Leverage does not get the Credit it Deserves

First of all: Yes, there is a pun in this title and it is intended. But as with most jokes, there is a truth to it. The use of the term leverage in daily conversation, will usually care a negative connotation. Leverage gets a bad rap, you could say. 

The cause of this, I guess, is because most people will associate leverage with debt. And although debt is definitely a form of debt, not all leverage is debt. In the world of engineering, the term leverage simply means the exertion of force by means of a lever

The Law of the Lever, which was proven by Archimedes using geometric reasoning, shows that if the distance a from a fulcrum to where the input force is applied is greater than the distance from the fulcrum to where the output force is applied, then the lever amplifies the input force. “Give me a place to stand on, and I will move the Earth”, Archimedes is famously quoted. 

Leverage and Investing

When we think about investing and business in general, leverage tends to mean financial leverage. But not all leverage is created equal. There are many types of leverage and those different types of leverage have different kinds of qualitative attributes.  

Many investors use leverage and there are probably more types and forms of leverage at your disposal than you can imagine. Savvy investors and entrepreneurs excel when it comes to creative use of leverage. 

Different Types of Leverage 

Once you start looking for leverage, you will start seeing it everywhere. Operating leverage, for example, is a generally under-appreciated form of leverage. Many of the most successful businesses in the world have been able to use operational leverage on favourable terms. Operational leverage is a necessary ingredient in any venture trying to scale fast. 

When we think of Financial Leverage, we tend to think about loans. But there are other forms of financial leverage, such as derivative instruments. 

Operational leverage

  • Other People’s Assets (think marketplaces and aggregators)
  • Other People’s Money (think asset management companies) 
  • Negative Working Capital (think insurance float) 
  • User-base leverage (think new products to your existing user base)

Financial Leverage

  • Debt
  • Unsecured Notes
  • Margin Loans
  • Options
  • Futures
  • Forwards
  • Warrants 

The Beauty of Non-Recourse Leverage

Determining whether leverage is recourse or non-recourse is crucial to any reward/reward assessment. The beauty of non-recourse leverage is that it is asymmetric. If you invest in a stock, the most you can lose is the money you put up. The upside, however, is infinite, theoretically speaking. If you start a limited liability company, your theoretical upside is infinite, but you can only lose the equity you put up (unless you are providing personal collateral). 

Non-recourse leverage often comes at a price. If you buy a call option, you have to pay for it. The further out-the-money it is, the cheaper the price. Unsecured loans are more expensive than secured loans. Etc, etc.

Finding a mispriced, perpetual, non-recourse option on something is the holy grail of fundamental investing. This is how the best investors and most savvy business people create wealth for themselves.

Read more on Leverage and Optionality

Will there ever be more than 21 million Bitcoin?

Anthony Pompliano is the host of the Pomp Podcast, where he talks about all things crypto and Bitcoin. He is also widely followed on Twitter. On Twitter, Pompliano often makes proclamations about banks and central banking. One of his most know catchphrases is “Long Bitcoin, Short the Bankers“.

Incidentally one might make the case that Pompliano is indirectly participating in the banking industry through Morgon Creek Capital, which is an investor in Blokfi.

This morning BlockFi announced that they have raised a $50M Series C round of funding. The investment round was led by my partners and I at Morgan Creek Digital, alongside an amazing list of co-investors like Valar Ventures, CMT Digital, Castle Island Ventures, Winklevoss Capital, SCB 10X, Avon Ventures, Purple Arch Ventures, Kenetic Capital, HashKey, Michael Antonov, NBA player Matthew Dellavedova and two prestigious university endowments.

I will be joining BlockFi’s board of directors as part of this investment.

Pomp Newsletter, August 2020

What does BlockFi do? Well according to the newsletter:

For those that are unaware, let me break down what BlockFi does today, why I think this business can be one of the next multi-billion dollar fintech giants, and where they are going next. Today they have the following products:

  1. A lending product that allows an individual or organization to deposit crypto assets and take US dollar loans out against the collateral. This is popular for people who want USD liquidity, but would rather not sell their Bitcoin or other assets.
  2. An interest-bearing account where users can deposit Bitcoin, Ether, or stablecoins and earn up to 8.6% APY interest.
  3. A cryptocurrency exchange that has no transaction fees.

Sounds like a bank. Quacks like a bank. Must be a bank.

How to Create Bitcoin

I myself am a customer of BlockFi as I have a deposit there. I’m actually a quite content customer. I should also note that I have nothing against the banking profession or of Anthonly Pompliano being one. It’s an honorable profession in my opinion.

Anyways, the cryptocurrencies that I have deposited at BlockFi, as highlighted in the newsletter, carry interest. Interestingly, the interest rates offered through BlockFi are considerably higher than interest rates shown offered by banks.

It’s worth wondering how BlockFi pays its customers interest. There are a number of ways BlockFi can do this. One way would be to just buy cryptocurrencies and pay the customers. However, although this might be good for customer acquisitions, it does sound pretty costly.

A second way, would be to lend out the deposits. The problem here is that if you are accepting deposits by paying up to 8.4% interest, you have to find lenders that can pay even higher interests, to get a positive spread after factoring in delinquencies.

As described in the newsletter, BlockFi has a lending program whereby lenders have to deposit crypto as a collateral. It might come as a surprise that the collateral required to get a loan at BlockFi is double the amount that is being lent. Alas, we can assume that BlockFi is not in much need of writing off bad loans.

Bitcoin Printing

A third way for BlockFi to pay out interests would be to simply add the amount to their clients statements. After all, this is what banks to and banking is all about. The location of the so-called money printing does not happen at the central bank level but at the banks they service.

So what happens if BlockFi or any other banking institution built on top of Bitcoin does this (NB: I have know idea if this is the case, I’m just theorizing here)? Now there are more Bitcoins in circulation that have been created.

The question I ask myself is this. Even if the supply of Bitcoin is fixed, what is to say that the circulation of Bitcoin cannot be increased when lending and other banking related institutions, such as BlockFi, become more widely used?

How does BlockFi custody assets?

This question is answered on the BlockFi website:

When clients send crypto to their BlockFi account or purchase additional crypto within the BlockFi Interest Account, that digital asset is replaced with an obligation to return the same amount of that crypto plus any interest earned. In order to pay our clients crypto interest on a monthly basis and to meet withdrawal requests on a timely basis, we engage in a number of activities, including (1) keeping a material amount of digital assets available for withdrawal with third parties such as Gemini, BitGo, and Coinbase; (2) purchasing, as principal, SEC-regulated equities and predominately CFTC-regulated futures and (3) applying risk management to the lending activities in the institutional market. The credit risks to these institutions are mitigated by credit due diligence and/or collateral (such as cash, crypto, or other assets).

Digital currency is not legal tender, is not backed by any government, and the BlockFi Interest Account is not a bank account nor a brokerage account, and is not subject to FDIC, SIPC, or other similar protections. Interest rates, withdrawal limits, and fees are subject to change and are largely dictated by market conditions. This is not a risk-free product and loss of principal is possible.

Real Value | A Dan Ariely Documentary

Real Value, a economics documentary by the legendary Behavioral Economist, Dan Ariely, is a available in full length on YouTube. Ariely is know for his ground breaking work on experimental economics, covering fascinating and unconventional economic topics such as pain, attraction and cheating.

The Net Benefits of Gaming

Is the video game industry a net benefit or a cost to society? Does it do more harm than good? If you were to perform a cost-benefit analysis of the video game industry you would go about trying to quantify the economic benefits (job creation, research and development, etc) against the societal costs (addition, power consumption, etc).

From a qualitative perspective, I would image that the effect of the video game industry on societies would be somewhat similar to wars. Wars have a huge cost to society. They take up huge resources both in terms of labor and capital but more importantly is the destruction of human lives and the irreparable damage it can leave on its participants.

Wolfenstein 3D" Graphics Compared to "Wolfenstein: The New Order ...
Castle Wolfenstein (1981) vs Wolfenstein: New Order (2019)

At the same time, wars have been known to accelerate the advancement of certain technologies and scientific discovery. Often, these advancements will have applications far beyond than just some wartime utility.

In the same vain, there are undoubtedly victims of the video gaming industry. Games are hyper-optimized to reward the user of playing and video game addiction is well recorded academically. Countless hours are spent daily on video games, that could otherwise have been deployed to more productive uses.

Yet, the video game industry is also a hotbed for technological advancement. There are countless examples of technologies that were originally developed for the gaming industry, which subsequently found application elsewhere. Slack – a public company with a $16 billion market capitalization as I write this – was originally developed as an internal chap application for a gaming company.

Cost-Benefit Analysis of the South Korean Digital Game Industry

In this cost-benefit analysis of the South Korean Gaming Industry, the researchers attempted to estimate the economic costs and benefits of the digital game industry. Addiction to digital games induces economic costs such as increase in crime, facilities investments for curbing addiction, increase in counselling costs and other welfare losses. The digital game industry in South Korea which is known to have one of the highest rates of game addiction.

The annual cost of game addiction is estimated to be approximately $3.5B while the annual benefit is approximately $24.3B ($3.7B for addicted user market). The proportion of the total costs to total benefits from the game industry is an alarming 14% (95% for addicted user market).

What is Inflation Anyway?

I feel like we have made inflation deceptively simple. We have this exact number for it. The Bureau of Statistics will declare something like “last month, the inflation was 2.46%, annually adjusted.” It will do so with an number that is so precise that at will have at least two decimals, implying the surgical accuracy employed to get to that particular number.

We don’t seem to ask ourselves how we come up with these number, do we?

Do We Even Know What Inflation Is?

The great Milton Friedman did not have even a shadow of a doubt: “Inflation is always and everywhere a monetary phenomenon.” Well, here is what the equally great Robert Solow said about Milton Friedman: “Another difference between Milton [Friedman] and myself is that everything reminds Milton of the money supply. Well, everything reminds me of sex, but I keep it out of my papers.”

In Japan they have been expanding the money supply for decades. They can’t seem to produce inflation, no matter how hard they try. If we ask the European Central Bank what inflation is, they say something like “inflation occurs when there is a general rise in prices.” (They will also ask if you have seen the inflation monster and offer you to watch a cartoon about price stability).

If inflation is just general rise in prices, then why do prices rise or fall? Most would say, because changes in supply and demand. Don’t prices of products and services tend to drop over time? How do we even measure this?

How to Measure Inflation?

This seams to me an exceptionally tricky undertaking. If inflation is supposed to measure changes in the price of the stuff we buy over a period of time, what happens when we start buying different stuff over time? Our behaviors and preferences are constantly changing? Imagine a lab scientist that has to test his experiment on rats one day and then repeat the experiments with hamsters.

Do you see the problem here? The stuff we buy is not constant. Take mobile phones for example. How can you realistically measure the inflation in mobile phones from one year to another? Or even, how do you compare the price inflation of mobile phones to a period 20 years ago, when there were no mobile phones?

What about all the stuff we don’t pay for yet derive some benefit from? How do you factor in the change in cost of consuming Google searches into any inflation measurement? Should you measure the increase and decrease in paid ads displayed with organic searches? 

And there there are substitute products. If pork rises in value, relative to beef, you might be inclined to consume more beef and less pork. But the baskets of goods and services will take that into account.

So next time, when you see an inflation number with a couple of decimal points. Ask yourself how it was measured and how accurate that measurement could be.

Universal Basic Income and Inflation

Imagine if the government would decide that everybody would receive a monthly check of $4,000 as a Universal Basic Income. Now imagine that you are in need of a good plumber. How much do you think the plumber will charge:

  • Less than before UBI.
  • Same as before UBI.
  • More than before UBI.

If you think that the plumber will charge less than he did before UBI, you are probably overestimating the compassionate nature of plumbers. If you think a plumber would charge the same as before, you are assuming that plumber will disregard the effect of extra monthly $4,000 to their life.

My assumption would be that most plumbers are not plumbers of passion. Rather, they entered into plumbing because it paid well. The reason it pays well is because nobody aspires to be a plumber. But there is a price where the occupation of plumbing attracts enough of people to satisfy the need for plumbing.

My guess would be that many people would of alternative uses of their times when presented with Universal Basic Income. But the jobs aspire to leave behind would still need be done…just at another price.

The Joys of Compounding

On January 18, in 1963, a 32 year old Warren Buffett sent his annual letter to the limited partners of the Buffett Partnerships. The compound annul return for the limited partners that had been there from the start, five years ago, the return was 21.1%. The cumulative return for limited partners over the five years was 215.1%.

Gross of the management fees that he took as the general partner, Warren Buffett had compounded capital at 26% per year. In the letter, Buffett wanted to better educate his partners of the powers of compounding. In a section that he called “The Joy of Compounding”, he writes the following:

I have it from unreliable sources that the cost of the voyage Isabella originally underwrote for Columbus was approximately $30,000. This has been considered at least a moderately successful utilization of venture capital. Without attempting to evaluate the psychic income derived from finding a new hemisphere, it must be pointed out that even had squatter’s rights prevailed, the whole deal was not exactly another IBM. Figured very roughly, the $30,000 invested at 4% compounded annually would have amounted to something like $2,000,000,000,000 (that’s $2 trillion for those of you who are not government statisticians) by 1962. Historical apologists for the Indians of Manhattan may find refuge in similar calculations. Such fanciful geometric progressions illustrate the value of either living a long time, or compounding your money at a decent rate. I have nothing particularly helpful to say on the former point.

The following table indicates the compounded value of $100,000 at 5%, 10% and 15% for 10, 20 and 30 years. It is always startling to see how relatively small differences in rates add up to very significant sums over a period of years. That is why, even though we are shooting for more, we feel that a few percentage points advantage over the Dow is a very worthwhile achievement. It can mean a lot of dollars over a decade or two.

– Warren Buffett, 1963 Letter to Partners

Here’s the accompanying table:

Compounded Value of $100,000 at different rates and durations
Compounded Value of $100,000 at different rates and durations

All of Warren Buffett’s annual letters to partners are a treasure trove for any aspiring investor. You can find a compendium of the Buffett Partnership Letters over at CSInvesting.org.

3 Great Finance Films Available on YouTube

If you are a finance nut, chances are you already know this. But for the rest of you, I’ll let you in on a little secret: On YouTube – free to view – are three great full-length feature films about finance. And not just some random finance stuff. These are Hollywood quality movies about historic evens in finance.

Here you go:

The Last Days of Lehman Brothers

Written by Craig Warner and directed by Michael Samuels, The Last Days of Lehman Brothers is a British television film, first broadcast on BBC Two and BBC HD on Wednesday 9 September 2009.

A fictional character by the name of Zach narrates the story of how the collapse of Lehman Brothers unfolded and set the financial collapse of 2008 in motion. The film features a sloth of notable character, such Henk Paulson, Dick Fuld, Jamie Dimon and many more.

Barbarians at the Gate (1993)

Barbarians at the Gate is a 1993 television movie based upon the book by Bryan Burrough and John Helyar, about one of the most famous leveraged buyout (LBO) in history. The 1988 buyout of RJR Nabisco.

In this one, you’ll see notable personas such as F. Ross Johnsson, Henry Kravis, George Roberts, Jim Robinson and Peter Cohen. Well written and entertaining account of a crazy era in the history of finance.

Rogue Trader (1999)

Rogue Trader tells the amazing story of Nick Leeson, an ambitious investment broker who singlehandedly bankrupted one of the oldest and most important banks in Britain, the Bearings Bank. It’s a well-executed film, starring Ewan McGregor as Nick Leeson.

Read more on How to Value Stuff

The Economics of Cryptocurrency Mining

What is Cryptocurrency Mining? What are Mining Rigs? How do miners make money and are they consistently profitable? What is Proof of Stake and how does it differ from Proof of Work? Read this transcript of an interview with a seasoned investment manager and Cryptocurrency proponent, Murray Stahl, and learn more about the economics of Cryptocurrency Mining. 

Consensus Money

Horizon Kinetics is one of the first conventional asset management companies to get actively involved in the field of Cryptocurrency and Cryptocurrency mining. Since 2015, the company lead by Murray Stahl and Steve Bregman has been publishing research on Cryptocurrency.

Last year, they started publishing podcasts in Q&A format, under the name Consensus Money. In the third episode of Consensus Money, published in April 2018, Murray Stahl answers question on the intricacies of Cryptocurrency Mining. The podcast is delightfully insightful and lays out the economics of cryptocurrency mining in simple and understandable terms.

What follows is a transcript of the podcast. We have changed the text slightly for a better reading experience. You can listen to the full Q&A session on the dedicated Consensus Money page on the Horizon Kinetics website.

What is Cryptocurrency Mining?

Hugh Ross: Welcome to another episode of consensus money, a podcast series with Horizon Kinetics about cryptocurrencies. I’m Hugh Ross, COO of Horizon Kinetics and today I’m joined by Murray Stahl, the chairman and chief investment officer of Horizon Kinetics. In today’s episode, we’re going to discuss the topic of Cryptocurrency Mining in general and also Horizon Kinetics’s approach to mining. So Murray, with that, why don’t we talk a little bit about mining? Can you tell us what Cryptocurrency Mining is?

Murray Stahl: Okay. Well, Cryptocurrency Mining refers to the process of validating transactions on the blockchain. So, essentially the so-called miners are really operating servers, which are endeavoring to validate transactions that are happening over, what’s called, a block interval. A block is basically the transactions that have happened over the course of 10 minutes and the validation process are things like making sure the public keys and private keys match and have the privilege of writing that to the blockchain.

You’re trying to solve an equation, a branch of mathematics known as elliptical functions. It is not really important what elliptical functions are, but more that people are competing to solve that problem. And whoever’s the first person to solve it within a 10-minute span, or the first entities, get the block reward.  Which, at the moment, is 12.5 Bitcoin, in the case of Bitcoin. In the case of other coins, there are different block amounts of awards.

Different Types of Miners

Hugh Ross: Gotcha. So, I know there are different kinds of miners and mining rigs. Can you perhaps explain the difference between what an ASIC and what a GPU rig is and what does ASIC stand for? What does GPU stand for and why do you even need different kinds of rigs?

Murray Stahl: Okay, ASIC stands for application specific integrated circuit. GPU stands for graphics processing unit. Basically, the coins, the logic behind the Cryptocurrencies were designed to operate on different machines. And that’s why you need different kinds of machines for different kinds of currencies.

Now, with ASIC you’re using that for currencies like Bitcoin and Bitcoin Cash. GPU is used for currencies like Etherium, Etherium Classic, Zcash and oddly enough, Bitcoin Gold and there are some others as well. So you need different kinds of machines to essentially mine or validated transactions of different kinds of Cryptocurrencies, depending on how they were designed.

Owning Rigs vs Cloud Mining

Hugh Ross: Right. Okay, perfect. What is the difference between – you hear the term cloud mining a lot and then when you own the rigs, you’re mining with your own rig. So what’s the difference between mining with your own rigs and cloud mining?

Murray Stahl: Well, essentially what you’re doing in cloud mining, is that you’re leasing capacity.  The same way as you want to store music or pictures or data on the cloud. Basically, you’re leasing someone else’s equipment and you’re not responsible for the operation of the equipment whatsoever.

You pay a certain fee and you get a certain revenue. And presumably, the revenue you get is greater than the fees you pay. The idea is similar, in the case of the mining that you do yourself, except you are responsible for the operations of the machines. There is no one to turn to other than your own faculties

Proof of Work vs Proof of Stake

Hugh Ross: Right. Perfect. Okay. Now, a couple of terms that are out there that I think it is important that people understand. So, there is what’s called Proof of Work and there’s Proof of Stake. Perhaps you could explain to everybody what is the difference between Proof of Work and Proof of Stake?

Murray Stahl: Okay. Well, it can be a little convoluted. So, to begin with, Bitcoin was the first cryptocurrency. They wanted to have a certain issuance rate from its inception – which was roughly in 2009 – until the last Bitcoin was going to be mined, in the year 2140.

The idea was to make the issuance rate a little bit analogous to gold. So, why was gold, for the course of 5,000 years, frequently used as a currency? Because you could always get some gold. But it became progressively harder and harder to find gold. So, the amount of gold that entered the monetary system in any given year was, generally speaking, a small amount.

The idea of Proof of Work that came up, it was to make you do some work to validate the transactions. Basically, you have to get a rig, you have to consume copious amount of electric power and operate equipment and so on and so forth. And basically, you have an operating cost. The idea was to put an impediment upon issuance, (a) so it would be a controlled amount, and (b) if you set up a program like Bitcoin did, there would be a certain difficulty rate.

Difficulty refers to the probability of solving these equations or elliptical functions. And that can be actually fairly predictable. You can have a predictable issuance rate to the year 2140. Which means you will know what the inflation rate is going to be up to the year 2140. Beyond 2140 there is no inflation whatsoever because there is no net currency issuance whatsoever. And that would be discounted in the price. That’s the idea of Proof of Work.

Proof of Stake came up or was invented because a lot of people thought the Proof of Work concept is wasteful of things like electric power. It uses copious amounts of electric power. Some people feel it’s bad for the environment. So they understand that you want to put an impediment upon instruments.

So, instead of using electrical power and calculations, the idea was to actually put up Cryptocurrency and Cryptocurrency, presumably, is valuable. You put up a Cryptocurrency and the block awards are allocated randomly, pro rata, based on how much cryptocurrency you put up.

The only Proof of Stake system which might be issued, of which I am aware, is Etherium, which is currently Beta testing their Proof of Stake system . We’ll see if it actually operates or not.

Hugh Ross: Do you have a view of whether one is better than the other?

Murray Stahl: Well, no one has actully operated Proof of Stake. So, it has a good side and a bad side. Theoretically, or practically speaking, we can’t make an assertion because we don’t know Proof of Work. We’re all familiar with or we know how it works.

Here is the good side of Proof of stake and I’ll give you the bad side. So, we mine Etherium with GPU servers. Let’s assume that Proof of Stake is a valid concept. From our point of view, we’ve held a certain amount of Etherium that we´ve mined. We continue to mine every day.

In theory, we could put up that asset and then liberate the servers that are currently mining Etherium to mine something else, like Zcash or Etherium Classic, for example. Actually turning our Etherium into a doubly productive asset. It appreciates or has appreciated thus far. That’s one vector of productivity. And then we could actually earn more Etherium.

So theoretically, if Etherium has, let’s say, somewhere between a 14 to 15% inflation rate and 10% of all the people who own Etherium then put up Etherium for the Proof of Stake. That 10% would own the entirety of the inflation rate. So, the inflation rate spread among the currency is 15% but spread among the 10% who prove a stake, 150%.

So, theoretically, if 10% of people chose to participate in the Proof of Stake and we were one of them, we would earn a 150% rate of return, or nearly so, on our Etherium. Which would be pretty good. That’s the good side.

The bad side, in theory, is that if everyone thought that was so alluring, and you can clearly see – and this is why I said the good side first – if everyone saw that there are certain people that are making 150% on their Etherium cryptocurrency by just leaving it in a wallet – or in some cold storage or on the server – then a lot of people might want to do it.

So, you can have a situation where if enough of people who own Etherium posted for Proof of Stake, you can come very close to demonetizing all the system. Meaning Etherium wouldn’t circulate. Everybody would just, it would be one of these Gresham’s law situations. People would rather have the return than actually transact in the currency. So it can be very reflexive in the sense that it created a bad situation. No one knows what’s going to happen because no one has tried it.

Hash Power Supply and Demand

Hugh Ross: Could there be a massive amount of Hash Power that shifts from Etherium to, for example, Zcash, in the event that we go to Proof of Stake? Because then what do they mine? They’re not be mining any Ethirioum on it anymore.

Murray Stahl: Yes. That could well happen. And even more the case, there might be GPU equipment right now that’s still being used for Etherium that is nearly obsolete. And if it moves to a currency like Zcash, Zcash has a much lower difficulty rating. So, what might be is that that equipment might be much more productive in a Zcash mode. Or maybe, there are some other forks of  Zcash that have even lower difficulty ratings, where it might be doubly productive.

A lot of interesting things can happen. So from our point of view, we might be able to take our Etherium-based servers and move them to something like Zcash and increase the productivity of our mining activities. Might be very interesting.

Hugh Ross: Gotcha. As I know that you know, there was recently an ASIC miner released by Bitmain for Etherium and I wanted to just touch on how you think having an ASIC miner – which in theory is kind of a next-gen miner – will impact the mining of Etherium and Etherium Classic? How do you think this whole ASIC versus GPU hardware will play out and especially in the context of Etherium?

Murray Stahl: Well, the GPU miners clearly wouldn’t like that. And why wouldn’t they like it? Because if there is ASIC equipment that can mine Etherium as easy using that currency, it’s going to get a certain market share and it reduces productivity. It will make the GPU equipment worth less. Not worthless in the sense of zero but worth less money than it otherwise would be.

So, the natural impulse of the GPU miners is to fork the currency in such manner as it comes ASIC resistant. You can’t use it for that. Of course, it’s not necessarily a robust defence. Because just like you can fork the currency to be ASIC resistant, you can fork Etherium to be ASIC tolerant or ASIC sympathetic. Because all the code is open source. So you might end up having an Etherium fork which is ASIC compatible and you might have an Ethirium fork, rigid, ASIC resistant as possible.

Hugh Ross: Which is crazy considering Etherium has already forked once.

Murray Stahl: That’s right. So, it could theoretically happen. We just don’t know.

Cryptocurrencies without Mining

Hugh Ross: Right. Okay. So just for a kind of a compare and contrast: There are Cryptocurrencies that are not mineable. I thought we should touch on one or two examples of that, like Ripple. So if they are not minable and you, in theory, to quote-unquote, operate the system, in the world of Bitcoin, for example, there is an incentive to operate the system, right? Because you’re getting mining rewards. So what’s the incentive to operate the system in a Cryptocurrency where there is no mining?

Murray Stahl: Okay. So in order to discuss a Cryptocurrency with no mining, we have to introduce a little bit of new terminology. It’s not hard to use. It’s not hard to understand. There’s the dichotomy between a permission system and a non-permission system.

A non-permission system is like Bitcoin. If you have the money and go out and buy a server, you to can mine Bitcoin. So a non-permission system means; anybody who feels like it can take part in mining.

A permission system is; the group of people who are currently operating it have to collectively give their consent to admit you to join the network. If they don’t give you consent, you can’t operate the system. Now if they give their consent, you have an operating system, you have a cost of operating the system, but there’s no block reward to give out. So then the question becomes, to get back to the original question, why would you have the operating expenses and not have any reward whatsoever?

So, Ripple otherwise known as XRP was introduced to be a substitute to what is called the SWIFT network. Basically, it’s a global bank money transfer system. It’s actually not even a money transfer system. What it really is, is a notification that money is going to be transferred. So it’s cumbersome, it’s slow, it’s difficult to use. And then it also has the faculty that it operates in a variety of currencies.

So the idea behind XRP or Ripple as it’s sometimes called is that there will be this one currency. And you could pay any bank you wanted to in that currency on behalf of any correspondent, or any client. So it eliminates a lot of currency transactions and also eliminates a lot of accounting expenses. Because you’re only accounting in one currency as opposed to 180 currencies that are in the world. And there’s also, you don’t need trading in 180 squared pairs caused by any of the 180 currencies can be traded versus another currency.

So, if someone in Argentina wanted to pay someone in Sweden, you have to make a market. Argentine Pesos for Swedish Kroner. And that in itself is a great deal of work. So what you would be doing is – if you’re a bank or a global brokerage system and you are participating in this – you’re offering the service to your clients.

Presumably, it’s going to be faster and it’s going to cut your expenses and cut your errors. So, on the one hand, your expenses go up because you are operating the system. On the other hand, your expenses are going down for a number of reasons.

You’re not operating the SWIFT system anymore. It’s displacing it. You’re not having all of the accounting problems and tracking problems working in 180 currencies. And you also don’t have to maintain what’s called in banking Nostro and Vostro accounts. So, Nostro and Vostro accounts refer to kinds of accounts that balances other currencies you have to maintain in different countries.

So, when you’re paying someone in another country, on behalf of one of your clients, what’s really happening is that they are taking the money out of the account you maintain with a foreign bank and then eventually you reconcile with your client and get paid. There is enormous accounting expense and you’re also leading balances around the world in different currencies. And some of them may shift in value and you have significant hedging expenses.

Hugh Ross: So, so using Ripple as an example, it sounds like there are financial or economic incentives to use that currency, that don’t revolve around money. You don’t necessarily need money, but there are just, basically, another set of incentives.

Murray Stahl: There are other incentives. You can create other incentives to do it. And it is possible. There’s one other incentive. It’s minor, but it may not be a minor one day. The minor meaning m-i-n-o-r as opposed to a miner. Minor meaning of little significance right now.

There’s a tiny insignificant transaction fee for transacting in Ripple or XRP. That transaction fee doesn’t go to a banker or a brokerage firm. It just currency, it gets burned. So, Ripple started out with 100 billion units. Now it has 99.9 billion units. It does no transactional activity. The supply of the currency may decline a lot. So the higher the velocity of the currency goes, the faster the supply of money is going to shrink. And therefore, all things being equal, the greater the value of the currency itself.

Mining Approaches

Hugh Ross: So, why don’t we turn to Horizon Kinetics’ approach to mining. Why don’t we start off just by asking you when and why did Horizon Kinetics first get involved in mining?

Murray Stahl: When we got involved was late April, early May of 2017. Why we got involved was because it seemed like a very robust return was available. But it wasn’t only that. This plays a role in asset allocation.

So, mining in asset allocation should be known as Seniorage. Seniorage is basically the profit you make from printing money. So, historically when the United States Bureau of Printing and Engraving creates a $1 bill, it costs them 5.4 cents to print up the $1 bill. So they get a dollar out of it. The profits of mining aren’t quite as good, but they’re very robust. So it’s a way of earning a profit.

But it also plays a role in asset allocation because when you mine, the value of your equipment is being depreciated over the course of three years, in accordance with generally accepted accounting principles. So assuming you hold back the cash for depreciation, you’re unit value, month by month should be basically stable. What’s going to change is your profit. Or your dividend, if you decided to pay it out. Because the Cryptocurrency fluctuates.

So it plays a major role in asset allocation because of the problem right now with bonds, which are much more stable than equities. The lower the interest rates go, the greater the convexity you have in the bond portfolios. So if rates were to go up, you might take mark-to-market losses in bonds. And you don’t get a high yield anyway.

You get a much higher yield by mining cryptocurrencies and you also have a stable unit value. And that is real diversification versus publicly traded securities, that don’t have stable valuations. So I think it’s very important to asset allocation. I eventually think it’s going to be a major-sized asset class.

Choosing What to Mine

Hugh Ross: That’s great. So obviously I know we mine a bunch of different Cryptocurrencies such as Bitcoin, Bitcoin Cash, Litecoin, Etherium, Etherium Classic, Zcash and so on. What is your approach to or how do you think about optimizing the mix of Cryptocurrencies that Horizon Kinetics is mining, in terms of profitability?

Murray Stahl: Well, the returns fluctuate dramatically. Week by week, month by month. So, basically, we’ve weighted them more or less in accordance with the inflation rates. So Bitcoin and Bitcoin Cash have roughly 3.9%. I think it’s actually 3.94% inflation rates and that’s much lower than Litecoin right now. Litecoin right now I believe, right now, is over 10 per cent.

So, we mine much more Bitcoin than Litecoin and you could make an argument of saying that we really should do the reverse. Because the increase in value in Litecoin when the inflation rate drops, as it will about one of the third years. From let’s say 10 to 4.9% or whatever the number happens to be. That might lead to a greater percentage increase in value than you might get in Bitcoin. It’s possible, but at the moment we decided to do it the way it is.

Also, it’s arguable that Bitcoin Cash has a potentially greater profit than Bitcoin because a certain amount of mined Bitcoin Cash is going to be burned, very much like the way it’s burned in Ripple. So the supply of Bitcoin Cash will ultimately then be lower than the supply of Bitcoin. And Bitcoin is going to have a better monetary policy.

So all these things need to be taken into account. And there are some other Cryptocurrencies where when they forked – for example, Ethireum Classic, Bitcoin Gold, Bitcoin Cash, there are some others – it’s not clear that very many people got their forks. And they may be out there in the ether and no one will ever have access to them. So the supply of money, it may be much less than we think it is.

So all those things have to be taken into account and we’re always reevaluating our mix. At the moment GPU miners are uniquely expensive. It might have something to do with the idea that Etherium is going to move to Proof of Stake, and therefore you might be able to get alternative uses of the equipment. That said, we just don’t know. So at the moment, we have had, at least for the last couple of weeks, we haven’t really bought any GPU miners.

Profit Maximization

Hugh Ross: So, I know a lot of miners out there definitely look at profitability. Let’s say, hour by hour, minute by minute and they’re probably shifting their resources around from one Cryptocurrency to another, pretty frequently. What’s your approach to shifting resources from one Crypto to another? Do you do it often? Do you do it daily? Do you do it weekly or what is your approach to that?

Murray Stahl: Well, we haven’t done it often yet. The reason is that we are still building up our supply of service. So, one way to do it is when we’re making the next order. That’s a way of shifting your mix. So, if I had a lot of ASIC equipment and I wanted some GPU because I had in mind to mine Zcash, let’s say. Well it’s very easy, I’ll just order some GPU servers and one order is ASICS servers and now my mix is going to change.

The prices as they have been – as anybody who’s looking at the currency exchanges would realize instantaneously – is that the prices fluctuate enormously. Therefore the profits fluctuate enormously. Sometimes in the space of hours, sometimes even the space of minutes. And I think one of the reasons they fluctuated is people are constantly making these shifts. They try to optimize.

And I think when they make these shifts, that’s part of the reason these things fluctuate as much. So I decided I didn’t want to add to the variability by trying to outguess everyone else. So I’ve left it alone more or less and we have been very happy with the result.

Investing in Mining Equipment

Hugh Ross: Gotcha. I’ve certainly experienced and I know you have, that at times equipment can be hard to come by. And I think there are people out there, that take the approach that when they raise capital to invest in mining equipment, that they’re basically just going to go all in when they raise that money. I know you have a different approach. Maybe you could explain why you think it’s maybe better to have more of a prolonged, shall we say, approach to acquiring mining equipment?

Murray Stahl: Okay. Well, the first point is just a minor point. When you have a go-all-in approach you buy a tremendous amount of equipment at one time. You have to believe that you are actually impacting the price of equipment. So you want to buy a lot. The supply is not changing based on what your motivations are at that minute. Because the mining equipment manufacturers have no idea what you’re going to do. And so from their point of view, these are totally random events. When you put in a big order, you might actually make the price higher, not lower.

More importantly, however, over time the chip sets are going to improve. The software is going to improve. Everything about it going to improve. And if you believe in Moore’s law, eventually the chip sets will generate less heat. It will use electricity more efficiently and the price is going to come down as the manufacturers learn how to make your chips get higher yields.

There is a certain rejection rate when you’re making these ships. So the lower the rejection rate, the more profitable a given fabrication batches and the better a deal they can get for you. So if you put in an order for everything at once, you have no ability to react to changes in technology and changes in pricing.

So now, sometimes, like what happened recently, ASIC miners dropped in price. In our case, we didn’t invest that much money up front. We were investing gradually. So, now we have cash flow as well as the initial capital to buy many more miners at lower prices than we had before. You just have to assume that you’re going to get a better deal in future than you have been getting in the past.

Scale versus Flexibility

Hugh Ross: Got it, that makes sense. So, in terms of physically housing the equipment or locating the equipment, do you think it’s better to, basically, put everything in one large facility because of Economies of Scale or do you think that it maybe makes sense to choose multiple locations to house all your equipment. And if so, why?

Murray Stahl: We’ve taken the approach of housing our equipment in a variety of locations and we are actually interested in increasing the number of locations. And the reason is you never know what’s going to happen. There can be electrical outages and given the area is totally beyond your control, there can be natural events that are totally out of your control. You can have one hosting facility that just decides it doesn’t want to operate the facility anymore. You have to move your equipment.

There are a variety of things are going to happen and there’s always the possibility of disruption. So if you have all your eggs in one basket and you watch that basket very carefully, no matter how carefully you watch it, something might happen to put all your servers out of operation simultaneously. You don’t want that because they are not productive until you (a) find another hosting facility, (b) negotiate proper terms, (c) move and install all your equipment, which may be cumbersome.

Especially if you have a lot of servers and so on so forth. So I don’t think it’s a good idea to put everything in one basket. Just as I don’t think it’s a good idea to order all your servers in one fell swoop, which apparently everybody wants to do.

The Cost of Mining

Hugh Ross: Gotcha. And then in terms of the of the income statement of a mining operation, what are the biggest components of expense when you’re running a mining business?

Murray Stahl: Well, there’s really two, and I’ll break them down. One is the hosting expense. The hosting expense is, basically, that you’re paying for the electric power marked up by some suitable quantity and you’re paying essentially rent to put your machine on a shelf and you get a little oversight. That someone at least is looking at it, making sure it’s operating properly. And there’s at least some security in it. That somebody is making sure the facility isn’t broken into. If somebody does something untoward, they will call the appropriate authorities and so on so forth. So that’s one expense.

The other expense is depreciation on equipment. So basically you have to assume that in 36 months, your equipment’s is going to be fully appreciated. Meaning that it may work, but there will be more productive models out there. So, you’re not getting a high return on it although they might have some salvage value. So your depreciation is really a function of how much you pay for the machine. So essentially you’re using machine ratably over its useful life.

And those are the two primary components and some other minor expenses of operating a company. And it applies to every company. There is a tax return and there are certain filings, administrative expenses that every business has and cryptocurrency mining operators are not immune for that, but they are relatively minor. Those are the two significant costs.

Mining Revenues

Hugh Ross: So let’s talk about the revenue and the net income side of the financial statement. The profit margin associated with crypto mining, is that something that’s fairly consistent or does it vary? What causes it to vary? Can there be times when mining actually becomes unprofitable and what happens then?

Because, if you think about it, using Bitcoin is as the example, the miners have to have an incentive, right? To operate the system. Their incentive is they’re making money from mining. So, if mining becomes unprofitable because of either the cost of machines going up or the price of bitcoin falls enough, what happens? If the miners are not incentivized to operate the system, what happens to the whole system?

Murray Stahl: Okay, so to begin with, profit margins are not consistent. They vary and they vary very greatly. And what makes it vary the most? Well, the most important thing is the price of Cryptocurrencies is constantly fluctuating. So, as a generalization, the higher the price of the Cryptocurrency, all things being equal, which they never are, the better it is for you. If your profit margins lower, it is the worse it is for you.

Of course, the other variables vary as well. The cost of the equipment can go up it or it can go down. The electricity prices don’t seem to vary all that much, but they can. At least in theory. And then you could also have some machines that don’t last the requisite 36 months. As with any piece of equipment, something can go wrong with it. Although, that doesn’t happen all that frequently. So, those are all ways of varying the profit margins.

Then you might say: Whoa, what causes all those things to vary? Look at it this way. If you want to have a given cryptocurrency, Bitcoin or Etherium, you basically have two choices. You can buy it or you can create it by mining it. Those are ways you can obtain a crypto.

So let’s look at the example of the end of 2017, beginning of 2018. There were, I think, well over a thousand initial coin offerings. A lot of people compare them with Initial Public Offerings. They have a salient difference from our perspective and the mining perspective, in as much as, if you want to buy one, they don’t want fiat currency. They don’t want Dollars or Pounds or Swiss francs, Euros. They want crypto. So you had a whole series of people that wanted to participate in the so-called ICOs, initial coin offerings, that went out and bought Etherium and bought Bitcoin.

They had no interest in owning Etherium. They had no interest in owning Bitcoin and therefore they were pricing different buyers. Bitcoin and Etherium were merely modalities by which they paid for initial coin offerings. The only way to participate was to buy one of those two currencies. The orchestrators of initial coin offerings, therefore, received either Bitcoin or Etherium. In some cases, both.

They have no interest in holding Bitcoin or Etherium. It’s merely to fund some project. In most cases to fund their cost of creating the next generation of Cryptocurrency itself and making themselves very wealthy. So, in almost all instances, they were still in Cryptocurrencies.

So you had a few months when there was enormous pressure to buy. Virtually everyone was buying and then there was an enormous pressure to sell because they want to liberate this capital and put it into their coffers. You might say there were some traders that would look at these trends and maybe added a little fuel to the fire. Or you could debate whether that happened.

So, there were times when cryptocurrency mining went to break even. It happens. But it’s not going to stay there very long because cryptocurrency mining is designed to equilibrate. So let’s just say that it was unprofitable for a number of weeks. Well, most of these companies were very poorly capitalized.

So they can’t operate without profitability. They didn’t have huge cash reserves to operate unprofitably. What they would do to save cash is that they would turn off their machines. Which you can do in 30 seconds. If they turn off their machines, what happens is that the difficulty rating? Which you will recall, is the probability of solving this equation. If they turn up their machines, the difficulty rating goes down because there are fewer machines trying to solve the problem.

So when difficulty rating goes down and you leave your machine on, your machine necessarily becomes more productive. The probability of earning a coin goes up. So ultimately the whole thing is designed to equilibrate.

So, I’ve never really seen it being, maybe I’ve seen it for a day or two, get modestly unprofitable. Of course, it really isn’t moderately unprofitable, even so. Because when people calculate the cost of mining a coin, remember they are adding in the hosting fee plus the depreciation. The depreciation is not a cash expense. So on a GAAP basis, you might not be profitable but on a cash basis, you’re very profitable.

So in theory, you don’t have to take your accumulated depreciation expense and buy another machine if you don’t want to. It’s entirely a discretionary item.

The Least Efficient Entity

In any event, the way cryptocurrency mining works, it is unlike normal business activity. Because remember, this is the most important point. This is a permissionless system. And what makes cryptocurrency valuable are two things: a network effect, which is all people using it and the robustness of the network, which is the difficulty of hacking it, which is a function of how many people are actually operating it. So the more people operating it, the more robust it happens to be.

Now all those people don’t have the same cost structure. In normal business, there’s going to be some company that happens to be the most efficient company. So in theory, whatever good they’re producing, whatever service they’re providing, in theory, they could lower their price to a level where that individual enterprise makes a very high return on investment capital, but nobody else can match it. So, they basically drive everybody out of business or nearly so and they become the dominant player.

And therefore in most businesses, a dominant player sets the ceiling on return on equity or return on capital. So that’s the highest and nobody can compete with that. And that’s why most businesses have a dominant company or sometimes two dominant companies.

In cryptocurrency, if that happened, no one would use the cryptocurrency because it is hackable. So what needs to happen is, to make it robust, a lot of entities or a lot of people if you prefer, have to be operating it. Meaning mining it.

So the return on invested capital or return equity has to be sufficiently alluring so that the least efficient entity, whichever entity that is, has to make enough of a return to be interested. Everybody else is, by definition, more efficient than the least efficient entity. So everybody else is making a higher return.

So unlike the situation in all business, where the most efficient company sets the ceiling, in the world of Cryptocurrency, the least efficient company or entity or person, sets the floor on return on invested capital. Everyone else is going to make a higher rate of return.

Hugh Ross: Okay. Well, um, we are, we’ve been talking for over 35 minutes so I think we should wrap it up now. So I want to thank Murray so much for having this discussion with us. And thank you to our listeners. If you have any questions about what you’ve heard today, please reach out to us on info@horizonkinetics.com and please stay tuned for future episodes of Consensus Money. Thanks, Murray. Thank you very much.

Murray Stahl: Thank you.

The Value of the Road Not Taken

In 1916 Robert Frost published his poem The Road Not Taken. It is a narrative poem, where the narrator describes a moment when he comes to a fork in the road while taking a walk through a forest. After mulling it over, the narrator decides to take the road that seems to be less travelled.

The poem is by many regarded as one of the most misunderstood poems in history. It is often quoted when expressing views of individualism and not conforming to general convention.


At the end of the poem, the narrator sighs as he tells the reader that he took the road less taken and that it made all the difference. But the sigh is left open to interpretation by Frost, as the reader does not know if the sigh is from relief or regret.

The Misinterpreted Message

You have to be careful of that one; it’s a tricky poem — very tricky,” Frost is known to have said about the poem. The story has it that he wrote it to tease a friend of his, Edward Thomas, who often had problems with coming to a decision over choices that were offered to him. Frost describes him as a person who, “whichever road he went, would be sorry he didn’t go the other”.

An economist would tell you that the problem that Edward Thomas – just as the narrator in the poem – was battling with was the Opportunity Cost of the choices that he had.

Opportunity Cost

The Opportunity Cost of a decision basically equals the benefit of the best alternative option that you have to choose from. This means also means that the opportunity cost is dependent on the situation that you find yourself in at any given time. Furthermore, it means that your opportunity cost is not the same as my opportunity cost.

The concept of opportunity cost is well known in economics and finance, where it is relatively easier to measure the potential outcomes. The Opportunity Cost of Capital, for example, is the rate of return that could have been earned by putting the same money into a different investment with equal risk.

Mistakes of Omission

In The Road Less Taken, the narrator has two choices. Therefore, his opportunity cost is whichever road that he will not take. If he picks the wrong road, he will have made a Mistake of Omission. When asked about their biggest mistakes at the Berkshire Hathaway 2011 annual meeting, the legendary investors Warren Buffett and Charles Munger highlighted specifically about their Mistakes of Omission.

The Road Less Taken

Two roads diverged in a yellow wood,
And sorry I could not travel both
And be one traveler, long I stood
And looked down one as far as I could
To where it bent in the undergrowth;

Then took the other, as just as fair,
And having perhaps the better claim,
Because it was grassy and wanted wear;
Though as for that the passing there
Had worn them really about the same,

And both that morning equally lay
In leaves no step had trodden black.
Oh, I kept the first for another day!
Yet knowing how way leads on to way,
I doubted if I should ever come back.

I shall be telling this with a sigh
Somewhere ages and ages hence:
Two roads diverged in a wood, and I—
I took the one less traveled by,
And that has made all the difference.

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