Issue 1

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Bitfinex Alpha | ISSUE 1
Thought leadership | Research | Market Analysis

Welcome to Issue 1 of Bitfinex Alpha, an initiative of Bitfinex that provides an in-depth analysis of various topics
surrounding cryptocurrency and blockchain. We aim to give our users a more profound insight into the industry through
mind-opening subjects and analysis created by industry leaders in the blockchain and FinTech industries.

For a long time, Bitcoin’s energy requirement in its creation process has been a subject of contradiction, even within the
crypto community itself.

But, what if Bitcoin’s creation process generates not only Bitcoin but also global markets, such as electricity?
Whether you are a Bitcoin miner or a holder, we believe you will get valuable insight from our collaboration with a
fintech and crypto researcher, John Dwyer for the first issue of Bitfinex Alpha.

John Dwyer is a contractor for Bitfinex where he provides crypto research services. He first bought Bitcoin in 2013
and invested in the Ethereum financing in July 2014.

Previously he was Global Digital Assets Research Lead at Celent (the fintech research division of Oliver Wyman).
This followed a career in investment banking where he ran equity capital markets businesses at Macquarie Capital
(specializing in natural resources) and Goldman Sachs.

The views and opinions expressed in the note belong solely to the author and do not reflect those of Bitfinex.
Bitlectricity
Bitcoin as the Unit of Account for Electricity

By John Dwyer
Part One
Mining Finance (MiFi)

Bitcoin fuses technology, energy, and money in a manner which was not previously possible.

Bitcoin mining is the process of adding transaction records to the Bitcoin blockchain. It is a record-keeping process requiring
immense ongoing computing power whereby each miner contributes to the decentralized peer-to-peer network ensuring the
network is trustworthy and secure. Miners take energy, time, and mining hardware as inputs and create digital scarcity in the
form of Bitcoin.

The topic of mining has been covered extensively elsewhere and so we will only focus on it at a high level in this report. The
implications for global energy and electricity markets is the focus.

Proof of Work – Creates Hard Money

Adding blocks to the ledger is facilitated by so-called Proof of Work (PoW based on the SHA256 algorithm that miners run.
Miners incur expensive processing power to solve complicated mathematical problems which are hard to solve but easy to
verify. Miners costs are predominantly mining rig hardware (capex) and electricity (opex).
Mining Reward

The miner that produces the new block earns a reward which is currently
6.25 new Bitcoins. This is the financial incentive for miners to incur the
financial cost of mining. In effect, profitable miners are those that can sell
the Bitcoin they mine at a profit to their cost of mining it.

The Difficulty Adjustment – Predictable Bitcoin Monetary Policy

Hash rate is the measuring unit of the processing power of the Bitcoin
network. As the hash rate increases/decreases, this impacts the pace at
which the PoW problems are solved thus accelerating/decelerating the
rate of production of new blocks of transactions.
To compensate, the network has an in-built difficult
adjustment which means that the computing power
necessary to solve the PoW problems adjusts every 2016
blocks in response to changes in the aggregate mining hash
rate. The result is that the network is self-correcting,
approximately every two weeks, ensuring that new blocks
are created approximately every 10 minutes.

In short, the Bitcoin network combines time, energy, 2016 blocks at approximately 10 minutes per block is 20,160
minutes which equates to 14 days
and mining hardware to create Bitcoin
Bitcoin mining returns
Bitcoin miners think about returns in two ways.
i. Cash flow breakeven: this is when cashflow covers operating expenses (opex). Miners sell the Bitcoin they earn at a
price in fiat that they do not control. If this cash inflow falls below their opex then the economically rational decision for the
miner is to shut down their mining rigs.

It is assumed that Bitcoin miners can instantly shut down mining operations. However, this decision is impacted by the
agreement they have with their energy provider which may stipulate a minimum quantity of energy must be taken by the
miner over a given time-period. This has caused certain miners to operate unprofitably at sub cashflow breakeven levels.
Therefore, miners are incentivized to source the cheapest energy and optimize flexibility with respect to the usage of the
energy.
ii. Return on Investment (ROI breakeven: this is when cashflow covers both opex and capital expenditure (capex) on
the mining rigs/hardware. The higher the ROI then the higher the profitability of the mining operation.
The key drivers of ROI are the miner’s cost of electricity and the cost of their mining hardware (and thus the depreciation
schedule of that hardware).
Hash Rate Trends

Bitcoin’s hash rate is currently estimated at 150mn

terahashes (TH per second where 1 TH equates to
one trillion hashes per second. Mining hash rate is
a key security metric as the greater the hashing
(computer) power in the network then the greater
is the security of the Bitcoin network.
The efficiency of mining hardware has improved
consistently since the industrialization of Bitcoin mining
which commenced around 2014. Data from Coinshares
demonstrates that the efficiency of mining rigs has
grown consistently whilst the cost (on a $ per TH basis)
has fallen. The combination of this growing efficiency
and reduced cost has driven strong growth in the
hashing (computing) power generated by the total
Bitcoin network.

ASICs – Specialist Hardware

Bitcoin mining has evolved from CPUs (central processing units) to GPUs (graphics processing units) to ASICs (application-specific integrated
circuits).

ASICs are highly specialized chips which are optimized for the single purpose of Bitcoin mining thus are more energy efficient than GPUs or CPUs
and can be deployed into small and mobile connected devices. However, they lack an alternative use other than mining.

The pace of innovation in ASIC design means they have a high rate of depreciation and low residual economic value. This has implications for
the financial returns generated by miners.
The Key Variables Driving Bitcoin Mining Returns

● Bitcoin price –Bitcoin is a synthetic product, so Bitcoin miners are exposed to price risk on Bitcoin which is their primary
revenue driver. A miner’s theoretical reward complies with the law of large numbers and is proportional to its computing
power as a percentage of the total computing power on the Bitcoin network. Therefore, investing at scale in mining
hardware and electricity agreements to run a mining operation equates to a synthetic long position in Bitcoin.
● Transaction fees Miners also earn transaction fees, the level of which correlates positively with activity on the network.
As the network matures, transaction fees are expected to increase.
● Difficulty adjustment The difficulty adjustment creates uncertainty for a miner as to how many Bitcoins will be mined
over a given future time-period. The difficulty adjustment is positively correlated with the total computing power of the
entire network.
● Electricity prices – electricity prices are the key driver of opex.
● Hardware prices- hardware capex drives upfront cash investment and depreciation. The depreciation of ASICs (and their
lack of alternative use) means that the depreciation charge is analogous to the premium paid for a call option and time
decay. The cost of electricity prices can have a material impact on the time decay and profitability of mining hardware
Managing Miners’ Risk

Hash rate derivatives have emerged to assist miners with managing risk of total hash power, the difficulty adjustment,
and Bitcoin’s price volatility —this is a key area of growth in the years ahead.

Electricity prices (opex) and hardware purchase prices (capex) are the main two variables which a miner can control.
Mining hardware production remains relatively centralized although, like any hardware, it is becoming more
commoditized, smaller, and cheaper.

Therefore, the outlook for mining is that sourcing the lowest cost electricity is the main driver for successful miners. In
addition to lower opex (and improved profitability) it also offsets the lower energy efficiency of older mining rigs.
Lower energy costs offers miners the option of investing in older, cheaper mining hardware and still achieving a
positive ROI.
Mining Finance – ‘MiFi’

Previously we have highlighted that hash power will be recognized as a new asset class along with Bitcoin. Bitcoin mining is
essential to the future of Bitcoin and will attract large and growing amounts of financial capital from traditional markets and
institutional investors.

The traditional fixed income asset class faces challenges from low/negative nominal interest rates and central bank
intervention. Mining Finance (or “MiFi”) offers a new asset class for institutional capital to be deployed across the capital
structure into assets which can earn a probabilistic-based yield from Bitcoin mining.
Part Two
Two areas attracting growing interest from the Bitcoin community relate to electricity and renewable energy.
We consider each in turn examining the legacy challenges these markets face.

Electricity

Electricity cannot be stored efficiently or cheaply.

If we think of electricity as a commodity, then this is a unique attribute relative to other commodities and it inhibits the applicability of modern
financial asset pricing theory to electricity markets and the effective arbitrage of spot and derivative markets. Therefore, electricity markets
have certain traits.

Negative Prices for Electricity

Firstly, electricity spot markets can be volatile and experience negative prices2. Negative electricity prices occur when a power generator,
with little operational flexibility, continues to generate surplus power during periods of low electricity demand. The reasons for such
operational inflexibility can be technical in nature, contractual (a legal obligation to provide a contracted level of balancing power to the grid),
or financial (there are costs associated with shutting down/ramping up a power plant).

Electricity is a Localized Market

Secondly, electricity is a localized market as an electricity deficit in one geography/market cannot necessarily be satisfied by a surplus in
another geography/market due to the challenges associated with storage and transportation of electricity. An international homogeneous
electricity market does not exist – rather there are multiple discrete electricity markets around the globe.

2. https://energypost.eu/negative-electricity-prices-lockdowns-demand-slump-exposes-inflexibility-of-german-power/
Complex Microstructure

Thirdly, the combination of lack of storage and lack of flexibility of power generation assets creates complex market
microstructures in electricity markets driven by the need for ongoing real-time equilibrium between energy generation
and energy consumption. These microstructures typically feature an intraday market, a day-ahead market, and the forward
market.

Low Liquidity in Electricity Forwards

The day-ahead market (the spot market) is based on a fixed trading auction whereby participants bid/offer for a particular
hour of electricity for the next day. This specificity of delivery is important and impacts liquidity across the forward curve.

Electricity forward markets share many aspects with those of storable commodities (such as coal, oil). The most important
difference in electricity forward contracts from storable commodities relates to term structure. Electricity forward contracts
are highly specific on when delivery of electricity occurs and contracts can come in different delivery classifications:
baseload, peak-load, and off-peak. Consequently, there tends to be sparse liquidity across the electricity forward curve.

Finally, the absence of storage implies an unclear relationship between spot and forward prices by suppressing any arbitrage.
Unlike other commodity markets, participants cannot rely on convergence of electricity spot and forward prices.
Alternative Energy

We will use the term Alternative Energy to cover renewable, trapped, and waste energy.

- Renewable energy is an energy source that does not deplete and has a marginal cost of zero.

- Trapped energy is energy which cannot be commercialized through traditional methods.

- Waste energy is a by-product of an industrial process.

Intermittent Energy is Bad for the Grid

A principal feature of renewable energy is that it is intermittent, particularly wind and solar power. This poses a problem for the
power grid as its baseload power cannot be intermittent. Therefore, when supplying the power grid, renewable energy cannot
operate alone and requires energy buffering by combining it with on-demand fossil-fuel based energy (or effective energy storage).

Like all energy sources, renewable energy must be brought from where it is located to where it is consumed which requires
infrastructure. If the infrastructure is not in place, then this requires upfront capital expenditure which reduces the economic
feasibility of many renewable energy projects.

Bitcoin mining can mitigate both issues.

Plug-and-Play Infrastructure

Firstly, the intermittent nature of renewable energy does not pose the baseload power challenges as the renewable energy is not
being directed towards the grid rather it is going towards Bitcoin mining. Secondly, Bitcoin mining rigs mitigate the need to build out
traditional energy infrastructure. Instead, the mobile mining rig is the infrastructure, and it is brought to the energy source.
Bitcoin mining inverts the traditional centralized power grid structure to create a decentralized real-time market
for energy anywhere in the world.

Renewables – A Highly Nuanced Area

The topic of renewable energy is much more nuanced and complex than this though. The intermittent nature of
renewable energy means greater reliance upon it for supplying traditional power grids brings the need for a
proportionately larger build out of installed capacity to offset the risks of intermittency. The implications for the scale
of renewable physical asset construction are significant to say the least. The production of wind turbines and
photovoltaic solar panels requires a significant share of the global production of certain critical metals—a study by the
Government of Netherlands highlights the extraordinary quantities of critical raw metals which will be required for
renewable energy build out.6

Renewable energy also brings new challenges to existing, legacy grid infrastructure. Moreover, the American Society
of Civil Engineers published a report on the state of the US electric grid stating that the transmission and distribution
lines have reached or exceeded their 50-year life expectancy. This legacy infrastructure was designed to transmit
power from centralized fossil fuel power plants outwards in one direction to where it is consumed.
Renewable energy tends to be more dispersed and not unidirectional which, when combined with intermittency,
creates operational challenges for maintaining voltage and frequency of the power grid within acceptable limits.

In short, renewable energy presents certain challenges for legacy power grid infrastructure.

Waste Energy

Bitcoin mining has successfully monetized waste energy from the oil and gas industry.

Approximately 150 billion cubic meters natural gas is wasted through flaring each year. This waste is primarily driven
by poor financial incentives and presents a major environmental concern.

Upstream Data is one company providing solutions to the oil and gas industry leveraging the portable plug-and-play
infrastructure for Bitcoin mining. Their rigs use the vented gas as an energy source and use it to mine Bitcoin. The
benefits of this are significant:

- Creates a new revenue opportunity (counter cyclical to the core business)

- Reduces capex investment (no pipelines or powerlines)

- Mitigates regulatory risk related to flaring/carbon tax liabilities

- Can reduce emissions

Trapped Energy

The plug and play infrastructure of Bitcoin mining is the key driver of accessing traditionally trapped energy sources
as it mitigates the need for expensive, upfront capex on traditional energy infrastructure.

6 This estimate by the Government of the Netherlands indicates that for their single country needs of silver and rare earths, which are essential for renewable energy
infrastructure, are multiples of annual production alone based upon their renewable energy forecasts.
7 https://circulareconomy.europa.eu/platform/sites/default/files/metal_demand_for_renewable_electricity_production_in_the_netherlands.pdf
8 https://www.asce.org/uploadedFiles/Issues_and_Advocacy/Infrastructure/Content_Pieces/Failure-to-Act-Energy2020Final.pdf
Source: Global Gas Flaring Tracker Report July 2020 http://pubdocs.worldbank.org/en/503141595343850009/WBGGFRReport-July2020.pdf
9 https://www.upstreamdata.ca/
 The Transmission System Operator (TSO is the entity entrusted
Embedded Optionality with transporting electrical power on a national/regional basis
using fixed infrastructure. The TSO always needs optionality to
A traditional power plant creates value by buying fuel
maintain precise equilibrium between overall generation and
and selling power. The power plant can be viewed as
consumption. This optionality creates suboptimal outcomes given
a strip of call options on the spread between the
no storage for electricity, the operational constraints of major
fuel price and the electricity price. For gas-fired
power plants, intermittency of renewable energy, and uncertain
plants the spread is the “spark spread” for a
consumption patterns of customers.
coal-fired power plant it is the “dark spread”.
Power Grids Must Ensure Production & Demand Equilibrium
The consumption of electricity differs by customer
type which is typically classified as industrial,
professional, and household. Each customer type
differs by number, consumption volume, consumption
pattern, economic behaviour, needs, and the level of
information known about them. Retail contracts may
include a clause which gives the retailer the right to
charge the household a higher price if they do not
reduce their electricity consumption. Such a clause is
an embedded put option held by the retailer.
However, the Bitcoin network presents a new global customer for electricity which is open 24/7/365
and offers a single price for electricity regardless of location or type of energy source. Viewing Bitcoin as
a new electricity customer highlights the new optionality it brings to traditional energy capacity.

Bitcoin is a 24/7/365 Customer for Electricity

The Bitcoin network is a buyer of last resort for energy regardless of its geographical location bringing
single pricing for energy and increasing flexibility for monetizing energy assets.
Bitcoin Mining Implications for Global Electricity Markets

To conclude, we will summarize the implications of Bitcoin mining on the future of electricity markets and alternative
energy innovation.

Operational Flexibility

Legacy power grid infrastructure is old and faces various operational challenges which are exacerbated by the
growth of decentralized alternative energy sources. In addition, the traditional capex demands imposed by connecting
new energy sources with power grid infrastructure lowers the financial returns from many alternative energy projects
making them uneconomic.

The TSO requires flexibility to ensure that electricity generation meets electricity consumption. This flexibility
manifests in various suboptimal ways including a continued reliance on fossil fuels (as a buffer against intermittency
risk of alternative energy sources), negative electricity prices, and curtailment of energy production which wastes
energy.
Bitcoin mining uses mobile infrastructure which travels to the energy source thus mitigating the operational challenges of
centralized power grid infrastructure. Consequently, Bitcoin mining is responsive to any intermittency of alternative energy
sources and manages this variability much more seamlessly than a centralized power grid.

Financial Incentives

Bitcoin mining incentive is to earn revenue in Bitcoin which is an incredibly powerful incentive and supersedes traditional energy
incentives which are typically regulatory and/or subsidy driven. Bitcoin mining drives innovation to find the lowest marginal cost
energy source– implicitly this is alternative energy rather than fossil fuels.

Furthermore, the reduced reliance upon centralized grid infrastructure eradicates traditional constraints on energy innovation
and portends a future of localized, decentralized energy innovation by entrepreneurs seeking to find the lowest cost of energy to
earn Bitcoin. This has important implications for energy sovereignty and geopolitics which go far beyond the scope of this paper,
but clear national/regional regulatory support and state-subsidized energy projects in favour of Bitcoin mining are inevitable.
New Asset Class

As Bitcoin’s legitimacy as an institutional-grade reserve asset grows, then so will the level of financial sophistication across the
Bitcoin mining complex and the role of new institutional investors.

The Bitcoin network is the buyer of last resort for energy offering a single base-line market price and arbitraging energy regardless
of its location on a 24/7/365 basis. This fundamentally changes a major challenge of traditional electricity markets which are
localized and cannot be arbitraged like other commodities given the challenges around electricity storage and transportation.

Historically, Bitcoin miners have been entirely equity-financed and have absorbed all risks that stem from earning Bitcoin. Through
the growth of hashrate derivatives and difficulty derivatives, new financial tools are emerging such that the embedded risks of
miners can be disaggregated, priced, and transferred to other financial actors – like in traditional capital markets. This will bring a
suite of new institutional investors who will be investing across the capital structure within Bitcoin mining leveraging their expertise
in private equity, infrastructure, energy, derivatives, and structured finance. The area of MiFi will include new credit products and
attract governments who see an opportunity to monetize traditionally trapped or waste energy capacity within national borders.
Three New Global Commodities

To conclude, we will leave you with the thought of there being three new products emerging from Satoshi’s white paper.

Bitcoin: the institutionalization of Bitcoin as a new asset class is accelerating.

Hash Power: hash rate is the measure of a Bitcoin miner’s performance. Greater hash rate correlates with increased
opportunity for receiving the block reward. In aggregate, the Bitcoin mining industry generates hash power as an output
which secures the Bitcoin blockchain.

Electricity The Bitcoin blockchain is the buyer of last resort for electricity. It can operate independently of legacy power
infrastructure and can monetize energy from disparate sources anywhere on the globe. This creates, for the first time, a
single global market for electricity and portends a future where the unit of account for energy and electricity is in
Bitcoin.
Mining Finance (MiFi)

The combination of these three products is captured in Bitcoin

mining. A new probabilistic fixed-income complex is emerging
harnessing energy, infrastructure, electricity, and Bitcoin. It
could attract capital from global institutional investors to invest
across the capital structure. This is coinciding with the growing
irrelevance of the traditional fixed-income asset class given the
era of sustained central bank intervention and zero/negative
nominal interest rates.
 Electricity Markets without Electricity Markets with Bitcoin
Bitcoin
Operational Old, centralized infrastructure Unconstrained by legacy infrastructure

Flexibility Not built for alternative energy Seamlessly manages energy intermittency

TSO requires optionality Creates new mobile infrastructure (“Plug and Play”)
Bitcoin Mining Energy buffering with fossil fuels

Implications for Financial Incentives Poor financial incentives Incentive to earn Bitcoin

Global Electricity Innovation driven by high energy prices Innovation driven by low energy prices

Underutilized energy prevalent Local, decentralized innovation

Markets Negative electricity prices

- Summary Curtailment of energy production

New Asset Class Electricity cannot be stored efficiently Global energy arbitrage

Electricity a localized commodity Surplus electricity stored as Bitcoin

Multiple electricity markets A single base-line electricity market

Illiquidity in electricity derivatives Captures embedded optionality of energy

Poor spot/forward convergence Bitcoin a new 24/7/365 buyer of energy

Single, homogenous price for electricity

Leverages Bitcoin’s inherent fungibility

New highly liquid derivatives complex

New institutional investor constituencies

Emergence of MiFi

New credit markets

BTC the unit of account for electricity

Bitfinex Alpha | ISSUE 1
Thought leadership | Research | Market Analysis

If you would like to speak to the Bitfinex team you can contact - OTCBitfinex.com