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Bitcoin Mining Insights

# Debt Capital Markets in Bitcoin Mining (Part 2)

In Part 1 of this series, we reviewed the history of debt in bitcoin mining, examined key principles of debt, and looked at some of the most common structures available to bitcoin miners. Now that we understand the landscape, we will take a look at the considerations for borrower and lender alike, the effect of leverage on mining returns, and discuss how the future of the market might look.

Published on Feb 08, 2023
Published on Feb 08, 2023

## ‍Key Considerations

### From a Lender’s Point of View

Many of the lenders in bitcoin mining have been viewed as predatory, gouging hard-working hashers at usurious  interest rates and driving miners into bankruptcy. But your humble author believes this critique to be a bit unfair. The last 6 months suggest that bitcoin mining lenders were perhaps not conservative enough in their underwriting practices, and perhaps should have demanded even more protection or higher interest rates (remember the mantra, “there’s no bad risk, just a bad price”).

So let’s examine the key considerations for a lender to better understand where they are coming from. When evaluating the below considerations, instead of saying certain aspects of a loan make it “better” or “worse,” we will instead discuss them as having more or less “risk.”

Primary Goal: the lender’s primary goal is to earn attractive risk-adjusted returns (“return on capital”). This means AT LEAST receiving their principal back (“return OF capital”), and this latter concern is the motivating force behind most lender considerations.

### Loan Considerations:

• Creditworthiness of borrower: the less leveraged, the more “trustworthy,” experienced, and profitable the borrower, the less risk
• Loan-to-Value: the lower the LTV, the less risk
• Collateral: the more (and more liquid) the collateral, the less risk
• Term: the shorter the term, the less risk, as the lender gets their money back faster and uncertainty increase as you move further out into the future (not to mention halvings)
• Covenants: the more rules and restrictions that protect the lender, the less risk (an oversimplification but directionally correct)
• Interest rates: the higher the interest rate, the more attractive the loan, as the interest rate is the key determinant of lender returns. If other aspects of the loan increase its risk, the lender is typically compensated with a higher interest rate (remember the mantra of debt)
• Debt service coverage (cash flow divided by debt service expense): the higher the coverage, the less risk
• Balance sheet: the lower leveraged the borrower (and the more unrestricted cash), the less risk
• Sizing: the work required to originate a $1 million loan vs. a$100 million loan is surprisingly similar; so lenders often have minimum loan sizes to ensure that the juice is worth the squeeze
• Operations: lenders want to lend to borrowers who are operationally sound and profitable, as this reduces the risk of the borrower being unable to service the debt. In the case of bitcoin mining, this means miners with a proven track record and low-cost power

### Other Considerations:

• Portfolio construction: the more diversified the portfolio, the less risk. As stated above regarding sizing, while lenders might have minimum loan sizes, the desire for a diversified portfolio can impose maximum loan sizes as well. That way no single bad loan will cause their ruin
• Syndication: as discussed in Part 1 (see the “Back-end financing” section), the lender might have separate “investors” who purchase or lend against these loans once they are originated. This lies at the heart of the lender business model: a lender borrows at X% and lends that same money out at X+Y%, where Y% is their net interest margin. This consideration can lead to “origination targets” where a lender will seek to issue a given amount of loans in order to satisfy an agreement with investors

## Key Considerations for Bitcoin Miners

Now that we understand the considerations for lenders, we will examine how miners should approach these structural features. To simplify things, we will consider a loan to be “more attractive” from a borrower’s perspective if it comes with less restrictions thereby providing them more flexibility.

### Primary Goals:

• Capital-efficient expansion: the ability to finance larger operations and/or take on less equity dilution
• Enhanced returns: we will discuss this more in the Case Study section below

### Loan Considerations:

• Proceeds: miners will often seek to borrow as much as they can, but this can be a double-edged sword as it can both reduce net cash flows and increase balance sheet fragility
• Collateral: the less collateral pledged, the more attractive the loan
• Term: the longer the term, the more attractive the loan, as it gives the miner more time to pay back principal. In the case of an amortizing loan, this means lower the monthly payments
• Covenants: fewer covenants make for a more attractive loan; borrowers want freedom to act however they see fit, and covenants (especially operational covenants) can get in the way of this
• Interest rate: the lower the interest rate. the more attractive the loan. Miners are incentivized to seek the lowest cost of debt possible; this often is the key point that makes a miner choose one structure over another (if you have a bitcoin treasury, why borrow against ASICs at 15% when you can take out a bitcoin-backed loan at 5%?)
• Debt service coverage: while miners typically want to maximize their debt proceeds, they should also be conscious of the fact that too much debt can be a burden on cash flows
• Balance sheet: much like debt service coverage, balance sheet considerations are also a rare moment when borrower and lender incentives are aligned; too much debt can cause borrowers to become insolvent
• Hidden fees: another key consideration for borrowers are the hidden fees that lenders often structure into loans. Borrowers typically only think of the headline interest rate, but these fees can cause meaningful changes to the overall “cost of debt”
• Upfront or origination fees: typically 1 - 2%, these fees are the difference between the cash proceeds disbursed to a borrower and the outstanding principal amount on origination
• Warrants: some lenders might also ask for warrants (contracts granting the right to buy the borrower’s equity at a specified price) as a way of providing additional upside
• Related transaction fees (e.g., hedging): some lenders to bitcoin miners will offer a “discount” on the interest rate in exchange for guaranteed fees to other parts of the business

### Other Considerations:

• Initial diligence: given the asymmetric downside lenders face, they require borrowers to go through an extensive diligence process to ensure they are operationally and financially sound. From a miner’s perspective, the colonoscopy of due diligence is often worth it, but would-be borrowers should expect to disclose nearly every material aspect of their business to the lender prior to receiving a dollar of proceeds
• Firmware and advanced cooling technologies: loans with ASIC collateral often prevent the use of aftermarket firmware or advanced cooling technologies (e.g., immersion) without lender approval. These restrictions are intended to minimize potential damage to machines and maximize their fungibility on the secondary market, but they may hinder a miner’s ability to optimize their operations
• Operation simplicity: loans typically all come with their own operational and reporting requirements. The administrative work to fulfill these requirements on even one loan can be burdensome, let alone multiple

## Case Study

The following section illustrates the effect of leverage on the returns of a bitcoin mining operation. The outputs were created using a simple cash flow model which can be accessed here. The curious reader is invited to download a copy to play around with the model and explore the impact of leverage on various mining scenarios.

Before we dive into the details of the case study, we will state a few simplifying assumptions that are unrealistic, but helpful for purposes of forecasting.

• We assume a flat hash price during the entire forecast period
• We assume that capital is deployed during month zero, and hash rate is live the following month. In reality, this is also unlikely, but it is similar to a miner purchasing a completed site from a third party and commencing operations immediately
• We look at everything on a pre-tax basis
• Lastly, this case study considers a typical loan that might have been issued prior to the severe deterioration of mining conditions in mid 2022. The illustration of these terms does not suggest that such loans are readily available to miners

The operation assumptions are fairly simple:

• We assume that a new project is built for $2.4m • 1,000 S19J Pros purchased at$15 / TH ($1.5m in total) • Supporting infrastructure costs$300k / MW ($900k in total for an assume 3MW site) • For simplicity, we assume an S19J Pro pulls 3,000 watts • We forecast cash flows over a period of 3 years (conservative estimate for the lifetime of an ASIC) • We assume the site has 95% uptime and$55 / MWh all-in operating costs

Now, we will consider the effect of adding an ASIC-backed loan with a ~50% LTV ($750k of debt proceeds, prior to a 2% origination fee). We assume this$765k loan has an interest rate of 15% and an 18 month term.

For three hash price scenarios we will examine the following output. The top half of the analysis shows the monthly cash flows, and the bottom half shows the returns over a 3 year forecast period. The left and right columns show the results of the miner taking on that leverage (LHS) vs. the results if the miner never took on leverage in the first place (RHS). Notably, when looking at the monthly cash flows for the miner that did not take on debt (“unlevered”), the reader can see the cash flow profile of the levered miner after the debt is paid off.

As the “Base Case” we will look at the approximate 3 month trailing average hash price (~6.5 cents / TH / s / day). Under these conditions, the returns from a mining project with the above specifications are marginal. It takes nearly the entire 3 year period for the miner to recover their initial equity investment. This helps illustrate the brutality of recent bitcoin mining conditions.

Now, if hash price fell to 5.0 cents (the approximate hash price if bitcoin fell to $15.3k and the network held at 280 EH/s), the debt service exceeds the operating profit, resulting in the miner hemorrhaging cash until the debt is paid off. The returns in this scenario are even worse, with the levered miner never recovering more than 14% of its invested capital, while the unlevered miner earns only 45% of the invested capital. This highlights the role that leverage can play in harming the cash flow profile of a miner. In reality, however, it is unlikely a miner would continue to hemorrhage cash by servicing this debt until maturity. Typically, one or more of the following would occur: restructuring, default, or bankruptcy. The field of distressed debt is highly complicated and nuanced but below is an oversimplified discussion of each (disclaimer: the only true experts in this subject are practitioners with years of experience in navigating restructurings and bankruptcies). • Restructuring: a miner might “restructure” their existing loan, by renegotiating terms with its existing lender and/or refinancing their debt with a new lender, to reduce the ongoing debt service burden. Typically restructuring consists of some combination of the following: prepayment from the borrower (either from balance sheet cash. the sale of assets, or potentially new, more punative debt), extension of the loan term (perhaps in exchange for contributing additional collateral), and/or conversion of debt to equity. Restructuring is always a negotiation between the borrower and the lender and is therefore unique to each situation • Default: when a borrower fails to perform its obligations under a loan, a lender can trigger a “default.” Events of default are explicitly stated in loan agreements. Sometimes different events of default allow the borrower a certain amount of time to “cure” them, thereby preventing an actual default. But if the borrower does not, a lender has the option to foreclose on collateral and force certain actions from the borrower (e.g., the return of collateral). A default can also either lead to restructuring or bankruptcy • Bankruptcy: there are various different types of bankruptcies (often referenced by different chapters of the U.S. Bankruptcy Code), but in general it is a process where companies seek relief from debt that it cannot repay. This can either be imposed by a lender or entered into voluntarily from a borrower. The bankruptcy rabbit hole is far too deep to go down in this piece The reason many miners took such risks, however, was the effect leverage can have on returns (though some might claim ignorance played a role as well). To better understand, let us consider the returns if bitcoin pumped back toward its previous all time high of$69,420 the day after the loan was issued and the capital invested. This would result in ~23 cent hash price (assuming network hash rate stayed flat).

In this scenario, the levered miner earns a return on their invested capital 3x higher than that of the unlevered miner. And the operating cash flow so vastly exceeds the debt service, that the monthly payments are inconsequential. Looking at this scenario, it’s not surprising that so many miners aped into machines in 2021. Few other physical asset classes have the potential to offer returns like these (though it’s worth noting that the price of machines and infrastructure would likely inflate as well if mining conditions improved so drastically, but this is intended to be a simple model, so we try to minimize the number of changing assumptions).

The TLDR is perhaps unsurprising: leverage offers miners the ability to amplify returns and expand faster, but it comes at the cost of fragility during bear markets. Those seeking to understand the effect of different assumptions and added complexities on returns are invited to play around with the open-sourced model.

## The Future of Debt in Bitcoin Mining

### The Shortcomings of ASIC-Backed Debt

Two years ago, if you, dear reader, had asked me, your humble author (a former asset-backed securities investment banker and ASIC-backed lender) how debt capital markets in bitcoin mining would evolve, I would have said debt in bitcoin mining would evolve just like many other asset-backed credit markets with specialty lenders.

In these markets, when a new asset class emerges, originations start with smaller lenders offering new debt products at high interest rates. Over time people get more comfortable with the asset class and interest rates decline (as underwriting prowess increases and perceived risk decreases). Eventually other financial institutions agree to purchase these loans (back-end financing), changing the business model of the lenders to become “origination platforms,” collecting a fee on the loans they originate and then sell. Banks then facilitate the issuance of “term” asset-backed securities to other investors (largely insurance companies, seeking a fixed return over a fixed term). So the “origination platform” creates the loan and takes a spread, the bank takes another spread for packaging the asset-backed security, and the investor enjoys the rest of the loan’s economics. This is how securitization markets work. And given the parallels to other securitized asset classes (e.g., traditional equipment finance), I would have said that ASIC-backed debt would follow this same path.

But such securitization markets take years to develop, and the boom and bust of ASIC-backed debt in the last 12 - 24 months has highlighted many shortcomings of the structure that your humble author and many lenders did not predict. These shortcomings call into question the long-term viability of the structure, and are as follows:

• Correlation: in simple terms, as bitcoin price falls, so too do ASIC prices (the collateral value), and the profit margins of miners (their ability to service the debt). This means if a lender were to foreclose because a borrower is unable to service the debt, it is likely that the collateral, the very thing which was supposed to give the lender additional security, has also lost value
• Volatility: it would be one thing if the highly-correlated bitcoin and ASIC prices were stable, but recent history has shown us this is far from the case as both witnessed ~80% + drawdowns. In dollar terms, ASICs are volatile assets that people buy in hopes of producing another volatile asset (bitcoin)
• Liquidity of ASICs: unlike bitcoin, ASIC orderbooks can be quite thin, so if a lender is forced to repossess ASICs, it is unclear whether they will be able to sell them quickly (and without meaningful slippage in price)

The cost of capital for ASIC-backed debt also poses an issue. It is unclear if the interest rates of ASIC-backed debt will ever be competitive with bitcoin-backed debt. Perhaps this is unsurprising, as bitcoin is the best form of collateral in human history. For this reason, it seems unlikely that bitcoin-backed debt will ever go away entirely (in fact, the author expects this market to expand by many orders of magnitude over the next few decades). But even setting other structures aside, the macro backdrop of rising interest rates may hit ASIC-backed debt harder than bitcoin-backed debt, as a ~5% increase in ASIC-backed debt could take interest rates as high as 20-30%.

The above reasons cast doubt as to whether ASIC-backed debt will reemerge as the dominant structure when conditions improve. But what will replace it? While the exact structures are uncertain, the cost of capital will remain king. If miners do decide to employ leverage, they will continue to seek the cheapest and least onerous form of debt.

### Cost of Capital is King

Perhaps instead of ASIC-backed debt lenders will make a push for large corporate debt facilities with all-asset liens (i.e., bitcoin, ASICs, infrastructure, and any PPAs) or even site-specific loans. Such structures may offer a lower cost of capital perspective, as in an event of default, a lender could foreclose on an entire mining operation and run it themselves. The lender would then earn all associated free cash flow while they look to liquidate the site (if they want to liquidate at all). In such a scenario, a lender-cum-miner would have far more flexibility than they would if they were forced to liquidate a portfolio of offline ASICs. The desire for “self-sufficient” collateral may mean that hosted data centers are the best lenders of ASIC-backed debt for their customers, as foreclosure on collateral is trivial (the lender just needs to redirect the ASIC to the mining pool of their choice).

One other interesting manifestation of this theme is that retail miners with good credit scores (who often do not have access to ASIC-backed debt) may be able to take out personal loans to finance machines, which are sometimes priced at lower interest rates than ASIC-backed debt (if ASIC-backed debt is available to them at all).

The quest for interest rate arbitrage could also give an advantage to would-be-miners from other industries that have lower cost of capital. For example, an energy super major has far more debt products available to them at a lower cost of capital. Energy companies could use this to their advantage if and when they enter into bitcoin mining in earnest.

From a lender’s perspective, cost of capital is equally important. Only lenders with access to cheap capital will be able to compete in offering debt financing to miners. Imagine two lenders: one is a venture-backed startup the other a large bank. There is little chance a venture-backed startup will be able to provide loans at a lower interest rate than banks with access to the fiat debt capital markets (even when subsidized by fiat VC funding). The only way to win in financing businesses is to have the lowest cost of capital.

### The Forever Forthcoming Hash Rate Marketplace

Perhaps instead miner financing will be dominated by entirely novel structures. One debt-like product that might play a role is hash rate-based financing. While the market has yet to settle on one dominant structure, the crux of hash rate financing is that miners should be able to sell their future production similar to other commodity producers. The benefit is twofold:

1. Hash rate financing is non-dilutive (similar to debt)
2. Such products can also allow miners to hedge some of their future production

Famously, hash rate marketplaces have been 6 - 12 months away for the last 3 or so years, but Q4 2022 saw a new push of such products. This form of financing would be entirely new to bitcoin mining, and, at time of writing, it remains unclear whether there is sufficient demand for hash rate to allow this market to flourish.

### Only Time Will Tell

But regardless of what debt products dominate bitcoin mining in the future, at time of writing (January 2023), it seems likely that we will see far less debt in the near term, as miners and lenders alike have been burned in this downturn. Moving forward, miners will likely be more hesitant to use leverage and thereby increase the fragility of their businesses. Likewise, many lenders have left the asset class either due to poor loan performance or because they’ve gone out of business altogether (e.g., BlockFi and Celsius). Those lenders who do remain will likely be far more conservative moving forward (though the next bull run may see a return to similarly aggressive lending practices from new entrants).

This highlights one last key similarity with other credit markets. During bull markets, things are fine and everyone makes money; but during bear markets and recessions, many borrowers, lenders, and investors get burned, resulting in a decrease in originations and an increase in interest rates. This will persist for a while, until conditions improve. Optimism is regained. And the cycle repeats again.

Like other industries, there will be a diversity of attitudes toward debt. Looking back to the energy sector again, many energy companies choose to stay away from debt altogether because of volatile commodity prices. On the other hand, some energy companies binge on debt, a decision which can be wildly successful or catastrophic depending on market timing and execution. Only time will tell which strategies will succeed.

Check out Part 1 of this seris if you haven't already done so.

This article was written for the Braiins blog by Drew Armstrong. Drew is the President and COO of Cathedra Bitcoin, a company that believes sound money and abundant energy are the keys to human flourishing. Prior to joining Cathedra, he was a founding member of Galaxy Digital’s bitcoin mining team and helped build out Galaxy's mining equipment finance product. Drew began his career at Barclays' investment bank, where he focused on the origination of esoteric securitized products, such as data center securitizations and collateralized fund obligations. His views here do not reflect those of any of his past, present, or future employers. Follow Drew on Twitter.

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