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What would the basis of difficulty derivatives and insurance be? Like how could we structure someone such that if the difficulty goes above a certain amount there's a payout to protect miners, & stabilize their ventures?

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When miners invest in mining hardware, they get a device that generates hashes at a rate of X, essentially forever. What they will get from it is X times the integral from now to infinity of a*B*P/D, where P is the value of a bitcoin, D is the difficulty, B is the block reward and a is a proportionality constant. The future values of P and D are unknown, and so what they will get out of mining is unknown.

This can be abstracted by saying they have a speculative mining position of X, and they want to hedge their position by investing in instruments that negatively correlate with the future income of mining.

The more aligned the speculative instrument is with actual mining, the more efficient the hedging will be. The most efficient instrument, then, is a mining bond - an asset which pays the expected output of mining with a given hashrate, deterministically and perpetually. By issuing such an asset themselves, or selling on margin such assets in dedicated markets, the miner can neutralize his position, making sure changes in the future values of P and D have no effect on his earnings (as any decrease in the ratio depreciates his obligation by exactly the same amount, and vice versa).

A few such mining bonds were offered on GLBSE when it existed, and it is expected that now the void will be filled with assets issued on OpenTransactions, Colored Coins and so on.

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Excellent answer. –  Colin Dean Dec 5 '12 at 14:45
    
What's the proportionality constant? –  Kinnard Hockenhull Dec 12 '12 at 2:41
    
@KinnardHockenhull: It's (hash)/(2^32*second). –  Meni Rosenfeld Dec 12 '12 at 5:46
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Unlike a commodity which can limit speculation with a delivery requirement, speculation on the difficulty really is more suited for something like a predictions market like https://www.fairlay.com/event/category/bitcoin/difficulty/.

MPOe at one time had an options contract on future hashing but that is no longer offered.

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MPEx (MPOe as you wrote) actually has difficulty futures (forwards) now. –  smickles Jan 1 '13 at 3:44
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Difficulty based derivatives would be like this: http://mpex.co/?mpsic=X.IDIFF.MAR

Miners can buy them to ensure a set level of difficulty for their operations.

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