollar terms is much less than Butler's estimate.

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Second, Butler underestimates the rate of depreciation. He assumes that the ASICs are obsolete when they can no longer keep up with the hash rate so are no longer mining any Bitcoin. That is wrong. ASICs are obsolete when the Bitcoin they mine no longer pay for the electricity they use. The newer ASICs aren't just faster, they also use much less energy per hash. Look again at the depreciation graph, which suggests current ASICs go obsolete after 16 quarters. But Alex de Vries and Christian Stoll's estimate of 5 quarters to obsolescence is based on comparing the ASIC's production with the cost of their power consumption, which is the correct approach. The curves in the graph are correct out to the 40% line, but then should drop to zero.

Butler's post has an amazing sting in the tail:

There’s one group of people for whom bitcoin mining is an extremely lucrative business: executives. Last year, one MARA executive earned over $220 million in cash and stock-based compensation, in a year when the company’s total revenue was $150 million. RIOT’s top five executives collectively took home a more modest $90 million in a year with a net loss.

This, I think, points to the crux of the problem. Investors have been happy to provide capital to these companies, looking for anything in the public markets that provides some exposure to bitcoin, without paying much attention to what the companies are doing.

I don’t think it ends well.

PS: Butler's earlier post Betting Against Bitcoin is another well worth reading.