In some ways, the process of creating new Bitcoins is similar to that of extracting precious metals out of the earth. It is also known as “bitcoin mining”.
As mentioned in the Bitcoin whitepaper:
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.
Here’s a simplified overview of Bitcoin mining:
- By using computing power, people can earn bitcoin rewards. This process is known as Proof of Work (PoW). Because only those who have demonstrated that they have worked hard enough will be eligible to win the rewards, the process is called Proof of Work.
- Every 10 minutes, rewards are given to one winning miner.
- The ‘block reward’ is a newly created bitcoin. The current block reward is 6.25 bitcoins. However, it will be reduced in half starting in May 2024 and then again in half four years later. (2) The fees associated with transactions in the current block. To encourage miners to include the transaction in the next block, end-users who wish to make transactions must attach a fee.
What is the purpose of bitcoin mining?
Bitcoin mining is an integral part of the network’s system to reach a consensus on the current state. It allows people to securely transact Bitcoin.
The Bitcoin network is a distributed global public ledger that contains a huge list of timestamped transactions. One ledger entry could indicate that Person A sent 1 Bitcoin to Person B on Monday at 10:00 AM. Each ‘block’ contains a list of new transactions and is added to the ledger approximately every 10 minutes. The ledger is voluntarily stored by thousands of participants, known as “nodes”, and allows anyone to view both the current state of the ledger and the complete history of bitcoin ownership.
It is not possible to have a central authority decide which transactions should be added to new blocks. The state of the ledger, ie. The ‘truth’ is reached collectively by nodes and coordinated following the Bitcoin protocol. This decentralization is what gives Bitcoin some of its most interesting properties – namely, censorship resistance and permissionlessness.
Most nodes only verify the authenticity of transactions and store the ledger. They also pass along updates to other nodes (again these updates are in the form of new blocks being added to the chain). A smaller number of nodes, known as miners, can create new blocks. Miners are updating the state, or the truth, about who owns what, when they create new blocks.
There are many functions that Bitcoin mining can serve:
- This is a way to distribute new coins.
- It is part of a larger system to ensure that only valid transactions are added to the blockchain.
- It allows you to prioritize transactions with limited throughput.
- It offers a financial incentive to participants (miners), to allocate resources to the network. The resources dedicated help protect the network from attacks. It is important to note that attackers are primarily miners. Bitcoin makes it more expensive to mine. This ensures that miners comply with the rule.
How can bitcoin mining protect the network?
Proof-of-work mining is a way to protect the Bitcoin network. It requires potential attackers not to invest more resources in an attack than they can gain from it. It makes it extremely unlikely that anyone would attempt to attack Bitcoin.
What is the process of mining bitcoins?
This process is described in the Bitcoin whitepaper.
- New transactions are broadcast to all nodes.
- Each node collects new transactions into a block.
- Each node works on finding a difficult proof-of-work for its block.
- When a node finds a proof-of-work, it broadcasts the block to all nodes.
- Nodes accept the block only if all transactions in it are valid and not already spent.
- Nodes express their acceptance of the block by working on creating the next block in the chain, using the hash of the accepted block as the previous hash.
Let’s take a closer look at this.
Miners are those who propose updates to Bitcoin’s ledger. Only miners who have completed the Proof of Work can add new blocks. This code is embedded in the Bitcoin protocol.
Miners can choose valid transactions from a pool that is broadcast to the network via nodes. These transactions are then collected into the “mempool.” The mempool is a collection of transactions that honest and rational miners choose based on their fees. This allows them to maximize the higher fees. The fee market is a way to make sure that the block space is being used efficiently and fairly.
The Proof of Work is completed by the first miner. She then broadcasts her new block to the wider network of Nodes, who then verify that it follows the protocol’s rules. These are the key rules: (1) All transactions within the block are valid (ie. There is no double-spending. (2) The new block refers to the previous block and is numbered next in the chain. The new block is the latest in the longest chains. Nodes can send the new block to other nodes if it does. This allows the new block to spread across the network until it becomes widely accepted as the truth.
It is possible and often does, for more than one miner to complete the Proof of Work simultaneously. He then broadcasts his block out to the network. Due to network delays or geographic separation, nodes might receive new blocks at slightly different times.
A miner can propose a different block than another. As mentioned above, miners decide which transactions are included in a block. Even though they try to maximize profitability, different factors like location and other factors can cause variations. Two miners sending out different blocks can lead to competing versions of the truth that spread across the network. The network eventually converges on the correct version of the truth when it selects the longer and faster-growing chain.
Let’s take a look at the last part. Let’s say there are two competing chains. Let’s assume 75% of miners choose version A because it is the first version that they have seen, and then begin their Proof-of-Work for the next block. 25% of miners choose version B, again because it was the first version they saw. Then, the process continues building on that version. Statistically, version A will be completed by version B miners first. The Proof of Work will then be broadcast to the network. Version A will soon dominate the network, as nodes choose the longest chain. The probability that version A will outperform version B with every additional block decreases exponentially, making it statistically impossible to add six blocks. A transaction confirmed in six blocks is considered to be a set-in-stone transaction by most participants. An orphan block is a block that doesn’t become part of the longest chain (version A in our example). These blocks are usually created between 1 to 3 times per day, according to estimates. Transactions included in orphan blocks are not lost. Because if they aren’t included in the version with the longest chain, they will be added to the block with the longest chain.
What is Bitcoin’s hashing algorithm called?
Secure Hash Algorithm 2 is a military-grade encryption algorithm used in Bitcoin. When a Bitcoin miner finds a random number, they are given BTC. This is because the hashing algorithm can only be run over and over again. This is similar to winning a lottery, where you buy more tickets and the chances of winning increase. Miners can effectively buy more lottery tickets by putting more computing power into the hashing algorithm.
What is the difficulty adjustment for bitcoin mining?
Every 2,016 blocks or approximately every 2 weeks, the difficulty level of Proof of Work is automatically adjusted. These adjustments are made to maintain a constant mining time of 10 minutes per block.
The difficulty adjustment is based on the computing power (or ‘hash power’) that is being used to calculate the hashing algorithm. The difficulty of mining becomes more difficult as computing power increases. Mining becomes easier if computing power is decreased.
The adjustment process makes bitcoin mining very different from mining precious metals. For example, if the price of gold increases, more miners will be attracted to the market. More gold will be produced if there are more gold miners. This will eventually lead to a lower market price for gold due to the forces of supply and demand. The Bitcoin protocol (ie) predetermines the amount of bitcoin that is produced. The number and power of miners do not affect the production of bitcoin.
Is Bitcoin mining profitable?
Bitcoin mining is highly competitive and has narrow profit margins. Although electricity is the primary input, significant upfront investments are required in hardware and facilities to house it. The Application Specific Integrated Circuit (ASIC) is the key hardware. This is a computer device that is specifically designed to run the Bitcoin hashing algorithm. Profitability is largely dependent on having consistent access to low-cost electricity that is applied to the most efficient ASIC Hardware.
Bitcoin mining is a naturally equilibrating process. The price of bitcoin increases, which means that miner margins increase. This encourages more miners into the market. New entrants can make it difficult to produce new blocks. This causes all parties to spend more resources and reduces profitability. In the past, miners quit when bitcoin prices drop steadily due to rising costs.
What does bitcoin mining do to the bitcoin price?
Most miners will sell their bitcoins to pay for the mining costs. These costs contribute to the net selling pressure. Bitcoin’s volatility may be affected by miners’ attempts to maximize profits through holding or selling Bitcoin according to market momentum. This argument suggests that miners might try to hold Bitcoin longer to make more profit when Bitcoin’s price is rising. This would reduce net selling pressure and lead to a faster price rise. Miners will likely sell their bitcoins and other Bitcoin when the price falls. This would lead to volatility.