Cryptocurrency Mining Demystified

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In my previous 2-part post “Bits and Blocks,”within the Blockchain chapter of my blog, I introduced the idea of Blockchain technology and gave a brief overview of its utilization in cryptocurrencies. One aspect, however that I did touch upon briefly was the concept of crypto mining and I want to use this opportunity to go a bit deeper into what this really is and also provide some points for consideration for anyone looking to invest in the cryptocurrency space via mining. In order to fully understand the terminology used in this article, you need to have a basic grasp of Blockchain concepts such as nodes, cryptography, etc. If you haven’t already, I recommend you check out my article on an Blockchain HERE! (Link embedded).

Mining, by name suggests the exploration of some kind in order to extract a physical product (like with gold or coal), however, if cryptocurrency exists digitally, how really does mining work?

Image taken from Bits and Blocks 1/2: Let’s Talk Blockchain

As depicted in the image above, cryptocurrency mining is the key aspect of the Proof of Work consensus algorithm. Now I’m sure that line confused you so let’s start from the very beginning as to the concept of Proof of Work and cryptocurrency mining. In 1982, a problem known as the Byzantine Generals Problem, was introduced in a computer science paper which spoke about the ways in which reliable computer systems should aim to function consistently and effectively even in the presence of faulty parts. The video below describes this analogy:

In short, this problem described four Generals surrounding an enemy with the intention of conducting a coordinated attack; if they all attack at the same time, they would be victorious however, if they don’t attack together, they would be defeated. This scenario introduces the notion of finding a way to reach a consensus with all Generals of the army, given that some may not be trustworthy. The Bitcoin Blockchain has claimed to solve this problem through the introduction of the Proof of Work consensus mechanism.

Proof of Work is a method by which nodes/miners compete to solve very complex mathematical puzzles in order to verify and broadcast transactions to the Blockchain for a reward. This verification involves, ensuring accounts have the funds required for the transactions, no double spending of money, etc. The unique concept about the Proof of Work mechanism is the way it secures consensus decision-making, even in the presence of non-compliant or untrustworthy nodes. This is because all miners/nodes operate independently of each other and all compete to verify the same transactions. It is effectively a ‘race’ to see which node/miner can solve the complex puzzle the fastest and verify all transactions in each new block. The actual solving of the puzzle/algorithm occurs through random guessing. This is why the node/miner that solves the algorithm the fastest, shows that they have done more “work” (i.e. more or better guesses) than the other miners and therefore gets the reward hence the name “Proof of Work.” As expected, in order to quickly guess solutions randomly, high processing powers would be required.

In the event of a untrustworthy node/miner attempting to corrupt the Blockchain with false transactions, Proof of Work takes a consensus from the majority of other miners who are verifying the correct transactions while trying to compete for the reward, and ignores the transactions that are trying to be tampered with by the non-compliant node/miner.

Great now that you have a fair idea of what the actual process of mining is and how miners take advantage of higher computing and processing power to solve algorithms in order to earn rewards (cryptocurrency), let actually see how you can actually invest in Cryptocurrency mining in order to earn some Crypto! It is important to note however, that ONLY the cryptocurrencies that follow the Proof of Work mechanism can be mined (e.g. Bitcoin, Ethereum, Litecoin, Z-Cash, Dash, etc.).

There are two main ways to invest in Cryptocurrency Mining: via Mining Hardware and via Cloud Mining.

Hardware Mining

Hardware mining is the most straightforward means of getting into cryptocurrency mining. In this process, an individual can purchase some type of mining hardware, typically a unit with high processing power which can act as a mining node, in the selected Blockchain network.

Initially in the Bitcoin blockchain, miners were able to use personal computers as mining nodes, however, over time, the level of processing power required to solve the puzzles/algorithms in order to earn the rewards, increased. This is because as more users transact (buy or sell crypto) on the Blockchain, the more difficult the algorithm/puzzle becomes to solve. Take a look at the increase in the mining difficulty of the Bitcoin network since inception:

Source: Blockchain.com

Now, if it were just as simple as buying a piece of equipment and plugging it in, why doesn’t everyone do it? Well as the difficulty of the algorithm/puzzle increases, so to does the processing power, which means more and more energy would be required to operate the mining hardware. Herein lies the main hurdle in cryptocurrency mining, cost of electricity!

Maintaining and operating mining hardware does NOT come cheap due to the HIGH electricity requirement! The Cambridge Center for Alternative Finance has an estimation for the total annual power consumption from Bitcoin miners across the world – 82.71 TWh of electricity, equivalent to the TOTAL ANNUAL energy consumption of Finland!!

Of course with this requirement comes a high associated cost and carbon footprint which deters many persons from getting involved in the first place, but, if you’re still inclined to give it a try, let’s have a look at exactly what costs you need to consider.

  1. Cost of electricity in your city/country – I have included a figure below showing the approximate costs of mining in various countries using Bitcoin as an example. Intuitively, the cheaper the cost of electricity, the more profitable mining becomes.
  1. Cost of equipment – Whereas in the early days, crypto mining could have been done on a personal laptop, the high processing requirements now require the actual hardware needed to get started, to specific mining rigs. These mining rigs, range in price from US$300 – US$1,000+ depending on the processing power you desire. For more information on some of hardware required for Bitcoin mining, you can check out these examples: AntMiner S9i or the Gekkoscience Terminus Pod Miner
  1. Cooling costs – Cryptocurrency mining generates a very high amount of heat and typically in order to avoid overheating, some form of cooling mechanism is required. This can be through ventilation fans or air conditioning.

Have a look at this figure which gives an idea of the costs required to mine 1 Bitcoin per country.

Source: Elite Fixtures via marketwatch.com (Data as of 2018)

Once you’ve considered the costs, you then need to think about: which mining pool you will join when mining and, how would you store your earnings. Firstly, let’s discuss what exactly is a mining pool?

As the processing power required to mine cryptocurrencies increased over time, groups of miners decided to combine their processing powers through ‘mining pools’. Each miner pool ran a common puzzle solving algorithm and are linked remotely to ensure the distribution of miners in the pool, act as one big miner. Therefore, in order to have a chance of competing for the task of verifying and broadcasting each block with the opportunity to get the block rewards, it is highly suggested to join once of these pools. Of course it is not compulsory to do this and some miners do choose to mine independently for cryptocurrencies with a less difficult algorithm/puzzle than Bitcoin.

In terms of storage – Typically, a cryptocurrency wallet is used to store earnings (e.g. Ledger Wallet). The earned cryptocurrency can later be sold on the market via crypto exchanges to obtain fiat currencies.

Source: BTC.com

Above shows the approximate distribution of mining pools currently mining Bitcoin. You can also look at the University of Cambridge’s Bitcoin Mining Map which gives a good indicator of the current global distribution of miners for the Bitcoin network.

In conclusion, it is key to note that though Bitcoin is the most popular cryptocurrency, and most attractive to mine, other cryptocurrencies which follow the Proof of Work mechanism can offer a better return. I would suggest for you to take a look at this mining calculator from Cryptocompare to see what option is best for you! Now that we’ve covered the basics of mining via hardware we move onto the second method of investing in cryptocurrency mining: Cloud Mining.

CLOUD MINING

Cloud Mining is perhaps the simplest but most risky way to get into mining. This was actually the initial means by which I myself got into the crypto space in 2017! Cloud mining is targeted at individuals who aren’t able/willing to put forward the high costs specified above but still want to get involved in mining. In cloud mining, large mining pools as discussed above, allow individuals to pay for a fraction of processing power to mine cryptocurrency. In this process, big players in the mining pools, who own large amounts of mining hardware, basically split the costs of mining with these individuals, and then share a portion of the rewards/coins earned from mining.

HashFlare and Genesis Mining are two popular platforms which offer Cloud Mining for those interested however, as mentioned above, this process is extremely risky and when there is high volatility in the price of Bitcoin, any dips below the mining breakeven cost could translate to no reward payouts. Before getting started, I would recommend performing due diligence into the platform selected and I would advise trying to secure extended duration (lifetime) length contracts in order to mitigate the risks of short-term price volatility.

Now that we’ve focused on how to get into mining, I thought it fit to touch a bit upon the most hyped topic in the cryptocurrency space at the moment and that is: The Bitcoin Halving.

The Bitcoin protocol specified a cap on the supply of Bitcoins (21 million) that would ever be in circulation. Does this mean there are 21 million Bitcoins out there right now? Nope, in fact the total number of Bitcoins would never reach exactly 21 million, but instead would tend towards it (but for practicality purposes you can assume there will be 21 million Bitcoins). This is due to the ‘halving’ concept which follows the scientific principle of a half-life. New Bitcoins are introduced into circulation as mining rewards (as discussed above). So let’s understand how this works:

The Bitcoin Halving is an event that happens every 210,000 blocks mined or approximately every 4 years. At this point, the number of Bitcoins that are rewarded to miners for mining one block is halved. The first Bitcoin halving event happened in 2012, where the reward was cut from 50 BTC to 25 BTC per block mined. In 2016, the second halving further reduced the mining rewards from 25 BTC to 12.5 BTC per block. As we near the third mining event on May 11th 2020, the mining reward per block would now be reduced to 6.25 BTC per block. Why does this all happen you may ask?

2020-05-11T14:00:00

  days

  hours  minutes  seconds

until

The 3rd Bitcoin Halving

Bitcoin was created as a deflationary currency which is the stark opposite to traditional fiat currencies which are inflationary. This is evidence by Bitcoin undergoing a halving in supply instead of increasing supply via printing new money in the case of fiat currencies. This is similar to gold which appreciates in value as the commodity becomes more scarce. When inflation occurs, the purchasing power of money decreases; whereas with deflation, the purchasing power increases. Have a look at this chart showing the effect of inflation by increasing the money supply of the US dollar.

The last two occurrences of the Bitcoin halving saw a price per Bitcoin increase of 9,200% (in 2012) and 2,900% (in 2016). This can be explained by the simple economic principle of supply and demand, as the reduction of supply of something without a change in demand causes an increase in price. The increase in price also ensures that miners are compensated for the increasing mining difficulty and by extension increased costs (as discussed above).

Henceforth, it is not surprising that there has been such an increase in the price of BTC leading up to this event. There are many debates as to the short- and medium-term effects of this event on the price of Bitcoin. Many believe that this supply shock would cause the price to explode further, whilst others expect that this event has been priced into Bitcoin’s current and future value. There is also the argument that this event may force some miners to exit the market as their profit margins decrease. As a whole however, most of the Finance industry are looking to this time for Bitcoin to prove itself as a true hedge against inflation with the currency economic conditions, which may bring some inkling of trust into the space or may force may people out of it; but I suppose only time will tell.

I hope you enjoyed this article and found the information to be easy to understand. Remember to like, share and leave a comment below letting me know whether you’ve invested or thinking of investing in Cryptocurrency mining! Make sure to follow me on Instagram and Twitter to get daily updates and tips and recommendations on how to make smart and good investments!

DISCLAIMER: Please note this article does NOT represent Financial Advice and is intended only for educational purposes! The Investing Virtuoso is NOT responsible for any losses on investments made after reading this article. Invest at your own risk!

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