Blockchain Blog 10: Bitcoin Mining

Aakash S
Coinmonks

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Bitcoin is the first asset in history with absolute, mathematical scarcity. This scarcity is verifiable by any member of the network and is regulated by an algorithm in Bitcoin’s source code. This algorithm allows miners who create blocks to receive newly minted bitcoin. This subsidy helps miners cover the high costs of mining. Every four years, however, the algorithm cuts the subsidy in half in an event called the halving. This process will continue until around the year 2140 when the flow of new bitcoin will drop from one satoshi per block to zero.

When a halving occurs, miner revenue is roughly cut in half. As with any industry, a 50% loss in revenue can force a business out of operation. In the case of Bitcoin, mining directly provides security to the network, so a flight of miners from the network could jeopardize Bitcoin’s security model. As the block subsidy trends towards zero, Bitcoin skeptics believe that low miner revenue could lead to lower security and a diminishing value proposition for Bitcoin itself.

Skeptics have also expressed fears of a deflationary currency. As Bitcoin’s inflation rate continuously falls, some economists have claimed that there will not be enough Bitcoin on which to base a monetary system and that Bitcoin will never support retail payments due to its high price.

Bitcoin Mining

New bitcoin is released through mining, which is the process of confirming Bitcoin transactions. When a miner finds a new block, they are rewarded 6.25 BTC. Every 210,000 blocks, the subsidy for each new block falls by half. Reducing the subsidy per block keeps the supply of new bitcoin at a constantly decreasing rate, and allows the current supply of bitcoin to always be known. Bitcoin has a finite supply of just below 21 million bitcoin. When the last bitcoin has been mined, the production of new bitcoin will end. Unless an overwhelming majority of the miners and node operators can convene to override the supply constraint, which is highly unlikely given the number of network participants required to change the framework of the blockchain, no new bitcoin will be released.

Miners spend resources to create new blocks for transactions to be placed into and are rewarded for their efforts in newly minted bitcoin. Different from the regular connotation of mining, Bitcoin mining is the process in which specialized computers confirm transactions on Bitcoin’s blockchain. These transactions are processed by miners through the SHA-256 hashing algorithm, a cryptographic function invented by the NSA. We covered SHA-256 in Blockchain Blog 07: Inside the Blockchain Technology

This algorithm is used to secure transactions and is the backbone of the mining process. Essentially, miners all over the world are running hundreds of thousands of computers to generate hundreds of trillions of hashes. Transactions are confirmed when a miner is able to generate a valid hash that results in a new block being “found.”

When a miner finds a new block that is accepted by the entire Bitcoin network, it is rewarded in newly minted bitcoin, and transactions waiting to be confirmed are placed into this new block and added to the blockchain.

Coin Distribution

Miners receive new bitcoins as a reward for their efforts. However, almost all miners must pay their operating costs — new equipment, employee salaries, and most significantly, energy costs — in the local fiat currency. This forces most miners to immediately liquidate some if not all of their newly minted bitcoin. These new coins are sold on exchanges or OTC desks. Miners are thus a fairly consistent source of sell pressure on the network. As Bitcoin’s inflation rate continues to be cut in half every four years, the impact of this miner-driven sell pressure will presumably decline as well. Additionally, if Bitcoin gains adoption within the energy sector, miners could begin paying some of their operating costs in Bitcoin.

Mining is one of the two core components that secure the Bitcoin blockchain. In a simple way, it can be looked at as the process that actually builds the blockchain by discovering new blocks and joining them to the previous ones. The other component is the nodes that keep track of the history of all transactions and verify new transactions.
What Do Bitcoin Miners Do?
1 Confirm Transactions
2 Secure the Network
3 Release New Coins

What Are Bitcoin Mining Pools?

Bitcoin mining pools are networks of distributed Bitcoin miners who cooperate to mine blocks together and distribute the payments based on each entity’s contribution to the pool. This allows miners to smooth out their revenue at a slight discount in the form of fees paid to the pool coordinator. Whenever any miner in the pool finds a block, they pay the block reward to the mining pool coordinator. After taking a small fee, the coordinator pays each member of the pool based on their hash rate contribution.

For a small miner who has impossibly low chances of finding a block on their own, joining a mining pool will provide a steady stream of revenue. This revenue will be proportional to the miner’s size, so it will still be small, but the consistency of revenue helps the miner continue to cover operating costs and profit.

Mining pools exist because as an industry, Bitcoin mining has inherent economies of scale. However, energy, and cheap energy, in particular, is geographically distributed, meaning that mining takes place across the globe. Thus, mining operations have an incentive to operate in different physical locations but cooperatively share hash rates and block rewards.

Whereas bitcoin mining farms are comprised of large arrays of miners that are usually housed in warehouses. Setting up a mining farm often requires a very large investment as well as the ability to source cheap electricity, and is much more difficult to do today than it was many years ago.

Economic Concerns

As Bitcoin’s inflation rate is cut in half every four years, it will slowly become the hardest currency in the world. During the most recent halving, when the block subsidy dropped from 12.5 BTC to 6.25 BTC, Bitcoin’s inflation rate dropped from ~3.7% to ~1.8%, making it less inflationary than the stated U.S. Dollar inflation target of 2%. The halving of 2024 will make Bitcoin less inflationary than even gold, an asset long valued for its low stock-to-flow ratio.

From an economic perspective, many academics fear the effects of deflationary money on an economy. They would argue that Bitcoin’s deflationary policy will leave insufficient money in a financial system, and would send interest rates too high, stifling growth. With regard to deflation, most Bitcoin advocates believe that fears of Bitcoin causing a deflationary spiral and killing demand for goods are overblown. As inflationary money, fiat currency has incentivized individuals to spend their money immediately rather than save it for future use. Bitcoin certainly reverses these incentives, encouraging long-term investment rather than short-term consumption. However, no human can lower their consumption to zero.

Satoshis

To solve the perceived problem of a “lack of money” in a system, Satoshi Nakamoto created each bitcoin is divisible into 100 million pieces. These pieces are called satoshis, and if the Bitcoin price is $43,700, a satoshi is worth $0.000437. As Bitcoin appreciates in value and gains adoption, smaller and smaller pieces of bitcoin will carry larger and larger purchasing power. As Bitcoin rises in price, the price of goods denominated in Bitcoin will fall. Thus, the total amount of bitcoin in the system hardly matters; instead, it is the purchasing power of each satoshi that matters.

The paper currencies still exist today, and the fact that more than 2 billion people don’t have bank accounts is very unfair. If we think about the future of the money, we see that more people will use smartphones and entire access to banks will come on the smartphone, but having proper knowledge about how to use technology will also become more important as more scams will come in place.

Cryptocurrencies will lead the government to either make their currency more secure or regulate these cryptocurrencies as these cryptos can become the biggest threat to national security.

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