Are Difficulty Based Derivatives in the Pipeline for Bitcoin Miners?

Cash-settled difficulty based derivatives are discussed by Zap founder Jack Mallers in an interview with Max Keiser. Such a product would allow miners to hedge against the risk of difficulty increasing which typically results in miners producing less bitcoin.

Quick take;

  • Bitcoin futures contracts have been used by miners to transfer risk associated with future price movements
  • The development of a derivative pricing in the risk of difficulty would allow miners to hedge against increases in difficulty
  • Mallers claims the difficulty-based derivative will initially be available in an over-the-counter market but holds hopes for it evolving into a publicly listed futures product

Jack Mallers recently appeared on the Keiser report where he discussed derivatives designed for bitcoin miners to transfer risk associated with their operations. Mallers is the founder of the Lightning Network desktop wallet Zap but has recently been focusing efforts on developing derivative products for miners which he feels to be an “untapped market”.

Derivatives in Mining

Derivatives are not an entirely new phenomenon in the mining industry. There is already markets developed which allow miners to hedge future price risk by trading futures contracts.

Futures and options enable miners to take a lot of uncertainty off the table. As Mallers describes in the interview, miners are very similar to margin traders in the manner that they are highly exposed to future price risk.

Bitcoin mining hosting company Bcause founder Thomas Flake is also exploring the development of a derivatives market for miners. Flake explained through an example that miners can move from not knowing what the price of bitcoin will be in nine months to knowing that they will be able to liquidate at $6,500 as a result of acquiring an options contract.

Mallers described in the interview that the need for derivatives arose from the need to transfer risk in traditional industries. Similar to how corn farmers cannot be certain of corn prices six to twelve months into the future, bitcoin miners cannot be certain of bitcoin prices or mining difficulty levels in the future.

A Bitcoin Mining Difficulty Derivative

Mallers notes that bitcoin miners are “inherently short difficulty”. When difficulty goes up, miners produce less bitcoin and vice-versa. A difficulty based derivative would enable miners to hedge such a rise.

“If difficulty runs away from them to the upside, they can have a long difficulty position that pays them out”

When questioned by Keiser about whether Mallers seeks to create derivatives related to costs of production, Mallers noted they are focused on pricing the risk associated with difficulty. Mallers does envision the potential for a spot hash rate product where mining pools would enable investors to buy in and out of the hash rate running on their pool.

As it stands, the market for the difficulty-based derivative is confined to over-the-counter trades. However, Mallers holds hope that it can evolve into a publicly-listed futures product.