You don’t need to own cryptocurrencies to trade on them.
Find out more about trading on bitcoin with IG.
The majority of cryptocurrencies are created through a process known as mining. Cryptocurrency mining is where a number of computers will race to finish an easy, but highly inefficient, equation in the hope of earning a cryptocurrency reward. The most well-known cryptocurrency blockchains such as bitcoin, bitcoin cash, ether and litecoin all follow this validation process, and each user will be rewarded by the appropriate cryptocoin if they validate first.
At the moment this mining process, known as ‘proof of work,’ takes up a significant amount of computational power and time, and by extension, electricity. As we all know, electricity isn’t free, so there is an associated cost with this process. There is also a continued need to upgrade computer hardware, chips, cooling mechanisms, and support infrastructure to make sure you have the fastest equipment out there. If you’re not the first to validate a block, then there is no reward.
When we’re trying to value a cryptocurrency, there is an argument to suggest that the base cost of how much it costs to mine an individual coin is going to be the ‘fair value’ of what that coin is worth. In the same way as a drilling rig wouldn’t extract oil at a cost of $120 /barrel if you could only sell that oil at $60 /barrel, crypto miners are unlikely to continue to mine (or at least sell) their coins if the free market value is less than the cost to mine.
A big factor affecting how much a cryptocurrency costs to mine lies in the cost of electricity and the relevant tax implications based on geographical location. The cost to mine can even change based on where you live in a single country. For example a recent blog post published by CESCO from January 2018 showed that the cost to mine a single bitcoin in Hawaii was almost $9500 while in Louisiana, which came as the cheapest state in America, just over $3200. This was when the price of bitcoin was about $15,000 on the open market.
Alternatively, you can look at the average cost to mine bitcoin. If you take the average cost of electricity in the United States to be $0.12/kWh, and assume the entire bitcoin network was mined at a requirement of 27.6/tWh, then the cost of producing one bitcoin is roughly $5041.
China, as you may expect, has a significant concentration of miners due to their low electrical costs, relatively cheap technology, affordable rent, and efficient labourers. Areas like Alaska and Iceland are being investigated more and more as miners look to reduce the cost of cooling their computers with the ambient temperatures, and therefore increasing efficiency. If you know the cost of electricity, then you at least have a start.
However, even if you know the cost of electricity in each region, you will still have trouble figuring out how expensive it is to mine a cryptocurrency, as it’s unlikely there will be a fixed energy requirement. Most blockchain systems have a variable mining difficulty which adjusts the hash power needed to mine a single block. In the case of bitcoin, a new block is mined roughly every ten minutes, but the ability to mine in this time is dependant on how much power you have on the network as a whole.
If the network suddenly receives a boost to the computational power it’s receiving (which should in theory cause each block to be mined quicker) the bitcoin algorithm will increase the hash difficulty (which should reduce each blocks mine time back to a consistent ten minutes). These changes will use more/less energy in a non-linear scale depending on the adjustment. Essentially, it’s not only difficult to calculate, but it’s difficult to predict.
As with everything, the price of an asset is based on supply and demand, and the utility (or perceived future utility) it may have. Mining itself is going to have a knock-on effect on the price of that asset, simply because it doesn’t make sense for an individual miner to sell their cryptocurrencies reward if the market price doesn’t match or beat the equipment and electrical cost it took to generate that coin.
To put it another way, if it cost you $1000 to set up the hardware and $4000 to pay for the electricity to mine a single bitcoin, you’re unlikely to sell if the current market price doesn’t match at least $5000. If you take this basic principle, factor in different energy and hardware costs, project it globally, and then take the weighted average of how much it costs to mine a single crypto (for example bitcoin), you’re going to have a good base of where miners are unlikely to sell below. This, in theory, creates a soft floor or level of support for the price of a crypto asset. Calculating it is the hard part.
At the moment it’s very hard to judge how we can value cryptocurrencies based on mining, and there isn’t a simple formula yet. All the required data is out there, including where the hash power is focused, how much electricity costs in those regions, and how many bitcoin ASIC (Application Specific Integrated Circuit) chips are being bought to stay on top of the competition, however it’s scattered around and difficult for an individual to find and analyse.
When it comes to hardware, it’s ever so slightly easier because hardware costs are simpler to research and the required hash rate to mine a block in a single month is fairly consistent. At the time of writing it requires about 3000 TH/s. This alone would require about 115 ASIC AntMiner S9s which would cost just shy of $150,000. If we assume that bitcoin is priced at $9000 (as it is at the time of going to print), the 12.5 BTC reward is only going to generate $112,500. Without factoring in electricity, you’re not going to be making money in month one at the current market prices.
If the cost to mine is more than the current market price, there is less incentive for a miner to sell their cryptocurrencies and this can have a significant impact on the global crypto costs. Bitcoin, as an example, has about 1800 coins mined each day, but if all miners globally stopped selling their coins (because it wasn’t favourable at current market prices) then that would take $160,200000 a day off of the downside selling pressure. Assuming all other things are equal, less sell side pressure would lead to an increase in asset value.
Valuing crypto can be tricky, however there are a number of like-minded traders on IG Community who are discussing crypto trade ideas and market movements. If you’re a client you can sign in here, or check out the Cryptocurrency and Blockchain message board here. If you have an idea you would like us to explore, leave a message on Community and we may be able to write an article about it.
IGA, may distribute information/research produced by its respective foreign marketing partners within the IG Group of companies pursuant to an arrangement under Regulation 32C of the Financial Advisers Regulations. Where the research is distributed in Singapore to a person who is not an Accredited Investor, Expert Investor or an Institutional Investor, IGA accepts legal responsibility for the contents of the report to such persons only to the extent required by law. Singapore recipients should contact IGA at 6390 5118 for matters arising from, or in connection with the information distributed.
This information/research prepared by IGA or IG Group is intended for general circulation. It does not take into account the specific investment objectives, financial situation or particular needs of any particular person. You should take into account your specific investment objectives, financial situation or particular needs before making a commitment to trade, including seeking advice from an independent financial adviser regarding the suitability of the investment, under a separate engagement, as you deem fit. No representation or warranty is given as to the accuracy or completeness of this information. Consequently any person acting on it does so entirely at their own risk. In addition to the disclaimer above, the information does not contain a record of our trading prices, or an offer of, or solicitation for, a transaction in any financial instrument. Any views and opinions expressed may be changed without an update.
See important Research Disclaimer.