Bitcoin miners are likely to remain capital-intensive, low-margin businesses. Photo: supplied
It’s not often you see financial services businesses fill their websites with footage of staff joking around the office, being hit in the face by flying teppanyaki or describing the creation of a bank account as a ‘Kafkaesque task beset by bureaucracy’.
- Subscribe to Money’s weekly newsletter, delivered to your inbox every Wednesday
But in the alternative universe of bitcoins, it makes some sense. People who use the ‘cryptocurrency’ are often young and distrusting of authority. In fact the whole idea of a bitcoin miner launching an IPO seems quite subversive considering the community’s distrust of middlemen.
Distrusting or not, though, the bitcoin business is desperate for capital and Bitcoin Group – which describes itself as “Australia’s largest [Bitcoin] mining operator” – will soon be asking you for yours.
Bitcoin is a “cryptocurrency”. Rather than existing as physical coins and notes, bitcoins are evidenced by transactions on a on a giant ledger known as the “blockchain”.
The main attraction is that it’s considered free from manipulation from central banks and governments. The theory is that by cutting out these people, the purchasing power of a bitcoin will not be eroded over time. It is also hoped that transaction fees will be lower than those typically charged by credit cards.
So where, you might ask, do bitcoins actually come from? Well they don’t grow on trees, but they do almost grow out of computers – which is where Bitcoin Group comes in.
Bitcoin Group is “bitcoin miner”. Miners earn bitcoins by authenticating transactions on the blockchain. Miners compete to solve a mathematical puzzle by attaching a new block of transactions to the chain in a particular way (using the SHA-256 secure hash algorithm, no less – keep up at the back).
The successful addition of a block earns a reward of 25 newly minted bitcoins at the moment – currently worth about $8000. The puzzle is such that miners must essentially use trial and error to solve it, meaning that earning bitcoins comes down to probability based on the computing power thrown at the problem.
As the overall computing power on the network increases, the difficulty of the puzzle is increased so that the average time between new blocks being added stays at about 10 minutes.
The reward for adding blocks is also halved every four years, before being reduced to nothing when an arbitrary limit of 21 million bitcoins is reached. This is expected to happen some time in 2140, but 99 per cent of all bitcoins are expected to be mined by 2033. After the limit has been reached, record-keeping will be rewarded only by transaction fees.
Is it really worth it?
Given that the entire system appears to rely on new capacity entering the network and competing for reduced reward, it’s easy to understand why many consider bitcoin to be a pyramid scheme. The processors most miners use, known as ASICs, are expensive to purchase, use large amounts of energy and generate enormous amounts of heat.
Scale is now everything, with many miners operating warehouses of machines 24 hours a day. Many miners choose countries such as Sweden and Iceland due to the abundance of cheap and reliable electricity, as well as their cold climates, which reduce the cost of cooling.
Most of the capital raised through Bitcoin Group’s IPO will be used to invest in new hardware, which will be located mostly in China. The trouble is that, as the company itself readily concedes, hardware in this line of work typically needs to be replaced after just 18 months. Don’t expect a dividend from this company; they will need to reinvest everything they can.
Bitcoin Group forecasts that it will successfully mine between 80,000 and 115,000 bitcoins in the 2016 financial year. At current prices this means it would generate revenue of $28-$40 million, but considering the volatility in the price of bitcoins, it’s hard to have any confidence in this figure.
Operating costs for 2016 are forecast at just over $20 million. While some of the costs are paid using bitcoins, others require more traditional payment methods, so a slump in the price of bitcoins could see profitability eroded very quickly.
Historical figures for Bitcoin Group show a profit of $69,000 generated from $1.7 million of revenue from its brief time operating (it was incorporated in September 2014), but only $10,000 of this actually came from minting bitcoins, with the remainder coming from gains in their value.
One way or another, we’d expect competitive forces to maintain a marginal rate of profitability over the long term, although the enormously volatile price of bitcoins could make bitcoin mining unviable at times.
With competition eating away at the rewards, miners will likely respond with higher transaction fees, but this risks undermining one of the great advantages of the platform over more conventional methods.
More worrying perhaps is the real threat that the whole platform could become obsolete. New technology could disrupt or governments could just rule bitcoin illegal. The latter would stop legitimate businesses from using it and send it back to being nothing more than a niche payment method for drug dealers.
Bitcoin sounds like a great idea, but great ideas are only good if they are viable in the long term. Unless the general public, who don’t understand secure hash algorithms, feel safe using it then it is unlikely to gain critical mass and become a real alternative for payments.
Whether it catches on or not, though, Bitcoin miners are likely to remain capital-intensive, low-margin businesses and we’re very happy to watch on from the sidelines, with interest and bemusement.
Andrew Legget is an analyst with Intelligent Investor Share Advisor. This article contains general investment advice only (under AFSL 282288). Authorised by Alastair Davidson.
To unlock Share Advisor’s stock research and buy recommendations, take out a 15-day free membership.