Disclaimer: I’m getting a bit tired of saying this, but please do not take this as financial advice. Do your own research, make sure you understand what you are buying, the risks and rewards involved, and the factors that affect market pricing.
In a previous article, I explained what mining bonds are, but if you didn’t read that, think of mining bonds as a loan where you, as the investor, lends money to the issuer, and the interest you get in return is defined by some number of hashes of Bitcoin or Litecoin mining.
I posted that article based on a discussion around a certain mining bond PAJKA in which I currently hold a position (that means I own bonds for all you inexperienced investors).
Note: That was my disclaimer about having an explicit interest in PAJKA.
The result of that article was that one investor in particular got a bit of panic, sold of a substantial amount of his bond at whatever price he could get, and went on to claim that all perpetual mining bonds (PMB) are scams.
Well, PMBs are not scams and I’ll tell you why and try to answer the most common questions around why PMB may be a great investment or may be your worst nightmare.
Perpetual Difficult Climb
Perpetual mining bonds yield a fixed and pre-determined return based on a number of hashes per bond. However, if mining difficulty increases, that means the return will diminish. The faster the difficulty increases, the less return the bond will yield.
This may seem like an obvious scam because we all know that difficulty will keep rocketing into the sky forever, right? After all, technology becomes better and more and more people will mine, so the difficulty must go up forever just like the total number of computers on the planet, right?
Well, that’s the first mistake and false assumption.
The difficulty of mining Bitcoins has gone up significantly in the previous few months. This is largely due to the introduction of ASIC mining, a huge leap in technology that renders all other mining equipment significantly less valuable.
Note: To learn more about ASIC mining and why it is so important to Bitcoin, you can read my article “What are ASIC Miners and Why are they So Important?”
ASICs are certain to change Bitcoin mining forever, but it won’t drive difficulty into perpetual rise. The reason, in fact, is that ASICs are just computer chips that are bound by the same limitations that other computer chips are. You can only make them so small and so efficient before you start running into problems of sizes of atoms.
Currently, the most powerful scheduled ASIC miner is developed by Swedish KnCMiner. Their ASICs are built on a 28nm technology. Currently, the best normal CPUs use 20nm technology, and those chips are extremely difficult to make.
ASICs may be simpler devices, but it is still difficult to get much smaller than the 28nm without investing significant money into development. As such, the rapid increase in ASIC efficiency is bound to slow down significantly very shortly.
However, this doesn’t mean that you can’t build more chips. Distribution can easily counter any lack of technological progress, especially in Bitcoin and Litecoin mining where every computer is part of the same network and runs towards the same goals.
Of course, as more and more miners come online, difficulty will keep rising, and pretty quickly, the profitability of mining equipment drops to zero or below. After all, you wouldn’t want to buy an ASIC miner for $10,000 if during its lifetime it would only give you $1,000 back, would you?
So, as more miners come online, the incentive to add more miners will drop, thus reducing the rate of network difficulty increase. At some point, adding more miners will not make sense and network mining difficulty will stop increasing.
The whole Bitcoin network was designed to be marginally profitable to miners. There’s a gold rush right now because ASICs represent so much of an advantage, but sooner or later, they will become unprofitable too.
And guess what; no matter when that happens, you still have your mining bond that will continue generating money. You don’t pay for electricity, you have no risk of hardware failure, you just sit there and watch as your Bitcoin or Litecoin wealth grows.
Note: Some mining bonds have buyback policies that allow the issuer to buy back bonds under certain conditions. carefully read the contract before you buy in and understand the terms under which an issuer can buy back bonds.
Yes, the value and thus return of your bonds will drop as difficulty grows. No, you won’t reap 50% yield per year, but c’mon, any semi-experienced trader knows this is an insane return on any investment. In PMBs, you have virtually no risk. Find a risk-less investment in a traditional market and you’re lucky to get 3-4%.
The reduction in profitability applies to any mining operation, regardless of whether you buy bonds or buy hardware to mine yourself.
Speaking of which…
Buying Hardware is Cheaper!
A second argument against PMBs is that buying the hardware yourself is cheaper than buying a bond. For example, a 1 mh/s bond from TAT.VirtualMine at this time costs around 0.0079. If you buy a 7950 GPU costing around 2BTC, you get 500 mh/s. To get 500mh/s from TAT.VM, you need to buy bonds for almost 4BTC. Clearly it is cheaper to buy a GPU yourself, especially if you have cheap electricity, right?
Well, yes, in cost it is cheaper to buy hardware, but this again is a mistake and false assumption. Let me use a somewhat contrived example to show you why.
It is also cheaper to dig for oil yourself rather than buying shares in Exxon to drill that oil for you. If you buy into Exxon, with some fancy math magic, you get approximately $0.007 dollar per day in dividends. Compare that to the return you would get from drilling your own oil where you get 100% of the profit, or almost $100 per barrel of oil!
Sure, Exxon drills oil on a much larger scale, but c’mon, per barrel you’re getting those $0.007 divided by the roughly 4 billion barrels of oil Exxon mines every day. You’re getting scammed by buying shares in Exxon!
Nobody in their right mind would make such a claim because after decades of experience, society knows that to drill oil, you need a lot of skill, investment in expensive equipment, the knowledge to maintain that equipment, the market in which to trade your product, and so on.
Buying hardware, running, and operating a mine, taking on the risks of equipment failure, ensuring the power and internet connection stays on 24/7, having a heck of a time if you need to leave three weeks on vacation… Operating a mine is hard work! It comes with a lot of risk and burdens, and for some, it is simply not an option.
Add to that the cost of time you need to invest in learning how to operate that mine safely, the time you need for maintenance and optimization, and the risk you have solely on your shoulders if something breaks, and the cost isn’t as cheap as some would like to imagine.
Perpetual Mining Bonds are Never Meant to be Profitable for the Investor!
For obvious reasons, I can’t speak about the intentions of any asset issuer. However, the profitability of perpetual mining bonds are exceedingly easy to calculate. What is difficult is predicting the difficulty of the Bitcoin mining network, and the guesses from various parts of the community ranges from “nah, it’ll never go beyond 200 million” to “it will rise to 1 billion by next week and continue to rise at 100% every day for the rest of eternity”.
Neither of these predictions will likely be correct, but you, as an investor, is tasked with finding the middle ground. This is the research part you need to do. If you believe in perpetual difficulty growth then clearly buying mining bonds is a bad idea. However, if you believe that mining difficulty will stop and decline immediately, then mining bonds will yield incredible results.
For an issuer, however, the reverse is true. If they believe that mining difficulty will continue to rise at incredible speeds, then issuing a mining bond makes sense because it will be very cheap financing. If they believe the difficulty will drop then issuing a bond denominated effectively in that difficulty is a bad idea.
The main difference, however, is that in lieu of a buyback option, a PMB is always going to be a loss to the issuer given enough time. Granted, if difficulty rises enough, the sun may burn out before that becomes a serious issue, but in the end, a mining bond will always return a profit to its owners, albeit a small one.
Let me briefly mention PAJKA again as an example. PAJKA was initially issued in June of 2012, so roughly one year ago. During that time, the bond has paid out its principal (meaning the amount the bonds cost) plus a healthy profit for its owners. Even today, PAJKA returns over 50% at current trading prices, with absolutely no operational risk to its owners.
How would it be possible for the issuer of PAJKA to predict that in a year, difficulty would suddenly get a surge? The simple answer is that it is impossible to know.
If PMBs like PAJKA were scams, it would be the worst scam in the history of mankind, where the scammer ends up giving more money to his victims than they risked. It would be like a bank robber heading into a bank and screaming “THIS IS A ROBBERY! HERE, TAKE THESE $100,000 OR I SHOOT!”
So no, PMBs aren’t scams. If you want to be cynical, they are really bets, where you, as the investor, bets that the difficulty will not rise enough over a long time that your profitability goes away, and the issuer, well, the best interest of the issuer is that difficulty shoots through the roof forever, securing cheap financing of the bond.
But it’s not a scam.