Tuesday, December 6, 2022

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):
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.

20 comments:

David. said...

The fact that:

"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,"

is completely insane can be determined from the current CBECI estimate which is that the entire Bitcoin network consumes between 5.6 and 14.4GW, with a central estimate of 10.1GW.

Texas currently hosts between 10% and 27% of Bitcoin mining, probably 15%. Texas is proposing to add between 260% and 660%, probably 366% to the total. The probable result would be that Texas would host 38.5GW out of a total of 47.1GW, or 82% of the mining power.

Using De Vries' estimate of $10K/GWh the total network power cost would be $87.6B/year. The miners would earn 328.5BTC which, at $17K, would be worth about $5.6B. So the Texan miners are betting that BTC would stay above $266K just to pay for the power, not to mention the equipment, facilities and profit. Or that they can buy from the Texas grid at $0.006/KWh.

David. said...

It gets even more insane:

1) The total capacity of the Texas grid is 85GW, so if the bitcoin miners were using 38.5GW they'd be using 45% of the total.

2) The next Bitcoin halving event is due in May 2024. So unless BTC at least doubles by then, miners' income will be decreased. So all these uneconomic rigs bought a year ago being depreciated over 5 years are on the books at 80% of purchase price (but actually worth only 15% of purchase price) are being valued as if in 2025 and 2026 they would earn 6.25BTC/block would actually only earn 3.125BTC/block

David. said...

The impact of the BTC halvening being ~18 months away makes the insanity of mining economics even worse.

The economic lifetime of rigs is ~18 months. Thus the entire mining infrastructure needs to be replaced between now and the halvening. These new rigs will spend from 0 t0 100% of their life after the halvening. So investment in new rigs is a bet that BTC will at least double in the next 18 months just to maintain the unprofitable current mining economics. Would you take that bet?

David. said...

Another Bitcoin miner in trouble as Molly White reports in Argo Blockchain faces possible bankruptcy:

"When the company accidentally published draft bankruptcy documents to its website, Argo Blockchain was forced to reveal that it is in last-ditch negotiations to raise capital. The company stated that they were still hoping to avoid a Chapter 11 filing, but that they were "at risk of having insufficient cash to support ongoing business operations within the next month". The company has been trying to raise $25–35 million since late August, and when a $27 million equity deal fell through in early November, the miner acknowledged it might soon have negative cash flow."

Daniel Doonan said...

I think there are some problems with the calculated BTC, energy, and dollar quantities if Texas had 82% of mining consuming 38.5 GW continuously.

The following figures are as of now (not accounting for future BTC reward halving or electricity price changes):

82% x 1000 BTC/day x 365 days/year = 299.3 kBTC/year

38.5 GW x 24 hours/day x 365 days/year = 337260 GWh/year.
At $10k/GWh that's only $3.37B/year or $11.3k/BTC.

However, $10k/GWh is $0.01/kWh which seems low even for Texas.

I did a brief web search and found claims of 2.5-5.0 cents per kWh for long term BTC mining contracts in Texas; that's $25k-50k/GWh.
At this rate 38.5 GW costs $8.43B-16.9B/year or $28.2k-56.3k/BTC.

The Energy Information Administration is currently showing "industrial" electricity in Texas at 7.62 cents per kWh; that's $76.2k/GWh.
At this rate 38.5 GW costs $25.7B/year or $85.9k/BTC.

Daniel Doonan said...

Regarding the current situation of Bitcoin miners in Texas:

With 1.5GW of mining representing 15% of the total, they can expect to consume 36GWh/day and mine 150BTC/day. At $17k/BTC, this is equivalent to $70.8k/GWh or 7.1 cents per kWh.

With power contracts for 2.5-5.0 cents per kWh, their power cost is 35%-71% of the sale value of the mined BTC. But using the EIA "industrial" figure of 7.6 cents per kWh, the power cost is 107%.

Therefore, in Texas:
- Miners with the cheapest power contracts are still profitable.
- Miners with more expensive power contracts may be unprofitable (depending on their other expenses)
- Miners without power contracts are unprofitable.

David. said...

Daniel, you are right. Thanks for the correction.

I typo-ed the power cost number from De Vries, it should have been $100K/GWh, thus Texas miners would pay $33.7B/yr.

David. said...

Daniel, you would be right about the current profitability of Texas miners if power were their only cost. But they have to pay interest and principal on the loans they take out to buy the rigs, and rent on the data centers, and staff costs, and the lavish executive rewards:

" 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"

Only miners with 2.5c/KWh are likely to be profitable.

David. said...

In Core Scientific to File for Bankruptcy, Continue Mining Through Process: Report, Sam Reynolds writes:

"While many mining companies have experienced financial distress during the bear market, Core Scientific is the first publicly listed company to declare bankruptcy. On Tuesday, bitcoin miner Greenridge reached a debt restructuring deal with NYDIG that will allow the firm to avoid bankruptcy for now.

Compute North, which operates data centers that host many miners' operations, filed for bankruptcy in September. Generate Capital, a financer of Compute North, said the firm asserted several "technical events of default" in July as crypto prices plummeted during the implosion of Three Arrows Capital. Marathon Digital, a rival of Core Scientific, said that it only expects to recover less than half of the $50 million it deposited with Compute North for services."

The exchanges are stepping in to provide finance for miners using the same dud collateral as the foolish lenders:

"In October, Binance Pool launched a $500 million fund that would provide emergency financing for distressed miners, collateralizing the loans with physical assets as well as the crypto mined by the companies. Bitmain has also launched a $250 million fund with a similar mandate."

David. said...

David Pan reports that BlackRock Lends Money to Bankrupt Bitcoin Miner Core Scientific:

"BlackRock Inc. is among a group of creditors that lent money to Bitcoin miner Core Scientific Inc. so it can continue to operate while it’s in bankruptcy, according to a filing from the asset manager.

BlackRock has committed $17 million of a debtor-in-possession loan through funds and accounts managed by its subsidiaries."

Why would they throw good money after bad?

"The Austin, Texas-based crypto-mining company filed for bankruptcy last week and got access to $37.5 million of fresh cash from a group of creditors that holds most of the company’s more than $550 million of convertible notes. That debt has an interest rate of 10% that’s payable in kind."

David. said...

Jeremy Hill and David Pan report that Crypto Miner Core Scientific to Shut 37,000 Celsius Rigs:

"Celsius Network LLC has agreed to let Core Scientific Inc. shut off more than 37,000 crypto mining rigs that the bankrupt digital-asset lender hasn’t been fully paying for, resolving a months-long conflict.

Core, a Bitcoin miner that hosts rigs for third parties, itself filed for bankruptcy last month and partially blamed non-payment by Celsius for its downfall. Their hosting deal allows Core to pass on some power costs to Celsius, but the company hasn’t been paying those bills since it filed for Chapter 11 protection in July, according to lawyers for Core Scientific.
...
About 41% of Core’s total fleet — or 100,000 servers — were dedicated to hosting its customers as of the company’s Nov. 7 operational update.
...
Celsius owes Core at least $7.8 million for power costs tied to the rigs through November, according to court papers. Turning off the rigs will save Core thousands of dollars per day and the company could bring in an additional $2 million per month in revenue if it can sell the space currently occupied by Celsius to other customers."

David. said...

Lionel Laurent spots a telling sign in Crypto Crash Makes Blockchain a Dirty Word:

"Bitcoin miner Riot Blockchain Inc., once the poster child for rebranding designed to capture the investment zeitgeist, now wants to be known as Riot Platforms after a near-90% share-price fall in 2022. It's a symbolic moment that attests to the B-word's shift to curse from blessing on the stock market, where investors have fallen prey to misguided euphoria and the failure to deliver viable business models."

David. said...

David Pan's Bitcoin Miners Deleverage, Scale Back as Crypto Winter Continues into 2023 continues the theme:

"During the historic bull run in late 2021, miners raised billions of dollars in debt financing to fund their expanding operations. But since the crash early last year, publicly traded miners are refinancing and selling coin reserves as well as equity to repay loans and cover operational costs.

“Miners are trying to deleverage to avoid margin calls or an imminent liquidity crunch if Bitcoin drops below a certain price point,” Wolfie Zhao, an analyst at crypto-consulting firm BlocksBridge, said.

Miners like Marathon Digital Holdings Inc. have raised hundreds of millions of dollars in loans backed by the coin from crypto-friendly banks such as Silvergate Capital Corp., which has been reeling from the crypto industry meltdown."

David. said...

Having proven that they don't understand the business of mining Bitcoin by accepting collateral that would be worthless in 18 months, Crypto Lenders Morph Into Miners as Repossessed Rigs Pile Up by David Pan shows that they still don't understand it:

"Crypto lenders have repossessed so many Bitcoin mining rigs they’re resorting to plugging them in and extracting tokens themselves.

Lenders are getting creative as to what to do with the mining machines they accepted as collateral for the some $4 billion in rig-backed loans they underwrote when the rally in Bitcoin seemed unstoppable. With the recent surge in loan defaults and plunge in cryptocurrencies, the value of new generation machines has dropped 85%, according to data from Luxor Technologies."

Why do they think the miners defaulted in the first place? And what is increased competition for the fixed supply of mining rewards going to do to the miners that haven't yet defaulted?

David. said...

Good luck with that! David Pan reports that Bankrupt Lender BlockFi to Sell Bitcoin Mining Machine-Backed Loans:

"Bankrupt crypto lender BlockFi Inc. plans to sell about $160 million of loans backed by around 68,000 Bitcoin mining machines, according to two people familiar with the matter.

The Jersey City, New Jersey-based company, which filed for protection from creditors in November, started on the bidding process for the loans last year, the people said. Some of the loans have already defaulted and appear to be undercollateralized given the current prices of Bitcoin mining equipment, according to the people."

David. said...

Peter Guest's Bitcoin mining was booming in Kazakhstan. Then it was gone. explains the mining crash in Kazakhstan and elsewhere:

"But the gold rush was doomed from the start. Kazakhstan’s miners—both “white” miners, who took advantage of tax breaks and cheap power, and illegal “gray” miners, who exploited Kazakhstan’s crony politics and lax governance to operate below the surface—overloaded the country’s energy grid. By the end of the year, the mining industry was consuming more than 7% of the entire generating capacity of Kazakhstan, a country of 19 million people. The surge tipped the grid over from surplus into deficit. Power shortages led to localized blackouts in parts of the country, exacerbating existing tensions over corruption, nepotism, and the rising cost of fuel. In January 2022, these issues boiled over into mass protests. Within weeks, the government effectively cut miners off from the national grid, bringing the boom to an abrupt end."

David. said...

David Pan reports that Bitcoin Miner Argo Hit With Lawsuit Over ‘Misleading’ US IPO:

"The miner allegedly made false or misleading statements and failed to disclose that it was facing significant capital constraints, electricity costs and network issues, according to the Jan. 26 court filing. That in turn hampered Argo’s ability to mine Bitcoin, execute its business strategy, meet obligations and operate its Helios mining facility in Texas, claims the suit."

The IPO was in September 2021. "The shares have tumbled by nearly 90% since Bitcoin’s last bull run in November 2021."

David. said...

david Pan reports that Riot’s Bitcoin Mining Still Crimped by December Storm in Texas:

"The company has a 750-megawatt capacity Bitcoin mining facility in Rockdale, Texas — one of the largest sites for crypto-mining by computing power in the world. Riot said 17,040 out of its 82,656 Bitcoin mining machines were off as a result of damage to the facility from severe winter storms in late December, according to an operational update Monday.
...
“As previously disclosed, some sections of piping in Buildings F and G were damaged during the severe winter storms in Texas in late December, impacting approximately 2.5 EH/s of our hash rate capacity,” Riot’s Chief Executive Officer Jason Les said in the statement. Hash rate is a measure of computational power for Bitcoin mining operations. The company had a hash rate capacity of 9.3 exahash per second as of Jan. 31.

Riot sold 700 coins for about $13.7 million while producing 740 in January,"

The total hash rate is currently about 267EH/s so Riot at full power is about 3.5% of it.

David. said...

Philip Lagerkranser reports that Bitcoin Miners Hut 8, US Bitcoin to Combine in All-Stock Merger:

"Bitcoin miners Hut 8 Mining Corp. and US Bitcoin Corp. are merging in an all-stock deal after a prolonged slump in cryptocurrency prices heaped pressure on the industry.

The combined company will have a market capitalization of about $990 million, according to a statement on Tuesday. It will have “access to” roughly 825 megawatts of “gross energy” across six sites."

David. said...

David Pan reports that Bitcoin Miner Stronghold Restructures Debt to Improve Liquidity:

"Bitcoin miner Stronghold Digital Mining, Inc. said it has reached an agreement with lender WhiteHawk Finance to push back debt payments.

The Kennerdell, Pennsylvania-based company is the latest crypto miner that’s been able to negotiate new terms with lenders to delay debt repayment amid a sustained rally in Bitcoin prices. Public crypto-mining companies such as Greenidge Generation Holdings Inc. and TeraWulf, Inc. were able to improve their loan terms in recent weeks."

Lenders don't want the rigs, so:

"The new agreement gives Stronghold a five month “amortization holiday.” Stronghold was required to pay monthly principal amortization through June 2024. Under the terms of the deal, that’s no longer the case.

“Following a five-month complete amortization holiday, beginning June 30, 2023, at the end of each month, Stronghold will repay the principal amount of debt outstanding through a monthly cash sweep calculated as 50% of the average daily cash balance for the month in excess of $7.5 million.” the company said in the statement."