What is Bitcoin Mining ?
If you've ever wondered where Bitcoin comes from and how it goes into circulation, the answer is that it gets "mined" into existence. Bitcoin mining
serves to both add transactions to the block chain and to release new
Bitcoin. 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 block chain and claim the rewards. The rewards incentivize mining
and include both the transaction fees (paid to the miner in the form of
Bitcoin) as well as the newly released Bitcoin.
Security of the Network
Bitcoin mining is decentralized. Anyone with an internet
connection and the proper hardware can participate. The security of the
Bitcoin network depends on this decentralization since the Bitcoin
network makes decisions based on consensus. If there is disagreement
about whether a block should be included in the block chain, the
decision is effectively made by a simple majority consensus, that is, if
greater than half of the mining power agrees.
If an individual person or organization has control of
greater than half of the Bitcoin network's mining power, then they have
the power to corrupt the block chain. The concept of someone
controlling more than half of the mining power and using it to corrupt
the block chain is known as a "51% attack". How costly such an attack
would be to carry out depends largely on how much mining power is
involved in the Bitcoin network. Thus the security of the Bitcoin
network depends in part on how much mining power is employed.
The amount of mining power that gets used in the network
depends directly on the incentives miners have, that is, the block
reward and transaction fees.
Block Reward
The amount of new bitcoin released with each mined block
is called the block reward. The block reward is halved every 210,000
blocks, or roughly every four years. The block reward started at 50
bitcoin in 2009, and is now 25 bitcoin in 2014. This diminishing block
reward will result in a total release of bitcoin that approaches 21
million. According to current Bitcoin protocol, 21 million is the cap
and no more will be mined after that number has been attained.
As of today, block rewards provide the vast majority of
the incentive for miners. At the time of writing, for the previous 24
hours, transaction fees represented 0.3% of mining revenue.
Transaction Fees
As the block reward diminishes over time, eventually
approaching zero, the miners will be less incentivized to mine bitcoin
for the block reward. This could be a major security problem for
Bitcoin, unless the incentives provided by the block reward are replaced
by transaction fees.
Transaction fees are some amount of Bitcoin that are
included in a transaction as a reward for the miner who mines the block
in which the transaction is included. Transaction fees are voluntary on
the part of the person sending a transaction. Whether or not a
transaction is included in a block by a miner is also voluntary. Thus,
users sending transactions can use transaction fees to incentive miners
to verify their transactions. The version of the Bitcoin client
released by the core development team, which can be used to send
transactions, has fee minimum rules by default.
Mining Difficulty
How hard is it to mine Bitcoins? Well, that depends on
how much effort is being put into mining across the network. Following
the protocol laid out in the software, the Bitcoin network automatically
adjusts the difficulty of the mining every 2016 blocks, or roughly
every two weeks. It adjusts itself with the aim of keeping the rate of
block discovery constant. Thus if more computational power is employed
in mining, then the difficulty will adjust upwards to make mining
harder. And if computational power is taken off of the network, the
opposite happens. The difficulty adjusts downward to make mining
easier.
The higher the difficulty level, the less profitable
mining is for miners. Thus, the more people mining, the less profitable
mining is for each participant. The total payout depends on the price
of Bitcoin, the block reward, and the size of the transaction fees, but
the more people mining, the smaller the slice of that pie each person
gets.
Mining Hardware
Anyone with access to the internet and suitable hardware
can participate in mining. In the earliest days of Bitcoin, mining was
done with CPUs from normal desktop computers. Graphics cards, or
graphics processing units (GPUs), are more effective at mining than CPUs
and as Bitcoin gained popularity, GPUs became dominant. Eventually,
hardware known as an ASIC (which stands for Application-Specific
Integrated Circuit) was designed specifically for mining Bitcoin. The
first ones were released in 2013 and have been improved upon since, with
more efficient designs coming to market. Today, mining is so
competitive, it can only be done profitably with the latest ASICs. When
using CPUs, GPUs, or even the older ASICs, the cost of energy
consumption is greater than the revenue generated.
As ASICs are advanced and more participants enter the mining space, the difficulty has shot up exponentially.
A lot of this activity has been incentivized by the large price
increase Bitcoin experienced in 2013 and speculation that the price may
rise further. There is also political power within the Bitcoin
ecosystem that comes with controlling mining power, since that mining
power essentially gives you a vote in whether to accept changes to the
protocol.
There are many companies which make mining hardware. Some of the more prominent ones are Bitfury, HashFast, KnCMiner and Butterfly Labs. Companies such as MegaBigPower, CloudHashing, and CEX.io also allow customers to lease hosted mining hardware.
Mining Pools
Mining rewards are paid to the miner who discovers a
solution to the puzzle first, and the probability that a participant
will be the one to discover the solution is equal to the portion of the
total mining power on the network. Participants with a small percentage
of the mining power stand a very small chance of discovering the next
block on their own. For instance, a mining card that one could purchase
for a couple thousand dollars would represent less than 0.001% of the
network's mining power. With such a small chance at finding the next
block, it could be a long time before that miner finds a block, and the
difficulty going up makes things even worse. The miner may never recoup
their investment. The answer to this problem is mining pools. Mining
pools are operated by third parties and coordinate groups of miners. By
working together in a pool and sharing the payouts amongst
participants, miners can get a steady flow of bitcoin starting the day
they activate their miner. Statistics on some of the mining pools can
be seen on Blockchain.info.
Electricity Costs
The main operational costs for miners are the hardware and
the electricity cost, both for running the miners but also for
providing adequate cooling and ventilation. Some major mining
operations have been purposely located near cheap electricity. The largest mining operation
in North America, run by MegaBigPower, is located on by the Columbia
River in Washington State, where hydroelectric power is plentiful and
electricity prices are the lowest in the nation. And CloudHashing runs a
large mining operation in Iceland,
where electricity generated from hydroelectric and geothermal power
sources is also renewable and cheap, and where the cold northern climate
helps provide cooling.
Regulation
Earlier this year, the IRS issued tax guidance regarding Bitcoin and said that income from mining could constitute self-employment income and be subjected to tax. FinCEN, the Financial Crimes Enforcement Network, is a bureau of the U.S. Treasury
that collects and analyzes data on financial transactions with the aim
of fighting financial crimes, especially money laundering and terrorist
financing. FinCEN has issued guidance saying that bitcoin miners are
not considered Money Transmitters under the Bank Secrecy Act and
recently clarified that providers of cloud mining services are also not
considered Money Transmitters.
The Bottom Line
Bitcoin mining is the means by which new Bitcoin is brought into circulation, the total of which is to be capped at 21 million BTC. Miners are in an arms race to deploy the latest bitcoin mining chips and often choose to locate near cheap electricity. As more computing power is used in mining, the difficulty of the puzzles increases, keeping profitability in check.
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