What do you mine bitcoin

How Does Bitcoin Mining Work?

Bitcoin Mining Explained

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Bitcoin is a sovereign system of digital money. It has no direct correlation to any real-world currency, nor is it controlled by any government or centralized entity. But people can (and do) use it to purchase real-world items at major retailers such as Overstock.com and Expedia.

To process these transactions securely, entities called miners compete to solve mathematically complex problems. The miner who is successful in solving the problem adds a block to Bitcoin’s blockchain and receives a reward of 6.25 bitcoins. In November 2020, a single bitcoin was worth more than $18,000—meaning every successful miner receives more than $100,000 worth of Bitcoin.

Not only is this a reward for the miner’s efforts, but the process of mining is how new bitcoins are generated and introduced into circulation.

Key Takeaways

• A blockchain is an online decentralized ledger that records approved transactions (blocks) that are tied together (chains) throughout a network.
• Bitcoin miners add individual blocks to the blockchain by solving complex mathematical problems, with the winner receiving a set number of bitcoins.
• The mining difficulty of bitcoin is extremely high, requiring expensive hardware, large amounts of electricity, and specific software.
• Whether bitcoin mining is profitable depends on the cost of electricity, though it is most profitable when miners work in pools to combine resources.

How Bitcoin Mining Works

All mining starts with the blockchain. This is an online decentralized ledger that records transactions throughout a network. A group of approved transactions is called a “block.” These blocks are tied together to create a “chain,” hence the term “blockchain.”

In the Bitcoin network, a miner’s goal is to add individual blocks to the blockchain by solving sophisticated mathematical problems. This requires enormous computational and electrical power. While many miners compete to add each block, the miner who solves the problem will actually add the block—along with its approved transactions—to the blockchain. This miner receives a reward of 6.25 bitcoins (as of November 2020).

The reward rate is cut in half every 210,000 blocks, which means roughly every four years. This process, called “halving,” is algorithmically enforced, ensuring a predictable, unalterable rate of introducing new bitcoins into the existing supply—eliminating concerns of inflation.

Due to the inherent difficulty in mining bitcoins, there are a number of requirements when it comes to the actual mining process.

What Do I Need to Mine Bitcoin?

Bitcoin is designed to adjust the difficulty required to mine one block every 14 days (or every 2,016 blocks mined). The overarching goal is to maintain the time required to mine one bitcoin to 10 minutes. Since Bitcoin has been around since 2009, its mining difficulty is currently extremely high, which is why resource-intensive, powerful hardware is required to mine it. 

Regular household computers—even those with incredible power by today’s standard—will not see any success in the modern Bitcoin mining ecosystem.

The first and most important piece of equipment needed to mine bitcoin is specialized mining hardware called application-specific integrated circuits, or ASICs. A new ASICs device can cost anywhere from several hundred dollars to $10,000. But the price of mining hardware is only a fraction of the expense involved. ASICs consume tremendous amounts of electricity, the cost of which can quickly exceed the cost of the device using it.

You’ll also need to choose Bitcoin mining software to join the Bitcoin network. This isn’t nearly as expensive as hardware. In fact, plenty of reliable software options are available for free.

To determine the profitability of Bitcoin mining, all expenses must be considered: hardware, software, and electricity. The current value of Bitcoin, which consistently fluctuates, must also be taken into account, as well as taxes you might pay.

Each block takes roughly 10 minutes to mine. If more power and resources are dedicated to mining, and if the time required to mine one block falls under 10 minutes, Bitcoin’s mining difficulty will increase to bring the average per-block mining time back to 10 minutes.

Can You Make Money From Mining Bitcoin?

At first glance, Bitcoin mining appears profitable. As of November 2020, the reward per block was 6.25 bitcoins, and one bitcoin is worth almost $18,000. According to these figures, Bitcoin generates more than $100,000 worth of value every 10 minutes. If that sounds too good to be true, that’s because it is—in part.

A single ASIC can consume as much electricity as 500,000 Playstation 3 devices, which is why Bitcoin mining simply isn’t profitable from home.

The profitability of Bitcoin mining depends mostly on the cost of electricity. For example, if you live in Louisiana and access electricity at an industrial rate of 4.58 cents per kilowatt-hour—which is the cheapest in the United States—you will lose money, even with top-notch ASICs hardware.

Fortunately, Bitcoin mining enthusiasts without direct access to cheap electricity have another option.

Mining Pools

One way in which Bitcoin mining can still be profitable—and perhaps the only way—is through mining pools. These enable miners to pool their resources, adding power but splitting the difficulty, cost, and reward of mining Bitcoin. There are several well-known Bitcoin mining pools across the globe, including F2Pool, Poolin, and BTC.com.

When a mining pool is rewarded, the individual miners get a very tiny piece of this reward. One bitcoin can be divided by eight decimal places, meaning a transaction of 0.00000001 BTC can be facilitated by the Bitcoin network, thus accommodating thousands of Bitcoin miners who collaborate through mining pools.

But miners might still wait a long time to successfully reap their reward. Though this is highly speculative, one analysis found that top-notch ASICs hardware would require about 1,200 days to receive one bitcoin from mining efforts as part of a pool.

Taxes

The IRS treats cryptocurrencies (including Bitcoin) received from mining as income. A miner needs documentation proving when a bitcoin was mined. The bitcoin will be valued based on its price the day it was mined. If a bitcoin is later sold at a higher price, the miner will need to pay capital gains tax on the difference.

If a mining operation is not part of an established business, additional tax obligations could apply. Such miners are likely to owe a self-employment tax of 15.3% on their annual income. 

How to Start Mining Bitcoin

Though it is extremely difficult and rarely profitable, Bitcoin mining is still feasible. While the best results will derive from joining a mining pool, the following steps can be taken to venture into Bitcoin mining:

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Bitcoin Mining

What Is Bitcoin Mining?

Chances are you hear the phrase “bitcoin mining” and your mind begins to wander to the Western fantasy of pickaxes, dirt and striking it rich. As it turns out, that analogy isn’t too far off.

Bitcoin mining is performed by high-powered computers that solve complex computational math problems; these problems are so complex that they cannot be solved by hand and are complicated enough to tax even incredibly powerful computers.

Key Takeaways

• Bitcoin mining is the process of creating new bitcoin by solving a computational puzzle.
• Bitcoin mining is necessary to maintain the ledger of transactions upon which bitcoin is based.
• Miners have become very sophisticated over the last several years using complex machinery to speed up mining operations.

The result of bitcoin mining is twofold. First, when computers solve these complex math problems on the bitcoin network, they produce new bitcoin (not unlike when a mining operation extracts gold from the ground). And second, by solving computational math problems, bitcoin miners make the bitcoin payment network trustworthy and secure by verifying its transaction information.

When someone sends bitcoin anywhere, it’s called a transaction. Transactions made in-store or online are documented by banks, point-of-sale systems, and physical receipts. Bitcoin miners achieve the same thing by clumping transactions together in “blocks” and adding them to a public record called the “blockchain.” Nodes then maintain records of those blocks so that they can be verified into the future.

When bitcoin miners add a new block of transactions to the blockchain, part of their job is to make sure that those transactions are accurate. In particular, bitcoin miners make sure that bitcoin is not being duplicated, a unique quirk of digital currencies called “double-spending.” With printed currencies, counterfeiting is always an issue. But generally, once you spend $20 at the store, that bill is in the clerk’s hands. With digital currency, however, it’s a different story.

Digital information can be reproduced relatively easily, so with Bitcoin and other digital currencies, there is a risk that a spender can make a copy of their bitcoin and send it to another party while still holding onto the original. 

Special Considerations

Rewarding Bitcoin Miners

With as many as 300,000 purchases and sales occurring in a single day, verifying each of those transactions can be a lot of work for miners.   As compensation for their efforts, miners are awarded bitcoin whenever they add a new block of transactions to the blockchain.

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 4 years). In 2009, it was 50. In 2013, it was 25, in 2018 it was 12.5, and in May of 2020, it was halved to 6.25.

Bitcoin successfully halved its mining reward—from 12.5 to 6.25—for the third time on May 11th, 2020.

This system will continue until around 2140.   At that point, miners will be rewarded with fees for processing transactions that network users will pay. These fees ensure that miners still have the incentive to mine and keep the network going. The idea is that competition for these fees will cause them to remain low after halvings are finished.

These halvings reduce the rate at which new coins are created and, thus, lower the available supply. This can cause some implications for investors, as other assets with low supply—like gold—can have high demand and push prices higher. At this rate of halving, the total number of bitcoin in circulation will reach a limit of 21 million, making the currency entirely finite and potentially more valuable over time. 

El Salvador made Bitcoin legal tender on June 9, 2021. It is the first country to do so. The cryptocurrency can be used for any transaction where the business can accept it. The U.S. dollar continues to be El Salvador’s primary currency.

Verifying Bitcoin Transactions

In order for bitcoin miners to actually earn bitcoin from verifying transactions, two things have to occur. First, they must verify one megabyte (MB) worth of transactions, which can theoretically be as small as one transaction but are more often several thousand, depending on how much data each transaction stores.

Second, in order to add a block of transactions to the blockchain, miners must solve a complex computational math problem, also called a «proof of work.» What they’re actually doing is trying to come up with a 64-digit hexadecimal number, called a «hash,» that is less than or equal to the target hash. Basically, a miner’s computer spits out hashes at different rates—megahashes per second (MH/s), gigahashes per second (GH/s), or terahashes per second (TH/s)—depending on the unit, guessing all possible 64-digit numbers until they arrive at a solution. In other words, it’s a gamble.

The difficulty level of the most recent block as of August 2020 is more than 16 trillion. That is, the chance of a computer producing a hash below the target is 1 in 16 trillion. To put that in perspective, you are about 44,500 times more likely to win the Powerball jackpot with a single lottery ticket than you are to pick the correct hash on a single try. Fortunately, mining computer systems spit out many hash possibilities. Nonetheless, mining for bitcoin requires massive amounts of energy and sophisticated computing operations.

The difficulty level is adjusted every 2016 blocks, or roughly every 2 weeks, with the goal of keeping rates of mining constant.   That is, the more miners there are competing for a solution, the more difficult the problem will become. The opposite is also true. If computational power is taken off of the network, the difficulty adjusts downward to make mining easier.

Bitcoin Mining Analogy

Say I tell three friends that I’m thinking of a number between 1 and 100, and I write that number on a piece of paper and seal it in an envelope. My friends don’t have to guess the exact number, they just have to be the first person to guess any number that is less than or equal to the number I am thinking of. And there is no limit to how many guesses they get.

Let’s say I’m thinking of the number 19. If Friend A guesses 21, they lose because 21>19. If Friend B guesses 16 and Friend C guesses 12, then they’ve both theoretically arrived at viable answers, because 16

Bitcoin vs. Traditional Currencies

Consumers tend to trust printed currencies. That’s because the U.S. dollar is backed by a central bank of the U.S., called the Federal Reserve. In addition to a host of other responsibilities, the Federal Reserve regulates the production of new money, and the federal government prosecutes the use of counterfeit currency.   

Even digital payments using the U.S. dollar are backed by a central authority. When you make an online purchase using your debit or credit card, for example, that transaction is processed by a payment processing company (such as Mastercard or Visa). In addition to recording your transaction history, those companies verify that transactions are not fraudulent, which is one reason your debit or credit card may be suspended while traveling.

Bitcoin, on the other hand, is not regulated by a central authority. Instead, bitcoin is backed by millions of computers across the world called “nodes.” This network of computers performs the same function as the Federal Reserve, Visa, and Mastercard, but with a few key differences. Nodes store information about prior transactions and help to verify their authenticity. Unlike those central authorities, however, bitcoin nodes are spread out across the world and record transaction data in a public list that can be accessed by anyone.

History of Bitcoin Mining

Between 1 in 16 trillion odds, scaling difficulty levels, and the massive network of users verifying transactions, one block of transactions is verified roughly every 10 minutes.   But it’s important to remember that 10 minutes is a goal, not a rule.

The bitcoin network is currently processing just under four transactions per second as of August 2020, with transactions being logged in the blockchain every 10 minutes.   For comparison, Visa can process somewhere around 65,000 transactions per second.   As the network of bitcoin users continues to grow, however, the number of transactions made in 10 minutes will eventually exceed the number of transactions that can be processed in 10 minutes. At that point, waiting times for transactions will begin and continue to get longer, unless a change is made to the bitcoin protocol.

This issue at the heart of the bitcoin protocol is known as “scaling.” While bitcoin miners generally agree that something must be done to address scaling, there is less consensus about how to do it. There have been two major solutions proposed to address the scaling problem. Developers have suggested either (1) creating a secondary «off-chain» layer to Bitcoin that would allow for faster transactions that can be verified by the blockchain later, or (2) increasing the number of transactions that each block can store. With less data to verify per block, the Solution 1 would make transactions faster and cheaper for miners. Solution 2 would deal with scaling by allowing for more information to be processed every 10 minutes by increasing block size.

In July 2017, bitcoin miners and mining companies representing roughly 80% to 90% of the network’s computing power voted to incorporate a program that would decrease the amount of data needed to verify each block.

The program that miners voted to add to the bitcoin protocol is called a segregated witness, or SegWit. This term is an amalgamation of Segregated, meaning “to separate,” and Witness, which refers to “signatures on a bitcoin transaction.” Segregated Witness, then, means to separate transaction signatures from a block — and attach them as an extended block. While adding a single program to the bitcoin protocol may not seem like much in the way of a solution, signature data has been estimated to account for up to 65% of the data processed in each block of transactions.

Less than a month later in August 2017, a group of miners and developers initiated a hard fork, leaving the bitcoin network to create a new currency using the same codebase as bitcoin. Although this group agreed with the need for a solution to scaling, they worried that adopting segregated witness technology would not fully address the scaling problem.

Instead, they went with Solution 2. The resulting currency, called “bitcoin cash,” increased the blocksize to 8 MB in order to accelerate the verification process to allow a performance of around 2 million transactions per day. On August 16, 2020, Bitcoin Cash was valued at about $302 to Bitcoin’s roughly $11,800.   

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