Foolish Lenders

From the "no-one could have predicted" department comes David Pan's Crypto Lenders’ Woes Worsen as Bitcoin Miners Struggle to Repay Debt. The TL;DR is that until recently companies accepted mining rigs as collateral for loans.

“There hasn’t necessarily been the best due diligence on whether a miner was credit worthy or not,” said Matthew Kimmell, digital asset analyst at crypto investment firm CoinShares.

These companies did so little due diligence that they didn't realize the collateral would be worthless in about 18 months, even if Bitcoin continued moonwards. Below the fold, the details.

Pan writes:

Miners, who raised as much as $4 billion from mining-equipment financing when profit margins were as high as 90%, are defaulting on loans and sending hundreds of thousands of machines that served as collateral back to lenders. New York Digital Investment Group, Celsius Network, BlockFi Inc., Galaxy Digital, and the Foundry unit of Digital Currency Group were among the biggest providers of funding to finance computer equipment and build data centers.

BTC "price"

Why can't the miners service their loans? Pan identifies three reasons:

The liquidity crunch hitting digital-asset markets after FTX failed comes as low Bitcoin prices, soaring energy costs and more competition weigh on miners.

These are three good reasons. A year ago BTC was around $57K, it is now below $17K. Bitcoin creates about 144 block/day, and each rewards miners with 6.25 BTC. The transaction fees are normally a small additional amount, so the miners get roughly 1000 BTC/day. So, as the graph shows, their revenue tracks the price closely.

Miners' revenue

But their ability to service their loans depends upon their gross margins. Much of their cost is energy. The spike in energy costs from Russia's invasion of Ukraine and OPEC's pre-election price manipulation clearly had a huge impact on miner's margins.

The "more competition" that Pan identifies comes from two sources, both illustrating the inability of the lenders to understand the business they invested in:

• The first was the inevitable result of the lenders own actions:
  

  “People were pouring dollars into the mining space,” said Ethan Vera, chief operations officer at crypto-mining services firm Luxor Technologies.

  Clearly, the result of massive investment in increasing capacity in a market whose income is fixed in BTC terms could only result in a reduction of the return on the investment in BTC terms. So the lenders were betting that the "price" of BTC would increase faster than the rate at which they were "pouring dollars into the mining space". After last November, this wasn't a good bet, but some lenders were still making it much later. NYDIG gave Iris Energy:
  

  a $71 million loan secured by 19,800 rigs as recently as March. That was the miner’s third facility secured by NYDIG,

  NYDIG was obviously way bullish on BTC back then, despite the Russian invasion of Ukraine's obvious impact on energy prices.`
• The second was the looming transition of Ethereum from Proof-of-Work to Proof-of-Stake. As was forseeable, miners who could no longer mine ETH switched to mining BTC. This caused a spike in the BTC hash rate, meaning the fixed supply of BTC rewards was shared among more miners, reducing their revenue.

Hash rate

You can see the Proof-of-Stake spike in the hash rate, but you can also see what has happened since as the increased competition hit each individual miners' share of the total revenue.

The lenders looked at the ludicrous margins the miners were earning at the peak of the BTC "price", and failed to understand that these didn't reflect the underlying profitability of the mining business.

Because anyone can mine if they can get their hands on hardware efficient enough to earn more than the cost of the electricity it burns, in a steady state margins would be very low. But when BTC is heading moonwards, that is a big "if". The profits they were making were because the supply of state-of-the-art rigs was constrained, limiting competition.

But there is another important reason that Pan doesn't identify:

Loans backed by the computer equipment, known as rigs, had become one of the industry’s most popular financing tools. Many lenders are now likely facing substantial losses since they can’t seize any other assets besides the machines, whose value has dropped by as much as 85% since last November.

This should not have been a surprise to the lenders. In 2014's Economies of Scale in Peer-to-Peer Networks I wrote:

When new, more efficient technology is introduced, thus reducing the cost per unit contribution to a P2P network, it does not become instantly available to all participants. As manufacturing ramps up, the limited supply preferentially goes to the manufacturers best customers, who would be the largest contributors to the P2P network. By the time supply has increased so that smaller contributors can enjoy the lower cost per unit contribution, the most valuable part of the technology's useful life is over.

And in 2018's The State of Cryptocurrency Mining, David Vorick wrote:

The biggest takeaway from all of this is that mining is for big players. The more money you spend, the more of an advantage you have, and there’s not an easy way to change that equation. At least with traditional Nakamoto style consensus, a large entity that produces and controls most of the hashrate seems to be more or less the outcome, and at the very best you get into a situation where there are 2 or 3 major players that are all on similar footing. But I don’t think at any point in the next few decades will we see a situation where many manufacturing companies are all producing relatively competitive miners. Manufacturing just inherently leads to centralization, and it happens across many different vectors.

In other words, mining profits depend on (a) cheap electricity and (b) early access to leading-edge rigs. Bitmain has a history of introducing a new, more efficient chip about every 18 months, so it should have been evident that rigs were a wasting asset. This effect wasn't news when in December 2021 Alex de Vries and Christian Stoll estimated that:

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

Depreciation rates

It gets worse. Miners' profits should also depend on accurate accounting but as Paul Butler documented, the miners were using bogus accounting to pad their margins. Their rigs were worthless after about 18 months but their accounts depreciated them over five years. Their margins were partly due to not reserving enough cash to replace their rigs when they became uneconomic.

So the lenders now have a huge pile of uneconomic rigs, either because the miners they lent to ran out of cash:

Iris Energy Ltd. said this month it expected to default on $108 million of limited recourse loans, which is mostly backed by mining rigs. ... Core Scientific Inc., which has warned of bankruptcy, had $39 million of rig-backed loans with NYDIG, and $54 million with now bankrupt BlockFi, as of September. Stronghold Digital Mining already returned around 26,200 mining rigs in August to eliminate $67 million debt owed to NYDIG.

Or because the miners can't make money using them:

While miners tend to default when they are cash-depleted, some companies may have decided to stop paying the loans even if they still have cash on balance sheets, according to Luxor’s Vera. The collateral can be worth less now than the remaining payments for some miners.

What are the lenders to do with the rigs?

Lenders are already looking at a glut of machines after liquidating rig-backed loans from miners. They face the option of selling equipment at a steep discount or finding data centers to mine Bitcoin themselves.

Neither is a good option. Selling will drive down the value of their remaining collateral and encourage miners to dump more rigs on them. If the miners can't make money running the rigs, neither can the lenders. And if they do end up running the rigs that is going to drive down the income of their borrowers, causing more bankruptcies and thus more rigs being dumped on them.

How bad is mining these days (hat tip Amy Castor and David Gerard):

Just how bad is the crypto collapse?

My landlord friend in Dallas just asked me if I know anything about bitcoin miners:

“This bitcoin mining company defaulted, moved out, and left all their equipment behind.”

200 Antminers 🏃🏽‍♂️💨 pic.twitter.com/qUNStCYT5F

— Zack Guzmán (@zGuz) November 21, 2022

The most amazing thing about this situation is that the lenders who didn't understand the business asking for money were not generic banks faced with an unfamiliar industry. They were specialist cryptocurrency lenders:

New York Digital Investment Group, Celsius Network, BlockFi Inc., Galaxy Digital, and the Foundry unit of Digital Currency Group were among the biggest providers of funding to finance computer equipment and build data centers.

Note that in the case of Celsius and BlockFi, it is the liquidators who are wondering what to do with the huge pile of worthless rigs, and it is likely that Digital Currency Group will join them. New York Digital Investment Group isn't looking healthy either. The tide is going out and we are seeing that everyone in the cryptosphere is swimming naked.

Also swimming naked is the state of Texas, as detailed in David Pan and Naureen S Malik's Texas’s Crypto Mining Boom Is Starting to Look More Like a Bust:

The digital gold rush in Texas is losing its luster as Bitcoin miners grapple with financial woes, leaving behind what some fear will be a wasteland of unfinished sites and abandoned equipment.

In an effort to become a haven for crypto mining, Texas has aggressively lured miners with cheap power and favorable regulations, prompting many to take out billions in loans to buy pricey machines and build out infrastructure.

However, soaring energy costs, a sharp decline in Bitcoin prices and more competition have compressed profit margins and made it difficult for miners to repay debt. Some are on the verge of bankruptcy.

Ever ready to destroy the environment for short-term profit, and never ready to make their electricity grid sustainable, Texas leapt on the opportunity of the Chinese crackdown on mining. Pan and Malik write:

For one, local authorities provided incentives such as tax abatements that reached into the tens of millions of dollars. The power generation planned that the region sorely needs to avoid another energy crisis may not materialize. Some developers made hefty investments to build out Bitcoin mining facilities. The average cost to have one-megawatt capacity of mining infrastructure is currently around $300,000 in the state, the high end of the range

Given that miners are declaring bankruptcy and defaulting on loans, the numbers are insane:

Texas has about 1.5 gigawatts of crypto mining capacity, mainly Bitcoin, operating with about 37 gigawatts vying to connect to the state grid as of Oct. 20, according to the most recent data available from the Electric Reliability Council of Texas. That queue has more than doubled in six months.

37GW at $300K/MW is $11B. Even if the existing miners were profitable, which they aren't, why would anyone think it made sense to invest another $11B to increase competition for the fixed supply of, at the current price, $5.6B/year?

Update: Part of the explanation for the Proof-of-Stake spike in the Bitcoin hash rate comes from Eliza Gkritsi's A Huge Glut of Bitcoin Mining Rigs Is Sitting Unused in Boxes:

Hundreds of thousands of brand new mining rigs that could be generating bitcoin (BTC) have never been used, further skewing the economics of cryptocurrency mining, a sector that has been hit hard by sinking prices for bitcoin and other tokens and by high energy costs.

Last year, miners struggled to buy enough rigs. Manufacturers couldn’t fulfill orders fast enough. Now, Matt Schultz, executive chairman of bitcoin miner CleanSpark (CLSK), figures 250,000 to 500,000 mining rigs are still sealed up in boxes in the U.S. alone, based on his conversations with analysts. Ethan Vera, chief operating officer of mining services firm Luxor Technologies, put the number at 276,000 worldwide in September.

Once the chips became available, the bottleneck switched to rack space. That bottleneck was alleviated by the "The Merge". Then it took a while for the added competition for the fixed supply of BTC at a fairly constant $16-17K to force out the least competitive miners, and bring the hash rate down close to the pre-Merge level.