Crypto Token Financial Risk Management: Analogy

March 15, 2018

By now this is a common story: a meteoric rise in market cap leading to follow-on investment in mining equipment and extended production contracts leveraged on the hope of sustained favorable Spot silver graphpricing.  A familiar story, though perhaps on an unfamiliar chart.  The adjacent graph is spot silver from 1998 to 2012 and the price scale is from $5 to $50 per troy ounce.  The differences between the prices of Bitcoin and precious metal are important (e.g. timescale, price scale, volatility scale, public sentiment), but the similarities between the two markets are striking.

 

 

The Mine

Miners have long been the poster child of speculation and the term prospector conjures images of scrappy risk takers looking to strike it rich.  Oil drillers are no different and wildcatters are portrayed as the eccentric optimists begging for investor money to be able to drill one more well and have one more chance to make it.

As fanciful as these stereotypes are, modern miners and drillers are highly sophisticated specialists making use of new technological and mechanical advancements. 

Constructing a silver mine or drilling an oil well is like any other large-scale construction project.  While there may be cost overruns and occasional setbacks in output, the total price tag is known up front to be within a well-formulated range.  When construction is done, theoretical projections become proven reserves with stable yields.

The same is true for a crypto mining operation.  Hashing power - like drill performance or geological conditions - is not constant, but the rate at which the problem becomes more difficult is well understood and, while not perfectly certain, can be forecast.

 

 

The Risk

Securing the hardware to cope with an ever-increasing need for hashing power is only the first obstacle.  Once the investment in the mining operation has been made, the real risk is the variability of the price of the tokens.

Consider the U.S. oil industry, for which 2008 to 2014 saw huge investments into shale oil.  New technological advancements opened up millions of barrels of untouched liquid gold.  Though the deep horizontal wells and fracking technology were more expensive, oil at $100 per barrel easily supported greater investment and financial models justified increased leverage.  At the time, estimates for worst case losses suggested anything more than a 30% drop was very unlikely.

The team of geologists and engineers who identified the proven reserves were right.  The team that planned and built the operations were right too.  The wells produced as forecasted and expenses followed the budget.  By all estimates, the companies were set for financial prosperity.

Then 2015 happened.  Oil dropped below $35 per barrel and the average price for the entire year was less than $50 per barrel.  Metals markets – gold, silver and copper – have all experienced similar peaks and troughs in pricing at different periods in time. 

Crypto currencies are experiencing a revolution right now and there are some valid reasons for all of the exuberance.  That said, once the tokens are “out of the ground”, what guarantees the return on the initial investment?

Bitcoinmarket price graphEnd of day Bitcoin price from January 1st, 2017 to January 16th, 2018.  The time scale is hidden to facilitate comparison to the price history of silver.

 

 

 

 

The Hedge

The oil price drop crippled the unprepared.  The selling price was below the price to produce.  Stopping production immediately stopped all the incoming cash needed for debt service and payroll.  At best, companies hoped to play a shell game to ride out the storm of low prices.  The low prices continued for more than two years.

Financial markets have created the opportunity for a different outcome.  When oil was at $100 per barrel in the spot markets, oil could also be bought and sold in the futures market for a price relatively near $100 per barrel.  The financial market was liquid for trades as much as 5 years into the future. 

A company that completed construction and began operations in 2013 could have locked in a portion of sales for the subsequent 5 years at prices near $100 per barrel, guaranteeing a financial return to investors and gaining momentum for the future irrespective of market conditions.

The story is the same for crypto miners.  Liquidity is increasing everyday on traditional exchanges like CME and CBOE for Bitcoin futures, while option contracts are available on LedgerX.  The upside potential of crypto tokens is very exciting.  However, if history is any guide, there is clear potential for loss.  Financial markets allow finding middle ground, providing enough certainty to pay the bills and lock in some financial returns, while also permitting some portion of the investment to benefit from crypto token upside.

 

About the Authors:

Christopher Wells

Christopher is a member of Chatham’s Analytics team. Prior to joining Chatham, Christopher was Assistant Professor of Physics at Houghton College where he taught at all levels of the undergraduate physics curriculum and advised numerical cosmology research. Christopher received a BS in physics and mathematics from Houghton College and a PhD in physics from The Johns Hopkins University; his doctoral work was on field theoretic models of dark matter and inflationary cosmology, including ideas from warped extra dimensions and supersymmetry.

Phil Weeber

Phil leads Chatham’s Financial Services Practice, providing insights and transparency to companies facing front, middle and back office challenges related to the financial hedging of annuities and the general account Since joining Chatham in 2003, Phil has worked across asset classes advising clients with risk strategy, hedging implementation and execution. Prior to focusing on public companies, he led Chatham’s structured finance team and business development efforts, working with public and private real estate companies. Phil holds a MBA from Emory (Goizueta) University, a Masters in Environmental Engineering from the University of North Carolina, and a BS in Civil Engineering from the University of Michigan.

 

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