Put simply, cryptocurrencies are doing things Wall Street and investors have never witnessed before. Last year, the aggregate value of all virtual currencies combined soared almost $600 billion to end the year around $613 billion. The aggregate gain of more than 3,300% represents possibly the greatest single-year return for any asset -- and there's a very good chance we won't see anything like it again, at least during our lifetime.
This surge higher in cryptocurrencies has spawned numerous ways for enthusiasts to make money. Obviously, buying and holding virtual currencies (known as "hodling" among the crypto community) for long periods of time has worked wonders for investors. Bitcoin, which had once traded below $1 per token, surged to around $20,000 per coin in December 2017. Meanwhile, Ethereum and Ripple, which are second and third, respectively, in market cap behind bitcoin, surged by 9,383% and 35,564%, respectively, last year alone.
Another potentially profitable venture has been buying into publicly traded stocks that have exposure to the cryptocurrency market. For example, the Bitcoin Investment Trust owns a relatively fixed amount of bitcoin in its portfolio, allowing investors a roundabout way of loosely tracking the performance of bitcoin. I say "loosely" because the Bitcoin Investment Trust has often been valued at a 25% to 100% premium over the net value of its held tokens.
The allure of cryptocurrency mining
But perhaps the most intriguing means of making money has been through cryptocurrency mining. Cryptocurrency mining simply describes the process by which persons or businesses with high-powered computers and servers compete against one another to be the first to solve complex mathematical equations associated with a group of transactions (known as a "block"). These complex math equations are derived from the encryption that protects data on a blockchain network from hackers and other undesired parties. Once solved, a block of transactions is considered true -- i.e., no virtual coins were spent twice -- and it's added to the previously resolved blocks, forming a chain. Thus the coined term "blockchain."
So, what's in it for cryptocurrency miners to validate these transactions? Being the first to solve a block entitles the miner to a "block reward." This reward is paid out in the tokens of the cryptocurrency being validated, with the amount of the reward, and difficulty in achieving the reward, varying from one virtual currency to the next. For bitcoin, a block reward entitles the miner to 12.5 tokens, which, with bitcoin valued at around $9,400 per token, works out to a handsome $117,500 haul! Not too shabby. However, bitcoin's rewards halve every 210,000 blocks, meaning the reward for mining bitcoin (and many other digital currencies) declines over time.
This is also a great time to point out that not all cryptocurrencies are mineable. While bitcoin, Ethereum, Bitcoin Cash, and Litecoin are mined, Ripple, EOS, Cardano, and Stellar are not. Validation of transactions is done in a different way for non-mined cryptocurrencies, which means new tokens aren't created or rewarded.
Three costs cryptocurrency miners must know about
Sitting back and relaxing while computers and servers do all the work might sound like a grand scheme to make money, but I assure you there are also some very grandiose expenses involved as well. Cryptocurrency miners need to be aware of three very prominent costs.
1. Electricity costs
One of the more sizable costs miners will contend with is the electricity expense needed to run graphics processing units (GPUs) or specialized ASIC (application-specific integrated circuit) chips, along with servers and computers. The proof-of-work model, as cryptocurrency mining is also known, is very electricity-intensive, meaning lower kilowatt-per-hour (kWh) prices are favorable to the margins of miners.
What countries offer the lowest kWh costs? In a stroke of irony, some of the most attractive places to mine also happen to have stringent rules on cryptocurrencies. China, for example, has some of the lowest kWh costs in the world. However, China has also banned initial coin offerings and domestic cryptocurrency exchanges, and it has throttled back electricity usage for some of the country's largest mining companies.
Recently, mining companies like HIVE Blockchain Technologies (NASDAQOTH:HVBTF) have been turning to the Nordic region for cheaper electricity costs. HIVE is setting up mining centers in Sweden and Iceland, both of which have below-average electricity costs relative to the European average. What's more, Nordic countries like Sweden are more heavily reliant on renewable energy, such as solar, wind, and hydroelectric power, to generate electricity, which helps keeps total kWh costs down.
In short, location matters!
2. Cooling costs
Secondly, cryptocurrency miners have to understand that operating a few dozen or more GPUs, along with servers and computers, can produce a lot of heat. This heat can create a non-optimal operating temperature for the mining hardware, leading to its failure if not properly dealt with. This means cooling systems may need to be in place to keep mining hardware from overheating and breaking. This is another electricity cost some folks might overlook.
It is worth noting that location can, once again, play a role in how much of an impact cooling costs have on mining margins. Operating in Iceland's naturally cooler temperatures may help HIVE Blockchain Technologies keep its cooling costs down. In fact, HIVE specifically lists "cold climate" as one of the three main selling points of putting a mining data center in Iceland (along with fast internet connection and low-cost green power).
3. Hardware costs
Lastly, cryptocurrency miners have to contend with hardware costs, which can actually turn out to be their biggest budgetary eyesore of all.
Miners can be hit with hardware costs in two specific ways. First, there are the start-up costs of initially buying the hardware needed to mine cryptocurrencies. And second, miners get hit with the need to constantly upgrade their equipment in order to remain competitive against other mining farms.
Over the past year, NVIDIA (NASDAQ:NVDA) and Advanced Micro Devices (NASDAQ:AMD) have watched as cryptocurrency miners have gobbled up graphics cards for GPUs at an incredible pace, dramatically cutting supply and causing the price for graphics cards to skyrocket by 100% to 200%. While initially great news for NVIDIA and Advanced Micro, it's sort of left these two giants in a bind. NVIDIA and Advanced Micro could choose to manufacture specific graphics cards for crypto miners, hurting their sudden surge in sales, or they could do nothing and risk alienating their core gaming customer who's irritated by suddenly high graphics card prices. It's really a no-win situation for either company, and it's been a major source of expenditures for crypto miners.
Now for that aforementioned wildcard...
There's also a wildcard among all of this that could make or break cryptocurrency miners: the underlying movement in virtual currencies.
As you've probably correctly guessed, falling cryptocurrency prices aren't good news for mining margins. The higher coin prices go, the more lucrative it often is to mine virtual tokens. Understand, though, that as it becomes more profitable to mine, the competition to resolve a block becomes fiercer, which can ultimately be a drag on margins.
Similarly, cryptocurrency miner margins will depend on what they do with the tokens they receive as a reward. Miners could choose to convert them into a fiat currency almost immediately, thusly locking in predictable margins at that time. However, they could also choose to hang onto their coins indefinitely and become investors. If the price of the virtual coins being held dramatically appreciates, miners will have added icing to their cakes. But if crypto prices fall, it could slash margins -- or perhaps even make it unprofitable to have mined tokens in the first place.
For the time being, the cryptocurrency mining industry is thriving. But will it remain so even three years from now? I'm not so certain.
Sean Williams has no position in any of the stocks or cryptocurrencies mentioned. The Motley Fool owns shares of and recommends Nvidia, but has no position in any cryptocurrencies mentioned. The Motley Fool has a disclosure policy.