Crypto and blockchain are increasingly attracting institutional investors who are fascinated by the technology’s potential. Cryptocurrency mining has a stable and constant return profile and high profitability. Many private equity (PE) and infrastructure funds are looking exactly for this kind of investment. But only two out of the largest thirty deals in the crypto industry were carried out in crypto mining.
What are the main challenges that many institutional investors still face when investing in crypto mining? The five biggest challenges we have faced in our projects are:
- A low-level professionalism in the industry
- Missing ESG compliance especially for coal powered mining
- Issues around reputation and transparency
- Low liquidity of mining investments
- General concerns of investors around security
Professionalism of the industry
So far cryptocurrency mining has been driven by adventurous individuals who believed in the potential of cryptocurrency mining. They often had to venture in remote countries to realize their idea. But this making-things-happen attitude even in the most adverse environments is not all what an investment target needs. Especially when minimal investments easily exceed ten million dollars.
„The biggest reason for mining projects to miss out institutional investments is their lack of creditworthiness”, says Lukas Pfeiffer, Managing Director at Crypto Oxygen. “Investors often refrain from crypto mining projects because they cannot assess the counterparty risk.”
Similarly, at Crypto Oxygen, we see that emerging mining projects often struggle to meet basic due diligence standards. At the same time these projects would show suitable economics for investors. Therefore, they miss out on funding which they could raise easily.
To become investable, miners need to play along the traditional investors’ rules and make sure to meet their standards of controlling, accounting, and governance.
While ESG contains „environmental, social and governance” guidelines, for mining the main topic is environmental compliance. As climate concerns continue to grow, investors are increasingly monitoring their investments’ carbon footprint. Crypto mining is an energy intensive industry. As Elon Musk pointed out in his famous tweet, part of the energy consumed for mining is fossil fuel based. This can be seen especially in countries such as Kazakhstan. As the total energy consumption for BTC mining now ranges close to the Netherlands’ total energy consumption, environmental concerns are relevant.
The high energy consumption of crypto mining is not a flaw. The reason why proof-of-work blockchains, such as BTC, consume so much energy is to guarantee their security. In a decentralized network, cryptocurrency transactions are recorded and stored by miners. If someone wanted to manipulate the blockchain registry of transactions, it is required to control more than 50% of the total mining capacity. As this is impossible due to the high energy consumption, the bitcoin blockchain is regarded as 100% safe from being hacked.
Already today, nearly 56% of cryptocurrency mining is powered by renewable energy sources. Based on Galaxy Digital, Bitcoin mining consumes less than 50% energy compared to gold mining. As crypto mining faces stronger price pressure, miners will be increasingly forced to reduce expensive carbon emissions and converge towards renewable energy resources. Such a move will enable also more ESG friendly funds to enter the space.
Reputation and transparency
Institutions face insecurity from both reputational and transparency risks. Reputational risks are mainly associated with the image that cryptocurrencies in general facilitate criminal activities. Transparency risks come mainly from AML (anti money laundering) considerations.
Whereas reputational risks are not mining specific but translate to the whole crypto industry, they appear counterintuitive. As all BTC transactions are saved on the blockchain for eternity. So, it is much easier to follow BTC transactions than transactions in traditional money. It appears a bad idea for criminals to use such a public record for their activities.
AML regulations can be trickier especially for existing projects. As financing has been always demanding for mining operators, some might have turned to dubious funds to pay for setting up miners. These would have then produced “clean” BTC. We also see AML concerns with most mining investors moving out of China, as crypto mining and holding BTC has been illegal in China since 2013.
To solve these potential issues mining projects must set up governance that is generally required for funds and investments. Thereby they can ensure that the respective projects are AML and KYC (know your customer) verified.
More and clearer regulation can help institutional investors overcome these reputation and transparency hurdles. Currently, there is still no uniform international regulation. The stance of governments is inconsistent. Some countries have banned the creation, sale, ownership, and trading of certain cryptocurrencies while allowing and encouraging the proliferation of others.
Investments in industrial sized data centers typically range tens to hundreds of million dollars (USD). Typically, institutional investors cooperate with banks to decrease their own cash exposure. However, typical investment banks are still hesitant to grant loans to mining projects, making it hard for investors to leverage their investments.
One main reason why banks still struggle with mining is mainly unclarity of regulation. While regulators worldwide have begun classifying and monitoring digital assets, the regulatory landscape is still diverse and scattered. In the U.S., states and municipalities take different regulatory approaches. This can result in detrimental effects for miners. For example, JPMorgan Chase allegedly shut down the accounts of Compass Mining, a BTC mining company based in Delaware.
Facilitating banking for crypto mining investments requires a clear and uniform regulatory framework that is based on trans-national definitions and rules. Such regulation is key for enabling investors to leverage their investments and to increase their liquidity. In Europe, Liechtenstein and Switzerland are leading in improving their regulation on cryptocurrencies. With a careful selection of custody and banking providers in crypto friendly jurisdictions, crypto miners and investors can overcome the liquidity challenges.
Many institutional investors have asked us on how to enable security and reliable custody. Recent events, such as the hacker attack on the PolyNetwork have additionally fueled such concerns. Investors buying cryptocurrencies through an exchange and hold them in an unsafe wallet can be exposed to the risk of losing up to 100% of their deposits in the event of a hacker attack on the exchange. This exacerbates concerns among institutional investors about how to keep cryptocurrencies safe.
To cover this demand from institutional investors a new class of custody providers for cryptocurrencies is emerging. One example is Coinbase Custody, which also offers custody solution targeted to institutional clients. Coinbase is one of the oldest and market-leading crypto custodians. The latest client in Germany was the Telekom AG. Additionally, Coinbase and other institutional grade wallet providers have insured their custody against criminal acts, protecting their digital assets against losses due to theft, including cybersecurity breaches.
Even more secure are hardware wallets or cold wallets. They are not connected to the internet and hence safe from hacking attempts. In this case, the coins are not held online on a crypto exchange, but they belong to the user of the hardware wallet. The cryptocurrencies remain on the blockchain, but the keys are stored offline in a physically secure location, like a vault of a bunker.
While crypto mining is lagging institutional investments, more and more large-scale crypto mining projects are financed by institutional investors. One example of institutional investments is the 175 million dollar (USD) investment of Orion Energy Partners in the Talen Energy’s crypto mine. Such institutional investments prove that crypto mining projects can be funded by institutional investors when they meet the requirements of these investors.
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Source 9: https://www.garp.org/risk-intelligence
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Source 11: https://www.jdsupra.com/legalnews
Source 12: https://cointelegraph.com/news
Source 13: https://decrypt.co/75557/the-regulation-race
Source 14: https://time.com/nextadvisor
Source 15: https://cointelegraph.com/news
Source 16: https://help.coinbase.com/en/coinbase
Source 17: Talen Energy (TLN) Gets $175 Million for…
Crypto Oxygen GmbH