Mining of Bitcoin : The Process of Bitcoin Mining

1. Introduction

The most famous and widely recognized cryptocurrency is Bitcoin. Bitcoin is a computerized payment system that was imagined by an unidentified person under an alias of Satoshi Nakamoto. The payments take place between the users, without any intermediary. Transactions are then verified by network nodes via cryptography and recorded in a public distributed ledger called a blockchain. Take away the geek talk and it’s now easier to understand that Bitcoin is converting real money into virtual money. Bitcoin can be acquired through various ways. It can be bought on an exchange, through transfer of product or services and it can also be mined. Bitcoin mining is the process of validating transactions and adding the transaction records to the public ledger. This is also the means by which new bitcoins are released. Anyone with access to the internet and suitable hardware can participate in mining. This has served to be a very profitable business. During the early days of Bitcoin, it was possible to mine with low powered CPUs or even high speed CPUs. But the competition is so high today and the difficulty on solving the algorithm has increased so much that with the high cost of electricity it’s near impossible to profit from mining without purchasing costly ASIC processors.

1.1. What is Bitcoin?

Bitcoin is a digital currency that was created in 2009. It does not have physical notes or coins, and it is traded entirely online. One of the biggest differences between Bitcoin and normal currencies is that Bitcoin is limited in number – only a total of 21 million Bitcoins will ever be mined. Bitcoins are essentially lines of computer code that are digitally signed over the internet each time they travel from one owner to the next. Transactions are noted on a public ledger known as a “blockchain”, which is what enables the verification of the sender’s funds and the prevention of invalid transactions. The blockchain and Bitcoin are so heavily reliant on one another that you cannot have one without the other. This is partly why the idea of Bitcoin has split into two conflicting ideologies. Bitcoin’s limited supply is not the only thing that separates it from fiat currency; it is also decentralized. This means that its system operates on a peer-to-peer basis with no central authority or administrator. The absence of a singular controlling body and its open-source nature are the reasons why Bitcoin can be accessed and utilized by anyone with an internet connection. Centralized control and problems with the modern banking system were among the main catalysts for its creation.

1.2. What is Bitcoin mining?

Mining is a distributed consensus system that is used to confirm pending transactions by including them in the blockchain. It enforces a chronological order in the blockchain, protects the neutrality of the network, and allows different computers to agree on the state of the system. To be confirmed, transactions must be packed in a block that fits very strict cryptographic rules that will be verified by the network. These rules prevent previous blocks from being modified because doing so would invalidate all the subsequent blocks. Mining also creates the equivalent of a competitive lottery that prevents any individual from easily adding new blocks consecutively to the blockchain. In this way, no group or individuals can control what is included in the blockchain or replace parts of the blockchain to roll back their own spends. This is only a very short and concise summary of the system. If you want to get into the details, you can read the original paper that describes the system’s design, read the developer documentation, and explore the Bitcoin wiki.

2. The Process of Bitcoin Mining

As Bitcoin’s price has risen substantially (and is expected to increase further in the future), mining at the older phase of the inflation schedule might have no incentive as the block rewards very little and the transaction fees make up a tiny percentage of it. Consumer electronics is an example of a market where prices constantly fall but which is not disappointing to the consumer. This same situation applies to Bitcoin, where consumers are expected to save most of their money and wait for a lower price in the future due to the expectation of a higher value of Bitcoin. This is a deflationary economic model. An increase in cryptocurrency mining increased the demand for graphics cards (GPU) in 2017. ASIC (application-specific integrated circuit) is frequently used in mining and was more efficient, leading to the use of GPU in gaming on PC becoming more difficult.

When the algorithm was created under the pseudonym Satoshi Nakamoto—which is believed to be an alias—the strategy was to cut the block reward in half every 210,000 blocks. The first halving event occurred on the 28th of November 2012, at block height 210,000. As of November 2020, the block reward is 6.25 Bitcoins. This means the block reward will decrease to 3.125 bitcoins per block starting in 2024. This creates an inflation schedule that mimics the extraction of gold, which ironically Bitcoin is likened to. The production and extraction of gold were exceedingly difficult and dangerous, thus it was of great value. Simulation of the model with current global Bitcoin mining has provided an expected result of the last Bitcoin to be mined around the year 2140.

Bitcoin mining involves three variables: the block, the mining difficulty, and a random number. The objective is to find a random number that solves a problem. In order to solve the problem, which is known as a proof-of-work, the miner must have a number of consecutive random numbers. A mining pool sets a difficulty level between 1 and the currency’s difficulty. If miners generate a block at the current global minimum difficulty, that block is worth one share. With significantly less luck, it might only produce one share being solved on average.

2.1. Setting up a Bitcoin mining rig

The final method is the cheapest installation, CPU mining. It is inefficient and not recommended as bare resources will not make it possible to cover the electricity costs.

FPGAs are an integrated circuit designed to be configured after being built. They are more flexible than GPUs and ASICs and are far more efficient than CPUs or GPUs. However, this is still not the best option to efficiently dedicate electricity for the power-hungry task of mining.

GPUs are the next step and are much more efficient at the process, but again, it is not nearly as efficient as using ASICs. There is mining software available for Mac, Windows, and Linux which will help improve the performance of mining with GPUs.

ASIC (Application Specific Integrated Circuit) is currently the technology used for the mining process. It is far too inefficient to be done on a personal computer. The hardware is typically built specifically to mine certain types of cryptocurrency and only does that specific task.

Creating a mining rig requires the correct hardware for both effectiveness and efficiency. The miners will utilize various types of hardware designed to get more BTC.

2.2. Joining a mining pool

The rewards are then split between the pool members, proportionally to the amount of hashing power their gear contributed to the solution. It’s a good idea to shop around to find the best paying pool for you. Aside from the Bitfury and BTCC pools, it is hard to find information on the size of mining pools. Two well-known mining pools are Slush Pool and Bitfury. We highly recommend making sure that the pool you are mining on isn’t controlled by 51% of the network. This would put the network at risk and open it to double spending.

When you first begin mining, you’ll have a low income because most likely you won’t complete a block successfully by yourself. So it could be a good idea to join a pool. A Bitcoin mining pool is a group of Bitcoin miners that combines their computing power to make more Bitcoins. This dramatically increases the chances of completing a block successfully and is the main reason why there are so many mining pools. It’s also a good idea to join a pool if you’re just mining for fun and don’t want to get too serious.

2.3. Solving complex mathematical problems

In order to decide who gets to add the next block of transactions to the blockchain as well as add new bitcoins into circulation, miners must complete a task that is very difficult to perform but easy to verify. The process of adding a block to the blockchain while also introducing new bitcoins into circulation is called the “block reward.” It’s a way to incentivize the network to continue doing things correctly and was part of the original bitcoin design by Satoshi Nakamoto. This block reward consists of new bitcoins made by the system as well as any transaction fees collected by the transactions in the block. When the total number of bitcoins reaches 21,000,000, the block reward will be the only compensation a miner receives for their work and it is suffice to say very slim to just live on. Today, the total network of bitcoin miners combined have an estimated earning of 1 million USD a day. In order to complete the block reward, miners must find a hash that is below a certain difficulty target. The process to find this hash is called solving a complex mathematical problem. The difficulty of this problem is automatically adjusted by the network such that it takes an average of 10 minutes to solve.

2.4. Verifying and adding transactions to the blockchain

The mining process involves compiling recent transactions into blocks and trying to solve a computationally difficult puzzle. The first participant who solves the puzzle gets to place the next block on the blockchain and claim the rewards. The rewards, which incentivize mining, are both the transaction fees associated with the transactions compiled in the block as well as newly released bitcoin. Bitcoin mining is a difficult, competitive, and computationally intensive task. It requires a lot of resources so it only makes sense for big players to participate. Due to the competitive nature of mining, it’s infeasible for individuals to make a profit with just a personal computer. A mining rig is a computer system used for mining bitcoins. The rig might be a dedicated miner where it was procured, built and operated specifically for mining or it could otherwise be a computer that fills other needs, such as performing as a gaming system, and is used to mine only on a part-time basis.

The Process of Bitcoin Mining

3. Challenges and Rewards of Bitcoin Mining

As mentioned earlier, the goal of the mining process is to discover and validate block transactions. Doing this allows you to collect the “block rewards” for solving the equation, a current 12.5 BTC. However, the amount gained by the reward has been constantly decreasing over time due to its fixed nature and the increasing price of bitcoin. With the next “halving” occurring at block 420,000 around July 2016, the block reward is reduced by 50% to become 6.25 BTC. This reduction in rewards puts additional strains on miners who are already feeling the effect of increased competition. One paper suggests that at the current value and difficulty, it would no longer be profitable to mine as a regular citizen or single entity. This is said to occur around the year 2049. By that time, the miners’ sole method of revenue for transaction validation will be through the small “transaction fees”. This is said to be a 0.01 BTC fee on average, per transaction. Though one can assume that the value and reducing supply of bitcoin would cause the fee to increase, it still poses the question of whether that would be enough to satisfy the global energy output.

One of the primary concerns of more economically-intensive miners revolves around the cost/bitcoin ratio. In the earlier days of Bitcoin, it was viable to mine using a standard CPU or high-speed video processor. But due to the increased complexity of the calculation involved, the requirements have exponentially increased. A recent report from online tech magazine Motherboard has suggested that moving forward, Bitcoin miners will need to use 5-10% of the global energy output to mine, given current trends. In a highly competitive environment, this number may be on the low side. This is due to the “energy consumption and environmental impact” of the increasing requirements and competition. One of the largest Bitcoin miners today, BitFury, released a white paper that detailed the benefits of their immersion cooling technology which might allow them to save up to 95% on the electricity costs of mining. This is just one example of the various innovative strategies to reduce costs in such areas.

3.1. Energy consumption and environmental impact

Statistics are hard to determine with the decentralization and privacy of BTC. No entity or company owns the blockchain and the data is freely accessible throughout the world. However, a useful method of determining the energy consumption of the network is to compare the total mining reward with the market price in USD. From which, a calculation can be done with the assumed percentage of miners selling coins immediately to cover costs (100% can assume it is all to cover costs) and the electricity cost of an average efficient miner. This gives a value for the cost to secure the network, and although not an exact method, we can assume the value will be close to the actual cost of mining. With these figures, the network has a relatively high cost to secure to the current USD value.

The energy-intensive puzzle that each Bitcoin mining machine solves every ten minutes. The miner that completes the puzzle before anything else adds the new block to the blockchain. This block is then verified by thousands of nodes around the world. Ensure that the current block is there has been no double spends with included coins, perform the same hashing process which the miner executed to solve the puzzle, repay the hash and check if it returns the same value, then verify the new block diff value stored in the block and stored in the last block and check it is less than the allowed target from the current timestamp and previous block time. Although this process is complex, it has been critiqued for the amount of electricity used in order to secure the network and complete the proof of work. It is expected that this will become more efficient in terms of energy consumption in the long run with the advancement of mining hardware.

Bitcoin mining is a specific type of virtual mining for virtual coins, which is a very computationally intensive process consuming a large amount of electrical power. In the early days of the currency in 2009-2010, it was estimated that 1 computer could mine 200 BTC within 3 days, before the block reward halving. The same amount of coins could be mined with 0.06 BTC in fees in 2017-2018, but this is highly speculative and relies on the price of the coins and the future of mining rewards. At current exchange rates for BTC, it is no longer profitable to mine Bitcoin without special-purpose hardware (referred to as ASICs) which have a rapidly growing difficulty and has been criticized for being a centralization factor with regards to the block reward.

3.2. Increasing difficulty and competition

At this point, the vast majority of miners would be better off to shut down their operations and contribute to the demand/supply dynamics than to spend more resources mining. This is a good thing for the network as a whole because it drives up the USD value of Bitcoin, which is required to pay the electricity bills. This mechanism can be seen to converge to an equilibrium in which mining is an activity profitable enough to be worth the resources consumed, but not so much that a large-scale increase in miners leads to an explosion in the rate of block creation.

Now, to combat the increase in energy consumption by an individual miner, the network has implemented a threshold below which a transaction cannot be included in a block. This required output complicates the puzzle and, combined with the cost of electricity to solve said puzzle, will only make block mining an economically viable activity for more efficient miners.

In the early days of Bitcoin, anybody could find a new block using their CPU. As more and more miners competed for the limited supply of blocks, individuals found that they were working for months without finding a block. During this time, they were expending electricity and computer resources which had to be paid for in fiat currency. This fact is a real problem in competitive mining because rewards are given to those who can find blocks the fastest.

The difficulty of a block is determined by a target value set by the network, such that the blocks produced by any one miner will have an average of one per 10 minutes. As more miners join the network, the rate of block creation increases. In order to realign the rate at which blocks are created, the network increases the complexity of the puzzle (a lower target value).

3.3. Block rewards and transaction fees

The only incentive for miners to contribute their hashpower to the network is the block reward and transaction fees. The block reward consists of newly created bitcoins, which are given to the successful miner of each block and is therefore effectively a currency issuance rate. It is a strong incentive to compel miners to direct their hashpower at the network. The rate of block creation is adjusted every 2016 blocks to aim for a constant block creation of 6 blocks per hour for the whole network, in light of the fact that more miners on the network result in more hashpower and the network will solve blocks at a faster rate. Therefore, block difficulty has to be increased to make sure the time to solve a block remains at approximately 10 minutes. In other words, the block reward and difficulty are designed to provide consistent incentives for miners to secure the network. The block reward started at 50 bitcoins and halves after every 210,000 blocks are solved. It is estimated that the last bitcoin will be mined in the year 2140. Block rewards represent a form of inflation for the bitcoin supply, which is deflationary in nature due to there being a maximum 21 million coin limit. Block rewards provide a way to bootstrap the network and provide an initial distribution mechanism for coins. It also provides a valuable incentive for miners to invest in hashing equipment and electricity in the early stages of the coin’s lifecycle. The block reward has faced criticism over the years for being excessive and wasteful and not aligning with the need for a low inflation bootstrap incentive. However, it has conscientiously served as a reliable incentive mechanism in the face of miner game theory.

4. The Future of Bitcoin Mining

If global adoption of Bitcoin has the same effects on climate as the letter of credit system currently in use (approx. 700kg of CO2 per $1m) then it will be a very lucrative future indeed for renewable energy providers. This trend is certain to continue, and whilst it may not be immediately apparent, market forces in the coming years are likely to drive an increasing development of more energy efficient and resources to renewable sources. However, the simulation has shown that the demand for renewable energy is largely driven by subsidies, as was observed with hash rate responding significantly to changes in solar subsidy rates.

An almost certain consequence of these trends will be an even more pronounced centralization of mining in countries where regulation is minimal and costs are cheapest. If the primary expense of mining is energy, then the logical conclusion is that widespread adoption of renewable energy will make energy production the main driver for locating mining operations, or else it will lead to more centralization in areas where the most cost-effective forms of energy are accessible. Of course, cheap energy is most abundant in countries with little to no regulation. High capital cost of entry for ASIC mining will also have the same effect. Gains in efficiency as a result of technology and economic competition will ensure that the cost of the resources consumed will not represent a higher percentage of earnings, otherwise there would be no point in expending them.

As Bitcoin mining is a probabilistic endeavor, there are many times when a miner will have to expend some optional work for minimal reward. This can come in the form of non-mining tasks such as providing hosting services for the network, or it can be extra mining work that doesn’t actually contribute to earning coins. An example of the latter is what occurred on the 15th May 2013, when a faulty version of the Bitcoin wallet caused a blockchain fork which resulted in a configuration of miners having to re-mine their work at the expense of the rest of the network.

In the search to further secure and legitimise the network, there are a few important trends emerging in the future of Bitcoin mining. These include a shift towards using renewable energy sources to power mining operations, the development of mining hardware that is more energy efficient, and the move away from mining pools. These trends are likely to have a significant impact on the Bitcoin market and it’s hoped will provide a more secure and transparent level of service.

4.1. Shift towards renewable energy sources

The Bitcoin network is sometimes criticized for being highly inefficient in terms of its energy consumption. Given that the average time between blocks is in the order of 10 minutes, the system is inefficient by design because economic competition among miners has driven electricity consumption, and the easy availability of cheap electricity from non-renewable sources (especially coal) is a key driver. As of January 2021, the Cambridge Bitcoin Electricity Consumption Index estimates that Bitcoin’s annualized electricity consumption is 76.76 TWh, close to the annualized electricity consumption of the Netherlands. Another dominating factor is that the locus of operations for miner and mining pool operator revenues are pooled into fiat currency. If the cost of Bitcoin in terms of electricity is low and there are some economic actors who can always provide liquidity to the miner in fiat terms, this acts as a poultice on the miner to sell the bitcoins right away to cover electricity costs without regard for the future value of the bitcoins being sold. This logically also increases electricity demand to some extent.

4.2. Development of more efficient mining hardware

In the near future, it is expected that there will be a transition to high-performance, power-efficient mining systems that offer a smoother transition than the one from CPU to GPU. This is feasible because there will be no new generation of mining hardware. Development will be restricted to the present generation technology, and it is here that the future of mining lies.

Stepping into the present, custom ASIC miners exist which are custom-built for mining using the SHA-256 algorithm. Prime examples of this era of mining hardware are the ASICMiner USB Block Erupter and Bitmain AntMiner S5. These devices represented an increase in performance, but power consumption has quickly become a crucial parameter in determining the long-term viability of mining hardware.

Initially, miners used their central processing unit (CPU) to mine, but this kind of hardware was not very successful. It would take a very long period of time to successfully mine a block, even with extremely efficient mining. This would require a large amount of memory to handle the high memory usage. The world eventually moved to graphical processing units (GPU) which were about 50 times faster than CPUs and used less power. This jump in power consumption is due to the large increase in efficiency over the prior CPU mining hardware.

In order to compete in this modern era, it is essential for miners to develop innovative hardware that circumvents the increasing electrical cost and the demand for highly efficient mining hardware. Moore’s Law asserts that chip performance per watt doubles approximately every 18 months. This means it is necessary to develop a new chip every year with 50% better performance per watt, just to stay competitive. For example, if IC technology progressed from 14nm to 16nm, this would imply that a 16nm chip has 2x better performance per watt compared to the most efficient ASIC miner, which is close to the end of its development life. As a result, Bitcoin mining hardware has followed a highly predictable path with technological advancement.

4.3. Impact of regulatory measures on mining operations

This section discusses provisions directed at implementing taxes on Bitcoin transactions and/or mining operations and the impact of these measures. Taxes on this income source would have little impact on the macroeconomic returns from the activity (unless tax rates were significantly greater than 50%), as Bitcoin mining is an international business. However, the losses incurred from changes to a higher cost base will affect the viability of marginal operators and the composition of the hashrate. There is a very high price elasticity of hashrate with respect to changes in the cost of mining. A given percentage increase in the cost of mining (say, electricity prices increasing by 20%) will lead to a greater percentage reduction in the quantity of resources employed to mine bitcoins. This is because the only durable good with significant resale value in the mining industry is ASICs. If the present discounted value of the profits to be made with a given ASIC falls below its resale value, the rational strategy is to turn off the machine and sell it. This leads to an influx of second-hand supply of these machines, reducing their market price and thus the marginal cost of mining, which is pivotal in a perfectly competitive industry. The increase in the cost of production of new ASICs and electricity will also be spread across a longer time period due to the nature of a durable goods duopoly, with oligopoly profits dissipating and there being a new industry equilibrium with a greater number of firms in the long run due to free entry and exit. This long-term increase in the cost of mining due to taxes or imposed costs will lead to a decrease in the long-term quantity of resources employed in mining. High-cost operators will close down, or if the new cost level is still above the operators’ margin of opportunity in their next best alternative industry, they will divert the resources elsewhere as there will be no sunk cost.

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