Demystifying Crypto “Mining”

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Coinmonks

6 min readFeb 21, 2022

“Mining” is somewhat of a misnomer in the crypto world, and it is a confusing term used to describe the act of processing transactions through Bitcoin’s consensus mechanism known as Proof-of-Work (PoW). The term was coined after Satoshi Nakamoto used an analogy in the Bitcoin whitepaper to describe incentives given to participants responsible for processing transactions.

Mining According to The Bitcoin Whitepaper

“By convention, the first transaction in a block is a special transaction that starts a new coin owned by the creator of the block. This adds an incentive for nodes to support the network, and provides a way to initially distribute coins into circulation, since there is no central authority to issue them. The steady addition of a constant amount of new coins is analogous to gold miners expending resources to add gold to circulation. In our case, it is CPU time and electricity that is expended.

The incentive can also be funded with transaction fees. If the output value of a transaction is less than its input value, the difference is a transaction fee that is added to the incentive value of the block containing the transaction. Once a predetermined number of coins have entered circulation, the incentive can transition entirely to transaction fees and be completely inflation free.

The incentive may help encourage nodes to stay honest. If a greedy attacker is able to assemble more CPU power than all the honest nodes, he would have to choose between using it to defraud people by stealing back his payments, or using it to generate new coins. He ought to find it more profitable to play by the rules, such rules that favor him with more new coins than everyone else combined, than to undermine the system and the validity of his own wealth.”

What’s The Point of Mining?

In a nutshell, Satoshi needed to come up with a way to allow new transactions to be processed without entitling such activity to a specific person or persons. To be more specific, the goal was to completely eliminate the need of a trusted entity who is traditionally responsible for either directly processing transactions or assigning who gets to process transactions. This was necessary to achieve network neutrality and prevent anyone from censoring transactions and/or seizing user’s balances. Enter Proof-of-Work.

The idea behind PoW was to create a computational problem that is hard to solve but at the same time allow for the correct answer to be quickly validated. The entire Bitcoin network is composed of millions of computers that are racing against each other in an attempt to figure out the solution to this computational problem. The computer that figures it out first immediately publishes the correct answer to the network and is awarded the rights to process a batch of Bitcoin transactions limited to 1 MB in size. These batches of transactions are known as “blocks”.

When a new block is published, all network participants validate it to make sure the computational problem was solved properly and that all transactions within that block are valid.

After a new block is created, a new computational problem must be solved. This new problem is partially defined by the block that was just created, therefore it is different from the previous one, and all mining computers start trying to solve it from scratch. Since each block created also creates a new computational problems, blocks become computationally linked to each other. This is the source of the word “chain” in blockchain.

The computational difficulty of these problems is adjusted by the protocol in order to ensure that only one correct answer is generated every 10 minutes. Therefore on average every 10 minutes a new block is added to the chain and at this rate Bitcoin was originally capable of processing ~4 transactions per second. This limit has since improved to ~7 transactions per second due to changes in the protocol (the block size limit was increased).

Mining requires powerful computers and it consumes electricity, so an economic incentive was necessary to finance mining. Fees are one way to finance mining. Transaction fees are awarded to block processors, but fees alone do not to provide enough financial incentives. This is where the minting of new coins comes into play; the protocol effectively mints new coins and awards them to whoever manages to add a new block to the network.

Crypto Mining vs Real World Mining

Now that we understand better what Bitcoin mining is, and why the system actually needs to issue new tokens, we can revisit the analogy to mining. It is catchy and expresses the process where new tokens are created, but it is a misleading analogy and it is the cause of much confusion to people who are still learning basic concepts about cryptocurrencies. It is fundamentally different from real world mining in two ways:

The sole purpose of real world mining is to acquire new resources. The gold extracted from mines is not a byproduct nor is it an artificially created incentive used to promote a different goal. The sole purpose of crypto mining is to process transactions in a decentralized fashion. The new tokens created in this process are more akin to newly minted currency, and having to do so is a necessary evil needed to promote neutrality. In other words, the minting of new coins is a negative byproduct. It is a subsidy needed to prevent censorship/seizures via PoW until transaction fees become high enough to provide enough revenue to finance the network operation on their own.
Unlike real world mining, more bitcoins cannot be created by adding more miners to the system. When more miners join the network, the system adjusts the difficulty of the problem in order to maintain an average processing speed of 1 block every 10 minutes. This is a key concept used to promote Bitcoin’s superior stock-to-flow model when compared to gold.

The Cost of Mining Is Not the Cost of Producing New Bitcoins

Bitcoiners often link mining costs with the cost of producing new bitcoins, but wrongly derive its value from the cost of mining. Linking the value of a monetary asset to the cost of production is only applicable to non-crypto assets. The cost of production related to legacy forms of money is just a way to restrict supply.

The beauty of cryptos is that the supply is established by network consensus, and the cost of production is a not a factor because there is none. Perhaps the confusion is in part caused by the poor choice of words to define the act of processing crypto transactions: mining.

Again, unlike real world mining, crypto mining is not producing anything. Mining is a service; it’s just processing transactions. However, it does cost money to process transactions and miners need to get paid. One way of doing that is by minting new coins and distributing them to miners as a form of security subsidy.

Here is another way to look at it: Bitcoin is minting 6.25 coins per block. It will mint 6.25 coins if every computer in the world is mining BTC. It will also mint 6.25 coins if there is only one dude with a pocket calculator mining. The protocol mints these coins for free, and computational power does not impact issuance. As matter of fact, the protocol is coded in such way to prevent hash power from affecting issuance. In other words, Bitcoin was deliberately designed to prevent the amount of work done by mining (and the cost) from having any impact on how many coins are created; that’s because coins are not really “mined”, they are minted.

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Demystifying Crypto “Mining”

Mining According to The Bitcoin Whitepaper

What’s The Point of Mining?

Crypto Mining vs Real World Mining

The Cost of Mining Is Not the Cost of Producing New Bitcoins

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Written by Adriano Feria