What is Crypto Mining; An Explanation for the Beginner

The concept of mining is at the center of the existence of cryptocurrencies. In other words, without mining, cryptocurrencies cannot exist. To understand what mining is and the critical role it plays, one needs first to understand how a cryptocurrency functions.

We need to pick one to use for the illustration. None is better for this purpose than Bitcoin. It is the first-ever cryptocurrency, it has the most significant market capitalization, and it is the most used around the globe.

Bitcoin is a digital currency. Meaning, it only exists in computers and other electronic devices. And it can only be sent and received over the Internet.

Now, cryptocurrencies are not the only digital currencies in existence. In fact, we’ve had some form of digital currencies since the 70s when banks and financial institutions began to embrace computers to manage their records.

Today in Sweden, and most of the other Scandinavian countries, not more than 20% of all transactions are settled using physical cash (coins and bills). Meanwhile, China is turning out to be the biggest cashless economy as it embraces mobile payment methods on a massive scale.

The transaction ledger

Cryptocurrencies like Bitcoin are just a special kind of digital currencies. A few things set them aside from the other digital currencies. The most important of those is how the transaction ledger is stored, updated, and secured. 

The transaction ledger is the record of who owns what value at what time. If you send someone in another city, state, or even country some money through a bank wire transfer, PayPal, or any other digital payment method, a ledger (or several ledgers) has to be updated to reflect the changes that your transaction occasions.

The balance in your bank account has to be reduced by the amount you sent. Meanwhile, the amount in the recipient's account has to be increased by the same margin. If the transaction is within the same bank, then we can assume the updates are made on the same ledger only. However, if the money has to go through several banks (or entities), then, of course, several ledgers have to be updated.

With commercial banks, as well as centralized online payment and remittance services, the ledger is hosted, maintained, and secured by the company. In other words, the bank or the online payment service has to buy or lease a server on which the ledger resides. They also have to hire tellers (human and machine) to update the ledger every time a user sends or receives money.

Also, given the amount of money involved, financial institutions spend a lot to protect their ledgers. According to one research, banks and other financial institutions spend as much as US$3000 annually on every member of staff they have to prevent them from being a loophole through which criminals can access the transaction ledgers. This translates to about US$750 million for JPMorgan Chase and US$600 million for Bank of America.

This cost is justified by the fact that there are many criminals out there who would do anything to get access to a bank's ledger so that they can edit it and, in the process, award themselves money they do not deserve (otherwise known as hacking).

Indeed, a few times, they are successful, and banks and other financial institutions lose over US$200 billion annually.

Who hosts, updates, and secures the transaction ledger?

Cryptocurrencies like Bitcoin have ledgers too. Otherwise, how can we tell who owns what value at what time? These cryptocurrency ledgers are known as blockchains. And they are called so because transactions are recorded in batches known as blocks.

Unlike fiat-based digital payment methods, cryptocurrencies do not have central entities such as a bank or company to (1) host the ledger (2) update it to reflect new transactions, and (3) protect it from possible hacking.

Nevertheless, the cryptocurrency ledger is hosted, updated, and adequately secured. Indeed, this is where the genius of blockchain technology is to be found.

The cryptocurrency ledger is hosted, maintained, and protected through consensus by a community of core supporters, who form a peer-to-peer network. Each of these core supporters keeps a copy of the ledger on their computer. And in the case of Bitcoin, all the core supporters synchronize their ledgers after every ten minutes to reflect new transactions.

The processes of adding new transactions to the shared ledger and synchronizing the copies all the core supporters keep is what is known as mining. Both the core supporters and their specialized computers, which participate in the process, are known as crypto miners.

So how exactly does the mining happen?

There are many ways through which the miners on the peer-to-peer network can arrive at a consensus on the status of the shared ledger. In the case of Bitcoin, the consensus is achieved through the miners competing to do a calculation to find a value that is provided by the algorithm that guides the process.

The kind of consensus mechanism that is used by Bitcoin is known as Proof of Work (PoW). In essence, it involves the participating computers doing some work while competing to find the value the algorithm defines. 

To participate in the competition, each miner takes all the transactions that users submit in a span of about ten minutes and creates a block (a batch). In the block, the miner also includes a special transaction in which they assign a designated amount of new coins to themselves (more on this in a moment).

They then hash (compute) the data from the transactions in the block to find the designated value. The first miner to get the value has their block of transactions identified as the next block on the ledger (the blockchain). Everyone else would synchronize their copy of the ledger to include it. And the process repeats itself, with a different miner winning every time.

The mining reward

The winner gets to keep the new coins that they assigned themselves in the block. This amount of new coins is known as the mining reward, and it is 6.25 bitcoins—the reward however halves after every four years. In fact, the most recent halving of the Bitcoin reward happened this week.

Between 2016 and this week, a winning miner has been earning 12.5 bitcoins every ten minutes. The next halving will happen in 2024. This halving procedure will continue until there is no more reward to go out as the total amount of 21 million bitcoins would have been mined (and that will be sometime in the year 2140). By then, the primary miners' revenue will be coming from the fees that users pay (the transaction fees).

Since the launch of Bitcoin in 2009, users have paid transaction fees, but it has been on a voluntary basis. However, those who attached a fee often had their transaction included in the next block ahead of those who do not attach any fees. Nevertheless, in the end, every transaction submitted to the network is confirmed.

Over time, however, these fees could become compulsory, as that is what will motivate miners to keep their machines running so that the ledger is hosted, maintained, and secured. It is important to point out that in the case of Bitcoin, the mining reward serves another function in addition to incentivizing miners. Through it, new coins are released to circulation.

The energy cost of mining

The hashing process (as the computation of the transaction data is known) consumes a lot of energy, and indeed paying for electricity is a major cost item. Indeed that is why the miners need to be incentivized through the reward of the newly minted coins and the transaction fees that users pay.

This revenue not only caters to the cost of electricity, but it also goes into recouping what is used to buy and set up the hardware. Ideally, of course, it should turn a profit for the miner.

It is important to emphasize that Bitcoin mining is energy-intensive, and indeed the amount of electricity that the Bitcoin network consumes has been estimated to be equal to what a small country like Switzerland consumes. And the computer power that is generated for Bitcoin mining makes its network, a unit, the most powerful computer.

Indeed, there have been concerns that Bitcoin mining, in particular, is contributing a lot to the greenhouse emission, and thus adding to the problem of climate change.

The transition over time

However, Bitcoin was not always energy-intensive. The competition amongst miners has forced them over time to upgrade to more energy-consuming hardware. In the early days, a typical CPU desktop was sufficient for one to participate in Bitcoin mining and get a substantial reward.

Some discovered that using graphic processing units (GPU) gave them an advantage over those using the ordinary desktop. Today you do not stand any chance of getting a mining reward if you are not using ASIC miners, which have really high computing capacity.

And to stand a better chance, you need to accumulate many of them, which can cost a lot of money. A single Bitcoin ASIC miner costs over $3000. And even with several of them, you might need to join a mining pool to generate meaningful revenue.

The mining options

A mining pool is a group of mining computers that act as a single unit on the Bitcoin network. Given the amount of resources that a mining pool can put together, it has a very high chance of winning in the mining competition.

The reward that a mining pool generates is shared among members according to the computer power that each contributed. Before you commit yourself to any mining pool, you need to do a lot of due diligence and ascertain their credibility as well as how exactly they share their revenue.

Another option you have if you are really interested in joining mining is to buy mining capacity from companies that have set up mining operations. This is often described as virtual mining. You should, however, be aware, though, that this is a risky option.

That is especially because you can easily be conned. Some entities online often claim that they have a mining operation with the intent of scamming. They invite investors to put in the capital for a share in the revenue, and they do not deliver on their promise. Unfortunately, it is generally challenging to prove whether a virtual mining platform is legit or it is one of those just interested in you paying, and then they disappear with your money.

A much safer option is to mine cryptocurrencies that do not need you to have a lot of computation power. And that could be because their protocols bar the use of high capacity computers (in particular ASIC miners) or they are in their early days, and major players with significant capital have not started to mine them.

You could also mine cryptocurrencies that use mining protocols that do not use proof of work. The most used alternative to proof of work that does not consume energy nor require one to invest in specialized equipment is proof of stake (PoS).

With this consensus mechanism, the miners do not compete through hashing of data to find a value, but they put part of their already earned coins in a special wallet. The algorithm then randomly picks nodes to maintain the ledger from amongst them.

Indeed, even some cryptocurrencies that were initially designed to use PoW are now actively considering moving to PoS. One such cryptocurrency is Ethereum. Through an upgrade known as Casper, the cryptocurrency with the second-largest market capitalization expects to make the switch later this year.

There are also new and drastic developments in the area of cryptocurrency mining. As we've seen, for the most part, it has been that some members of the community provide the needed resources for hosting, maintaining, and securing the ledger. And for their trouble, they get to keep the newly released coins (as well as the fees users pay).

But now there are protocols like the Tangle, which the IOTA blockchain uses. With this consensus protocol, every user is basically a miner. Everyone who sends a transaction on the network is expected first to confirm transactions by others before theirs is confirmed. This removes the element of the mining as a business enterprise some can engage in. We do not really know how this new mining protocols are going to change the industry going forward

To conclude, mining remains a critical element of the majority of cryptocurrencies. And that because in addition to helping host, maintain, and secure the transaction ledger, it is also the means through which new coins are released to circulation.