Gauging Interest: Difficulty Derivatives? Miners lock in future Diff.

[MJGrae]

Just trying to gauge some interest here to see if this would be a worthwhile endeavor. I thought this might get more of an accurate reaction in the mining forum, but I think it would end up being moved here so... it is what it is.

I'm considering offering derivative difficulty contracts so that miners would be able to hedge against large spikes in difficulty.

The way I'm thinking it would be structured is this: one contract would represent "x" amount of hashing power at a certain strike (difficulty). Should difficulty spike above the strike price before expiration, the contract would pay out the difference between what "x" hashing power would have mined at the strike difficulty and what WAS mined at the current difficulty upon expiration. Obviously some premium would be paid for the contract based upon historical/implied volatility and whatnot. I'm not going to discuss the full pricing model in mind here, but if you're interested and considering backing this endeavor I would certainly entertain more questions privately.

Put simpler: 1 ghash would be expected to mine ~0.352BTC in a week with difficulty at 10,000,000. If difficulty happened to rise to 20,000,000 we would only expect that same ghash to mine ~0.176BTC that week. In this case, the contract would be worth ~0.176BTC at expiration which would be settled with and paid out to the miner.

Bear in mind that these contracts are not designed to make miners money on the whole. They are designed to hedge against downside risks associated with volatile difficulty in order to provide more stable returns over time. These would be more beneficial the larger your mining operation is. To a lesser extent, these contracts would also allow individuals to speculate on things like: massive btc price spikes bringing more rigs on board, new companies delivering equipment, etc. There are a plethora of ways these contracts could be used besides hedging a mining operation.

It's just an idea that I've been kicking around my head for a little while, and I've got a few other "products" in mind but this seemed to me like the most reasonable to start with.

What do you think? Poke some holes in it if there is anything that bothers you. I just want to see how much, if any, interest there is in a service like this.

Some background about myself: I work on the floor of the Chicago Board of Trade in the options pits, trade all sorts of financial instruments, and have had a passion for this sort of thing since I was a lad.

[furuknap]

This would definitely be interesting, but if people are convinced that difficulty will go through the roof (perpetual proportional growth, or PPG) as it seems today, how would you fund it?

.b

[MJGrae]

This would definitely be interesting, but if people are convinced that difficulty will go through the roof (perpetual proportional growth, or PPG) as it seems today, how would you fund it?

.b

Good question, bear in mind that derivative contracts like these are not written to make the hedgers money. They are designed to stabilize their returns and bar some of their downside risk. Pricing models are typically designed to give the creator (writer) of the contract a certain probability of not having to pay out. This probability is quite often in the neighborhood of 95%.

Miners must determine whether the premium they are paying for the contract is worth it. This would be some function of the premium being paid for the contract, the risk that difficulty will rise above the selected strike, and the amount the miner stands to lose if difficulty DOES rise that high. They may also throw some blind speculation into the mix, but that's not for me to say, nor is that my policy when trading.

Be assured, though, that most of these contracts would end up expiring worthless for the miners and the writer would be keeping those premiums that were paid.

In short, if I'm being completely honest, these contracts are ALWAYS written in the writer's favor. That's how it works. As a whole, however, a net benefit is provided to both the writer and purchaser of a contract assuming that both are making wise decisions in their best interests using all of the information available to them.

Also, these contracts have expiration dates that would line up with approximate difficulty changes. They are not perpetual contracts and therefore miners would not lock in their difficulty forever. They could, however, lock in a certain difficulty weeks, months, even years into the future.

[Rival]

One thing to consider is that the rate of difficulty increases will never be linear. They have over the history of bitcoins followed a pattern more akin to quantum states because of technological advancements. That is to say, the rate of increase (integral) for cpu mining was somewhat stable as more nodes came on line, but jumped to a new quantum state when GPU began. This was followed by FPGA (for a short time) and then GEN1 ASIC. We are still at the GEN1 quantum state, which will be followed by Gen2, Gen3, and then probably settle forever in Gen4.

I would be highly adverse to making specific predictions on difficulty growth rates based upon future technology. When I say future technology, I do not mean cutting edge or undiscovered technology, but rather well understood technology delivered to consumers that is currently unavailable to miners. AMD or Intel could decide tomorrow to produce ASIC chips that obliterate all other mining rigs available, although they have to date shown no interest in doing so. It will take years for ASIC mining chips to reach the standard of technology that is already available in other applications for consumers. However, developers of ASIC chips do not have anywhere the resources of an AMD or Intel at this time. But perhaps in a year or two they may.

[MJGrae]

One thing to consider is that the rate of difficulty increases will never be linear. They have over the history of bitcoins followed a pattern more akin to quantum states because of technological advancements. That is to say, the rate of increase (integral) for cpu mining was somewhat stable as more nodes came on line, but jumped to a new quantum state when GPU began. This was followed by FPGA (for a short time) and then GEN1 ASIC. We are still at the GEN1 quantum state, which will be followed by Gen2, Gen3, and then probably settle forever in Gen4.

I would be highly adverse to making specific predictions on difficulty growth rates based upon future technology. When I say future technology, I do not mean cutting edge or undiscovered technology, but rather well understood technology delivered to consumers that is currently unavailable to miners. AMD or Intel could decide tomorrow to produce ASIC chips that obliterate all other mining rigs available, although they have to date shown no interest in doing so. It will take years for ASIC mining chips to reach the standard of technology that is already available in other applications for consumers. However, developers of ASIC chips do not have anywhere the resources of an AMD or Intel at this time. But perhaps in a year or two they may.

Definitely true, however shorter term patterns seem to be relatively linear in themselves. Obviously I would be more prone to writing shorter term contracts, with extra caution baked into premiums both in longer term contracts as well as contracts issued when new technology is expected. True that I can never predict when these will actually happen or if they ever will. But I would say that the probability of new technology hitting the market without any idea beforehand which would kick difficulty into one of these quantum jumps is quite low.

It is akin to options on agricultural products. We can never fully know when some freak natural disaster will hit and wipe out an entire crop, thus propelling prices to ridiculous heights. However, you can compensate for these probabilities in your pricing model as well as take on extra hedges when there is any sort of a hint that they might occur.

[Rival]

What you say is very true. It is useful to consider that within each "quantum state" that the difficulty increases will follow a familiar and predictable pattern based off of adoption. As more and more people adopt the new technology, the difficulty will be characterized as a quick increase followed by a long-tail taper, basically a plateau that grows more slowly with time.

The only other real influencing factor is organic growth, which can be characterized as larger populations of users. This concept may be made obsolete by the last jump to ASIC, wherein specialized equipment is now required to expect any return. I do not see much future growth in the number of miners, in fact, I would suggest the number of miners to diminish as hardware requirements increase. I would expect a long term trend of consolidation, where only a small number of mining companies are responsible for nearly all of the hash, ending the era of private ownership of mining equipment forever.

For this reason, any attempt to hedge is destined for eventual extinction, as your only customer base will be the few surviving mining companies who have little or no need of your services.

[helixone]

Just trying to gauge some interest here to see if this would be a worthwhile endeavor. I thought this might get more of an accurate reaction in the mining forum, but I think it would end up being moved here so... it is what it is.

I'm considering offering derivative difficulty contracts so that miners would be able to hedge against large spikes in difficulty.

The way I'm thinking it would be structured is this: one contract would represent "x" amount of hashing power at a certain strike (difficulty). Should difficulty spike above the strike price before expiration, the contract would pay out the difference between what "x" hashing power would have mined at the strike difficulty and what WAS mined at the current difficulty upon expiration. Obviously some premium would be paid for the contract based upon historical/implied volatility and whatnot. I'm not going to discuss the full pricing model in mind here, but if you're interested and considering backing this endeavor I would certainly entertain more questions privately.

Put simpler: 1 ghash would be expected to mine ~0.352BTC in a week with difficulty at 10,000,000. If difficulty happened to rise to 20,000,000 we would only expect that same ghash to mine ~0.176BTC that week. In this case, the contract would be worth ~0.176BTC at expiration which would be settled with and paid out to the miner.

Bear in mind that these contracts are not designed to make miners money on the whole. They are designed to hedge against downside risks associated with volatile difficulty in order to provide more stable returns over time. These would be more beneficial the larger your mining operation is. To a lesser extent, these contracts would also allow individuals to speculate on things like: massive btc price spikes bringing more rigs on board, new companies delivering equipment, etc. There are a plethora of ways these contracts could be used besides hedging a mining operation.

It's just an idea that I've been kicking around my head for a little while, and I've got a few other "products" in mind but this seemed to me like the most reasonable to start with.

What do you think? Poke some holes in it if there is anything that bothers you. I just want to see how much, if any, interest there is in a service like this.

Some background about myself: I work on the floor of the Chicago Board of Trade in the options pits, trade all sorts of financial instruments, and have had a passion for this sort of thing since I was a lad.

For this to really work well, I think we need a real futures exchange, where people can take part on either side of the trade, and the exchange is well capitalized to reduce counter-party risk. Margin requirements and settlements would also have to be very carefully worked out.

I'll add though, I believe the security you are thinking of launching may already exist: See iDiff futures: http://mpex.co/ https://bitfunder.com/asset/CoinBr.iDiff-E

-helixone

[Rival]

To elaborate, AM is following the same path Microsoft followed in the 1990's. They can easily dominate the entire system. But Microsoft actually pumped billion of dollars into Apple. AM sells massive hash to individuals, which are actually their competition. It sounds counter-intuitive, but it is actually genius.

AM welcomes that competition. They have a 50% barrier they cannot ever violate under any circumstances. This puts a ceiling on their growth. But by supplying hash to the world, they profit not only from their own hash, but also from the hash they sell to every other company. This affords them the capital to maintain an advantage, and to completely control the the entire ecosystem. This is the very definition of  the "cat-bird seat".

Attempting to hedge difficulty rates equates to nothing different than fed watching for bonds, except in our case we are AM watching. Unfortunately, there is nothing opaque or arcane about the reports from Friedcat. The only thing you will be doing is stripping btc from the uniformed and handing it to the informed, and extracting a fee for the service. Hardly an honorable way of making btc.

As I said, AM will welcome the rise of others such as Avalon or KNC, but they will never be threats. They are useful to AM only as a means on ensuring that the market cap of 50% increases and increases, ensuring almost infinite growth.

Of course, I may be completely wrong.

[MJGrae]

What you say is very true. It is useful to consider that within each "quantum state" that the difficulty increases will follow a familiar and predictable pattern based off of adoption. As more and more people adopt the new technology, the difficulty will be characterized as a quick increase followed by a long-tail taper, basically a plateau that grows more slowly with time.

The only other real influencing factor is organic growth, which can be characterized as larger populations of users. This concept may be made obsolete by the last jump to ASIC, wherein specialized equipment is now required to expect any return. I do not see much future growth in the number of miners, in fact, I would suggest the number of miners to diminish as hardware requirements increase. I would expect a long term trend of consolidation, where only a small number of mining companies are responsible for nearly all of the hash, ending the era of private ownership of mining equipment forever.

For this reason, any attempt to hedge is destined for eventual extinction, as your only customer base will be the few surviving mining companies who have little or no need of your services.

I was actually just thinking about this, and you could be right that we will soon be left with only just a few large mining companies because of the very real hardware gap that we have entered. However That is not to say that they would have no need for my service. In fact they may have even more need for it in the same way that the big oil companies do much of the same thing to hedge their oil and gas companies.  If we were left with only a few big mining companies they would be locked in a perpetual battle for network share with no indication of when their competitors will role out large amounts of new miners. The larger the operation, the more that is at risk when they lose market share. Therefore it would still be very wise for them to seek out ways to hedge being beaten to the punch by one of the other companies.

In fact, I personally know a trader at BP who's only job is to trade futures and options on oil and other products that the company uses in operations so as to not be pushed out of the market. He's saved them billions in a single year before.

[Rival]

I agree with all you have said except for one point: that they are locked in battle for market share. In my previous post I outlined why AM will always dominate and control the market share of their competitors.

It will not really be a free market. It will be dominated and manipulated by Friedcat. In fact, it already is.

[Kyune]

For this to really work well, I think we need a real futures exchange, where people can take part on either side of the trade, and the exchange is well capitalized to reduce counter-party risk. Margin requirements and settlements would also have to be very carefully worked out.

I'll add though, I believe the security you are thinking of launching may already exist: See iDiff futures: http://mpex.co/ https://bitfunder.com/asset/CoinBr.iDiff-E

Agreed.

It's hard to gauge how much room there is for another asset in this space in the absence of a fully-functional futures market.  We already have several tools scattered around the exchanges but I'm not sure they are getting that much traction for these purposes.  In addition to the iDiff futures, taking long positions in DMS.SELLING (https://btct.co/security/DMS.SELLING) or writing options on DMS.PURCHASE (as detailed in https://bitcointalk.org/index.php?topic=228327.msg2435960#msg2435960) can be done today.

[rini17]

As iDiff issuer I can say they are currently not used as a hedge, but more as a speculation by non-miners.  Miners just aren't interested to learn to use them or are afraid of counterparty risk, and most of them can't afford to hire an expert.

Also, anything beyond 3 months is plainly too expensive.