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January 27th, 2022

“He who controls the spice controls the universe.”

- Frank Herbert, Dune

 Saneel Sreeni

 Leo Zhang

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January 27th, 2022

Introduction

The primary motivation for participating in consensus production activities such as mining, is to earn the block subsidies and transaction fees. These cash flows represent the native economic activities accrued on the blockspace. However, the miners are burdened with increasing capital expenditure and operating expenses. Without effective tools to manage the risks, their financials are fully exposed to the vicissitudes of the market.

Meanwhile, the yields across the DeFi landscape today predominantly come from risking funds to provide liquidity, or lending activities collateralized by a basket of assets whose value are self-referential. As a result, these cash flows tend to be extremely volatile and require constant attention. In order for the deployment size in DeFi to scale, the yield needs to come from healthy sources of cash flow.

By bridging the two worlds, Alkimiya protocol solves two key problems:

0x9a5B
January 27th, 2022

“A lot of people automatically dismiss e-currency as a lost cause because of all the companies that failed since the 1990’s. I hope it’s obvious it was only the centrally controlled nature of those systems that doomed them. I think this is the first time we’re trying a decentralized, non-trust-based system.”

— Satoshi Nakamoto

Background

After a decade of exponential growth, the mining industry is at a crossroads.

Upfront capex grows as mining operations industrialize. A global arms race to source mining hardware intensifies, as institutional players with massive appetite and deep pockets enter the game [1]. Meanwhile, the blockspace economy is evolving. Fees as a % of total block reward are rising. Ethereum MEV foreshadows a whole new and far more complicated type of behavior that is destined to change the game forever [2].

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January 27th, 2022

“Anyone who attempts to generate random numbers by deterministic means is, of course, living in a state of sin.”

— John von Neumann

Overview

In the absence of experimentation, we can fall back on simulation. In tandem with other forms of analysis, simulation can render research on Bitcoin mining tractable despite the industry’s opacity and high capital intensity. It’s expensive to set up an operation without knowing what you’re getting into, but cheap to simulate one.

In Part I of this series, we built a Monte Carlo model to approximate the fair value of mining rigs and the sensitivity of this fair value to different market parameters. We showed that the market price of hashpower often deviates from its theoretical fair value, in part due to the illiquidity of the instrument.

0x9a5B
January 27th, 2022

“Market that can operate freely is like a wheel that can turn freely: it needs an axle and well-oiled bearings. How to provide that axle and keep those bearings well oiled is what market design is about.”― Alvin E. Roth, Who Gets What — and Why: The New Economics of Matchmaking and Market Design

Outline

  • Overview of the blockspace market
  • The supply side: the structure of Ethereum mining
  • The supply side: the Ethereum mining cycles
  • The demand side: the time value of blockspace
  • The demand side: congestion and fees
  • The Dark Forest and the Dark Pools
  • How will miners adapt to MEV?

Overview of the blockspace market

0x9a5B
January 27th, 2022

This article is a collaboration with General Mining Research, a Singapore based hashpower-focused company, who invests and trades hashpower of cryptocurrency networks, as well as derivatives. GMR supports our work by providing proprietary machine market data, as well as hashrate growth predictions over the next few months based on sales projections aggregated from manufacturers.

“You will be much more in control, if you realize how much you are not in control.”

― Benjamin Graham,The Intelligent Investor

The valuation of hashpower is one of the oldest and most arcane topics in the mining world. Several prior academic papers and industry research have explored the economic and game theoretic aspects of proof-of-work, but most of them oversimplify or make unrealistic assumptions about how the hashpower market works in practice.

In this paper, we illustrate that operating hashpower is akin to managing a portfolio, and the difficulties of reflecting the aspects of portfolio in the pricing of hashpower. We walk through how the popular pricing mechanism works, and the flaws of the current valuation heuristics. We parametrize a hashpower portfolio, and show how the outcome changes as we test a broad range of assumptions. As a coda, we argue that the importance of valuation framework is more than just a theoretical exercise, but a foundational step in developing a proper risk management practice for the hashpower industry.

The Fair Value of Hashpower

0x9a5B
January 27th, 2022

“When events have thinking participants, the subject matter is no longer confined to facts but also includes the participants’ perceptions. The chain of causation does not lead directly from fact to fact but from fact to perception and from perception to fact.”— George Soros, The Alchemy of Finance

In Part I of this series, we presented a simple heuristic for understanding hashpower as an asset class. In mining, everything is connected. To establish a comprehensive understanding of the market dynamic, we need to scrutinize the interactions between the underlying forces in greater depth.

In this article, we start by breaking the mining market cycle into four archetypal stages, each with distinct price trends, hardware capacity, and sentiments. We examine the driving forces in each scenario, and illustrate the roles that the hardware reaction time, and reflexivity in hashpower play in shaping these macro cycles.

Through a series of case studies and theoretical arguments, we intend to introduce a guiding framework for understanding different investment environments in mining. As a coda, we discuss the rising significance of fees in mining calculation. The new opportunities around the fees market, and how fees as a principal variable profoundly changes the hashpower market dynamic.

0x9a5B
January 27th, 2022

“Scientific method seeks to understand things as they are, while alchemy seeks to bring about a desired state of affairs. To put it another way, the primary objective of science is truth, that of alchemy, operational success.”― George Soros, The Alchemy of Finance

Outline

Part 1.

I. The Economic Value of Hashpower

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January 27th, 2022

“越透明的东西越神秘,宇宙本身是透明的,只要目力能及,你想看多远就看多远,但越看越神秘。”

— — 刘慈欣 《三体》

Bitcoin mining is a complex phenomenon that connects hardware and software, energy, and financial markets. Invisible rules govern every aspect of it. The performance of an individual operation is determined by various external factors that are often hard to quantify and almost impossible to forecast.

From a macro perspective, we can identify three principal forces that drive the mining industry as a whole: the emission schedule, the climate cycle, and hardware iteration. Each influences a different component in the miner’s profit calculation:

Mining profit