What happened

The world's largest cryptocurrency by market cap, Bitcoin (BTC 1.42%) was bouncing back on Wednesday. To briefly recap, the price of Bitcoin hit an all-time high of almost $65,000 just last month. But following some environmental concerns from prominent influencers and new restrictions in China, the price collapsed and dipped below $31,000 just a few days ago. However, the price has bounced back and even surpassed $40,000 earlier today before settling back down to around $38,700 as of this writing.

When the price of Bitcoin was spiking higher in 2020 and early 2021, investors in Bitcoin mining companies were extremely bullish. These companies include Marathon Digital Holdings (MARA 5.63%), Riot Blockchain (RIOT 4.01%), SOS Limited (SOS 14.93%), Bit Digital (BTBT 5.88%), and Ebang International Holdings (EBON -0.18%). But all of these stocks have been punished with Bitcoin's decline -- they're all down more than 55% from highs. However, these all bounced back today, rising between 11% and 14% as of 2:45 p.m. EDT.

A hand holding a golden coin displaying a symbol that represents Bitcoin.

Image source: Getty Images.

So what

When the price of Bitcoin falls significantly, it's bad for miners for at least two reasons. First, many of these companies hold the Bitcoin they mine instead of exchanging it for fiat currency. For example, Marathon Digital was holding 5,324 Bitcoins as of May 6, and Riot Blockchain held 1,771 Bitcoins as of April 30. Therefore, when the price of Bitcoin is falling, it's a double whammy for these companies -- revenue potential falls along with the value of its digital assets.

More than this, Bitcoin miners are increasing their costs to be able to mine more Bitcoin. This decision only makes sense if Bitcoin maintains a high price. Here's how it works: The amount of computing power collectively dedicated to the Bitcoin blockchain network is called Bitcoin's total hash rate. According to Blockchain.com, the total hash rate hit an all-time high over 180 million tera-hashes per second (TH/s) earlier this month -- nearly double what it was this time last year.

The increase to the total hash rate is ongoing, as evidenced by recent announcements from these Bitcoin mining companies. For example, both Marathon Digital and Riot Blockchain intend to increase their hash rates throughout 2021, with new shipments of mining equipment arriving regularly. If enough miners do this, the total hash rate will keep climbing.

Mining companies increase their hash rates when mining is growing in popularity in order to keep their share of the Bitcoin mining rewards. The amount of Bitcoin that can be mined is fixed, so rewards are proportional to the hashing power provided. Of course, as long as the price of Bitcoin is higher than its costs, a mining company's decision to spend money for more hashing power is justified. However, buying and running more machines raises a company's cost basis for mining, hurting gross margin. And that's a problem when Bitcoin pulls back.

With Bitcoin bouncing back up today, investors in these mining companies can breathe a little easier knowing that profit potential is maintained for now.

A woman is happy with what she sees on a computer screen.

Image source: Getty Images.

Now what

As reported by Reuters, China is increasing regulations for cryptocurrencies. Restrictions include using them as a form of payment, trading them, and even mining them. Logically, this would appear to affect companies like SOS, Ebang, and Bit Digital the most. But somewhat ironically, that may not be the case.

Consider that 98% of SOS's revenue in 2020 came from insurance marketing, not mining Bitcoin. Therefore, only its plans for mining Bitcoin are affected, not its core business. Likewise, Ebang only launched its cryptocurrency exchange in April. The company's main business sells chips that can be used for mining cryptocurrencies, but it can presumably still sell to customers outside of China.

Bit Digital appears to be the most affected of these companies by China's increasing regulations. According to the company's most recent quarterly report, 73% of its mining machines are located in China, the rest are in North America.

However, Bitcoin investors can't overlook what China's restrictions could potentially do to the entire network. According to some estimates, 65% of all Bitcoin mining comes from China. Furthermore, a lot of the trading volume comes from the country. A crackdown there could lower demand from a very important group of Bitcoin investors, sending prices lower. That would hurt Marathon Digital and Riot Blockchain just as much as Bit Digital.

This is an ever-present risk for Bitcoin mining companies. However, a major pullback in the price of Bitcoin shouldn't come as a total surprise to investors -- it's happened many times before. In the past, it's taken Bitcoin a few years to retake highs. There's no way to predict how long it will take this time, but investors should at least be mentally prepared in case it plays out this way again.