What Is Bitcoin Mining & How Does it Work?

Key Takeaways

• Bitcoin mining is a method of validating new transactions and adding blocks to the Bitcoin network blockchain.
• Bitcoin mining is crucial to maintain the decentralization and history of the blockchain network.
• The Next Bitcoin halving event is expected to occur in April 2024, which will limit the block generation rate and reduce the miner reward to 3.125 BTC.

What is Bitcoin Mining?

Bitcoin mining is the process of creating new blocks and verifying transactions on the Bitcoin blockchain. If you’re not new to crypto, you might already know Bitcoin is based on the blockchain network; it utilizes publicly distributed ledgers to keep a record of all transactions. The copies of these ledgers are also available on the systems of other network participants, ensuring the security and transparency of the Bitcoin network. 

When users proceed with transactions, it is verified and validated through the Bitcoin mining process before being recorded on the blockchain ledgers. This method of generating new blocks is referred to as “mining” as it involves high power utilization, just like energy required in natural resources mining. Bitcoin mining requires people to employ high computational resources, known as “miners”. These miner nodes compete with each other to guess the answers to complex cryptographic hash problems. The first miner node who guesses the answer correctly gets to select a group of transactions for verification, generate a new block and receive an incentive of the newly created Bitcoin.

There are several ways to mine Bitcoin depending upon the number of participants and hardware resources employed. A few types of Bitcoin mining methods are as follows:

• CPU Mining: In earlier days, when Bitcoin was introduced, it was mined using a normal computer CPU(central processing unit). So, anyone could mine Bitcoin with their laptops and PCs. This increased the number of miners and the complexity of hash problems, resulting in Bitcoin CPU mining becoming a less viable option.

• GPU Mining: Later, miners started employing GPU(graphical processing unit) along with CPUs to increase their chances of guessing the right answers to complex computational problems. Some miners even used to combine multiple GPUs for better hash rate output.

• ASIC Mining: Introduced in 2012, ASIC technology is specifically designed for mining crypto assets. ASIC, Application Specific Integrated Circuit, provides improved efficiency and performance than other mining hardware. However, ASIC-based mining hardware is costlier and could quickly become older with advancing technology, resulting in unprofitable mining.

• FPGA Mining: Unlike ASIC hardware, which is designed specifically for a single purpose, Field Programmable Gate Array (FPGA) serve better as they can be programmed and reprogrammed according to different algorithms and mining complexities of crypto assets. Furthermore, these hardware are cost-efficient and provide more speed than CPUs and ASIC mining.

• Cloud Mining: This mining method allows anyone to become a miner and earn mining rewards without purchasing costly hardware, softwares, or worrying about maintenance. In cloud mining, one pays cloud mining service providers a rent for utilizing their computational resources virtually. This also offers miners a convenient exit option in case mining difficulty rises or becomes unprofitable.

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How does Bitcoin Mining work?

The Bitcoin mining process begins with broadcasting new transactions to all network nodes. When new transactions are processed, they are added to a mempool or memory pool. Next, a miner node collects pending transactions from the mempool, checks their validity, and passes them through a hash function to group them into a block. The Bitcoin network hashing algorithm is SHA-256 or Secure Hashing Algorithm 256. It is a one-way cryptographic function that encrypts the transaction data into a 256-bit string, which can not be used to retrieve original data by decryption. 

These hashed transactions are then organized into a Merkel tree and passed through a hash function until a single hash is generated. In simple words, the Merkel tree is a data structure used for the verification and organization of blockchain transactions, we are not going to discuss this further as this article then might become a technical paper. 

In the next step, miners combine the hash of the previously generated block, the hash of the candidate block, along with a nonce(an arbitrary number) to form a unique hash identifier of the block. This process links the new block to the previous one, creating a chronological chain of blocks, what we know as blockchain. The first miner node to complete Proof of Work, and create a valid block identifier, broadcasts the block on the network for other nodes to validate. 

Proof of work is the consensus algorithm of the Bitcoin network in which miner nodes use their computational resources to solve a difficult cryptographic hash puzzle, as we discussed earlier. This PoW consensus ensures the integrity of the Bitcoin network by eliminating double-spending. 

Once the network nodes validate the block and confirm if the block hash adheres to the Bitcoin protocol. It is updated on blockchain public ledgers, and block miner nodes are rewarded. But what if there are two miners to solve the hash problem simultaneously? In case two blocks are mined at the same time, the block which forms the longest chain and continues the next block mined on top of it is considered the most valid block. The block that is left is referred to as the “orphan block.”

How does Bitcoin Mining affect the price of Bitcoin?

Bitcoin miners usually cover mining costs such as hardware expenses, electricity, cooling, and operational costs by selling or holding their BTC incentive. When there is a surge in Bitcoin price, miners tend to hold it further to maximize their profits, and if the price of Bitcoin falls below the profitability break-even point, they might be forced to sell their mined BTCs. These situations can potentially increase the chances of net sell pressure in the market, ultimately leading to a fall in Bitcoin price.

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Block Rewards & Bitcoin Halving

As already discussed, Bitcoin miners receive incentives to validate transactions and solve difficult computational puzzles using their processing energy. This reward includes free Bitcoins and a share of the transaction fee associated with the candidate block. As of 2023, Bitcoin miners receive 6.25 BTC as a block reward for every block added to the blockchain. However, this Bitcoin block reward is estimated to decrease to 3.125 BTC in April 2024 due to the Bitcoin halving event.  

Bitcoin supply was capped at 21 million during its creation of scarcity and value of BTC coins. Bitcoin halving is the process of reducing the rate at which new Bitcoins are mined and miner block reward to half. This process is programmed in the Bitcoin mining algorithm to reduce coin inflation and maintain the value of BTC as currency over time. However, Bitcoin halving can reduce network security since there will be less miner participation due to reduced block reward. For this reason, Bitcoin miners will continue to receive transaction fee rewards for maintaining the network even after the last BTC is mined(approximately in 2041).

Additional Read: Bitcoin Halving in 2024

Limitations of Bitcoin Mining

Below are a few drawbacks of the Bitcoin mining process:

• One of the major limitations of Bitcoin mining is high energy consumption in the creation of new blocks. According to Digiconomist tracker, Bitcoin mining consumes around 104 terawatt-hours per year, which creates concern about the environmental impact of crypto mining.
• Bitcoin mining requires specific hardware, which is costly and consumes more electric power. As the mining difficulty rises, older mining hardware tends to become less efficient and unprofitable.
• Furthermore, Bitcoin mining has witnessed a geographical concentration of mining operations in specific countries and regions. This can lead to the centralization of mining activity and risk the security of the Bitcoin network.
• Bitcoin miners rely on Bitcoin price to cover their mining expenses and profitability. If there is a significant decrease in BTC price, mining operations might become unprofitable, reducing mining activity and network security.

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