Click here to flash read.
Cryptocurrencies that are based on Proof-of-Work (PoW) often rely on special
purpose hardware to perform so-called mining operations that secure the system,
with miners receiving freshly minted tokens as a reward for their work. A
notable example of such a cryptocurrency is Bitcoin, which is primarily mined
using ASIC based machines. Due to the supposed profitability of cryptocurrency
mining, such hardware has been in great demand in recent years, in-spite of
high associated costs like electricity.
In this work, we show that because mining rewards are given in the mined
cryptocurrency, while expenses are usually paid in some fiat currency such as
the USD, cryptocurrency mining is in fact a bundle of financial options. When
exercised, each option converts electricity to tokens.
We provide a method of pricing mining hardware based on this insight, and
prove that any other price creates arbitrage. Our method shows that contrary to
the popular belief that mining hardware is worth less if the cryptocurrency is
highly volatile, the opposite effect is true: volatility increases value. Thus,
if a coin's volatility decreases, some miners may leave, affecting security.
We compare the prices produced by our method to prices obtained from popular
tools currently used by miners and show that the latter only consider the
expected returns from mining, while neglecting to account for the inherent risk
in mining, which is due to the high exchange-rate volatility of
cryptocurrencies.
Finally, we show that the returns made from mining can be imitated by trading
in bonds and coins, and create such imitating investment portfolios.
Historically, realized revenues of these portfolios have outperformed mining,
showing that indeed hardware is mispriced.
