Last updated on January 2nd, 2018 at 12:00 am
Every few weeks we’re going to send you a cool new video, just like this one, explaining some basic concepts around Bitcoin. This way you can learn about Bitcoin yourself or forward these videos to friends or family members who have questions.
And for today’s topic: Bitcoin Mining. You have probably heard that Bitcoins are “generated” using very powerful computers solving very complicated mathematical equations. You may also have heard that Bitcoin is a network of computers that maintain a “Blockchain”. Today we’re going to talk all about this and more. As usual, I’m going to keep it simple and straightforward.
The Bitcoin Blockchain is the public ledger which is kind of like “the history book of Bitcoin transactions”. Every Bitcoin transaction ever made since Bitcoin came into existence is written down and documented on it.
This history is really important – since it shows exactly how many Bitcoins each “bitcoin account” or address owns. Trusting this ledger is what makes Bitcoin work. Now remember, Bitcoin doesn’t have a central authority that can approve of this history book, which means that anyone can write it.
So how can you have a reliable history book that anyone can write and nobody approves? This could lead to many different versions of this book and we couldn’t know which is correct.
Perhaps we need some kind of voting system to make sure we can all agree on the “right” version of the history book, and make sure that bad people can’t profit by causing confusion. But voting systems are necessarily identifiable and centralized – there needs to be a central authority that uses identification and determines who has the right to vote. This can’t be the case with Bitcoin because the point is removing the central authority.
So this voting system needs to allow anyone to take part but still scare away crooks and other evil-doers.
To do this, Bitcoin mining is used. In a nutshell, the Bitcoin protocol grants new Bitcoins every time someone adds a new page of transactions to the history book – also known as adding a block to the Blockchain. However it requires that you invest computational power to do this. Wait, what? What do I mean by “computational power” and why is it needed?
There is a mathematical way to prove that you took data, like a page in a history book, and ran some calculations on it. This provable computational power costs time and electricity – that is, money. The protocol says that if there are two conflicting versions of the Blockchain, the one with the most computing power “wins”.
To put it another way, the rules are like this: it costs you money to write a new page in the history book. If everyone agrees to add your page to the history book then you’ll get paid for your work. But if they don’t agree to add the page, then you just wasted money to write it. This makes sure that everyone writing this history book try very hard to agree with each other in order to not waste money, and keeps crooks away because it’s simply too expensive to write up fake versions that will be thrown out anyway. This is essentially what Bitcoin mining is.
This may sound like a weird way to solve the problem, but really it makes a lot of sense. Miners have to invest money in mining as a kind of collateral, and they get their money back in Bitcoins if their mining was good for the network. Because miners are paid in newly issued bitcoins, it’s a sort of cost that all Bitcoin holders pay in the form of inflation in order to secure the network and to make sure the history book is accurate. This model solves two problems: it decentralizes the trust in the ledger so that we don’t need a central authority, and it also lets the protocol fairly create and distribute all the bitcoins that need to exist, instead of them all going to the inventor.
One of the core tenants of Bitcoin is how the coins are created. Once again they are not created all at once by the inventor – that would be unfair. Rather they are created slowly over time, paid to all those that take part in processing blocks of transactions and adding them to the Blockchain. The rate and limit of coins created are clearly defined in advance: 50 coins per block of transactions that is added to the blockchain (which takes roughly 10 minutes).
This number decreases by half each 210,000 blocks (roughly 4 years), for a total limit of 21 million coins. This is all very arbitrary, the actual numbers themselves don’t matter much, as long as they are agreed upon in advance and level the playing field for everyone. Importantly, the calculations that miners do are self adjusting to maintain this rate of one block per ten minutes, no matter how many miners there are.
You can be forgiven for thinking that miners have all the power in controlling Bitcoin because they are writing the history, but the truth is far more nuanced. In reality every time you use a Bitcoin wallet you are reading through the entire Blockchain and verifying all the information, including the cryptography, computational power and very importantly, the creation of new Bitcoins.
So why does you reading the history book keep miners fair? Well, if anything is out of place or illegitimate you toss it out and find a version of the Blockchain that does follow the rules. This would be devastating for miners because it costs them a lot of money to write that version. This can really explain why miners follow the rules: it’s really easy to simply delete their hard work in favor of a miner who didn’t break the rules. These rules are known as “The Protocol”, and they work because people agree on them and then check them.
And so are the checks and balances in the system known as Bitcoin. Of course, the further you look into these things the more nuanced and complex the system gets. If you’re interested more in the theory and potential problems with this system, there is plenty to read up.
And for the big question that many people wonder: should I be mining Bitcoins?
Let me just quickly get the simple short answer out of the way: you probably should not be mining Bitcoins. It is in no way “free money” or any form of guaranteed profit. But if you’re still curious, let’s take a look at miners.
A miner is a computer of some sort that runs the mining algorithm and is doing the actual mining, but the person who owns the computer is also called a miner. When you hear the word miner it may mean the computer or the person or both depending on the context.
So what does a miner do? Well, miners take the transactions that haven’t been processed yet and put them together in a block – that’s the new page we’re adding to the history book. Remember we said it requires computational power? The miner needs to run some calculations on this block, and these calculations have a difficulty that takes time to complete. This difficulty is self-adjusting so that blocks are completed once every ten minutes on average, but it’s quite random.
And so what happens is a kind of lottery, where all the miners are trying to complete these calculations until one of them succeeds. The one that succeeds gets the “reward” of new coins granted from the protocol. Every time a block of transactions is completed and added to the chain, all the miners start working on the next block. Of course, the faster your computer is, the more likely you are to solve the calculations first. But remember, you only get some finite amount of Bitcoins per block so it isn’t worth investing all the computers in the world just to solve this algorithm.
To summarize, the Bitcoin protocol is paying people to invest computational power in the Blockchain, but promises no profit. Mining is a zero sum game, which is to say that for every person who made a profit there is a person who made a loss – exchange rate profits and losses notwithstanding. And so because of this zero sum game, if you’re considering becoming a miner and buying mining equipment, you need to be better than the competition and that requires a lot of research and resources.
Back in the day, when Bitcoin was practically unheard of there were so few miners that the difficulty was low enough so that these few people can find a block once every ten minutes on average. And so, they used their laptops and desktops to mine for bitcoins. Nobody did this competitively because Bitcoins were worthless back then. However, as the exchange rate of Bitcoin started to rise, other people realized that they can mine Bitcoins and sell them for profit. More miners joined the party and the difficulty adjusted itself and made it harder to find blocks. So as the Bitcoin network gained more mining power, the difficulty grew stronger and the average time of 10 minutes between finding blocks remained.
Every block reward was now worth more and there were more people competing. So as a miner, you would find yourself finding fewer and fewer blocks, but each block was worth more and more. So instead of a steady business where they would get paid a little once a day, miners were playing a sort of lottery where they would get paid a lot once they got lucky enough to find a block.
Business savvy people tend to prefer a steady income over lottery tickets, and so they came up with an idea: mining pools. A group of miners banded together to find blocks, and when one of them found a block, they would split up the reward with everyone in the mining pool. They effectively get the same profit but it is much more steady and less random.
At the same time people realized that faster computers would generate more Bitcoins than slower computers. Instead of using regular computer processors, people started using graphic card processors and FPGAs, all in order to get more powerful mining capabilities.
But of course the difficulty continued to adjust to those processors as well and so ASIC miners were born. ASIC stands for Application Specific Integrated Circuit. These are computers that are designed specifically to mine Bitcoins and they are much better at it. Today profitable Bitcoin mining is done only with ASIC miners.
Remember, the protocol will still generates bitcoins at the same rate and it’s still a zero sum game, so faster computers will get a bigger share of the cake and slower computers will get a smaller share of it but the size of the cake won’t change.
It’s worth noting that as of filming this video it’s trendy to hear offers of “cloud mining”. This means that instead of buying a miner and running it yourself you lease mining power from companies who claim to own large mining farms and want to diversify their income streams.
While this can in theory be cheaper and more efficient, much of these services are quite shady and it’s very difficult to verify that you are getting the service you’re paying for. If you are not an expert, a good rule of thumb is to be skeptical of these services.
Bitcoin mining is a very technical field and a very competitive industry. The inventor of Bitcoin managed to design a system that gives everyone a fair chance to take part of every step of the way, and that is what is so innovative about Bitcoin. However some people believe that Bitcoin mining is bad because it’s a waste of electricity.
Now, these are very complex systems so I don’t claim to know the answer, but consider this: not using mining requires using systems that rely on central authorities and trust. There are lots of associated costs with traditional financial services, such as counterparty risk and all the infrastructure such as real estate, buildings, human services, and of course the millions of computers that are needed anyway.
Bitcoin isn’t magic, and it doesn’t remove these costs, they are simply different costs for a different system. The costs of mining are the costs of creating such a system without a trusted central authority.
Anyway that’s our second edition of Bitcoin Whiteboard Tuesday and I can’t wait to see you in our next video. If you still have any questions or comments on the video feel free to leave them in the comment section below. Bye for now!