Bitcoin Mining

By Sheri Kaiserman, Head of Advanced Securities at Wedbush Securities

Bitcoin is the first decentralized cryptocurrency based on blockchain technology.  Using a cryptocurrency, like Bitcoin, eliminates the need for a middleman, making peer-to-peer exchanges of value possible between any two parties quicker, cheaper, transparent and more secure.  Blockchain technology allows anyone, or anything, to enter into a peer-to-peer exchange where a distributed computerized system validates, processes and permanently records the transaction in a trusted manner.

There are three key principles of blockchain technology.  The first is security, which is achieved through cryptography and the possession of private and public cryptographic keys.  The second is decentralization.  Rather than one central authority having control, a distributed network of computers (nodes) maintains a record of every transaction on their own copy of an identical digital ledger and updates this ledger through a process of achieving consensus with a majority of nodes on the network.  A consensus protocol is used to establish the validity of each transaction, the processing of it and the safeguarding and updating of past and new data.  The third deals with the incentives that encourage participation and honest behavior.  For providing network security by participating in the decentralized consensus process of validating, processing and recording transactions, nodes are rewarded with new cryptocurrency as well as fees associated with every transaction they process.  Mining Bitcoin and adding blocks to the Blockchain go hand in hand.

How mining works

To become a Bitcoin miner, one needs to download the Bitcoin Software onto their computer which then becomes a connected node on the network.  More than 11,000 nodes in 104 countries are running the Bitcoin Software, contributing their computing power to support the network.  Each of these nodes keeps their own individual copy of the bitcoin digital ledger, which shows every Bitcoin transaction in history beginning with the genesis bitcoin block.

When Person A wants to send Person B some Bitcoin, all nodes on the network review their individual Bitcoin ledgers for the history to see if this announced transaction is valid.  Does Person A have Bitcoin to send to Person B?  Since each node has a complete historical unalterable record, this can easily be determined.  When a consensus is reached and a majority, or 51% of the nodes, validates the transaction, it becomes ready to be processed and added to a group of other validated transactions to form the next block on the blockchain.

Anyone who owns Bitcoin holds both a private and a public cryptographic key through which they can prove ownership.  This is a security feature of Blockchain, along with having the network be decentralized and managed by many distributed computers versus being under the control of one central authority.  Person A would use their private key, which no one else can see, to send Bitcoin to Person B’s public key.

Think of how much more secure this is than handing someone your credit card or a check that displays your account number.  By using Bitcoin there is no need to trust a retailer, or the people who work for them, with personal and financial data as we do when we give them our credit card, or a check with our driver’s license.

The bigger problem, as we have all come to discover, is that even if the retailer and their employees are trustworthy, their systems may not be and are subject to cyber-hacks.  Massive amounts of people’s private, personal and financial information have been exposed from what seems to be an endless barrage of cyber-attacks against companies with whom we transact.  With a blockchain based transaction using Bitcoin, that can’t happen!

Mining new Bitcoin and adding a block to the Blockchain go hand in hand. Roughly every ten minutes, all of the validated transactions get grouped together to form the next trusted block that gets added on top of the chain of all the other blocks containing groups of previously processed transactions.  This is why it is called a “blockchain”.

To add the group of transactions in the new block to the Bitcoin Blockchain, a consensus protocol is used called Proof of Work (PoW).  At the time a block is ready to be added, all of the nodes compete to solve a complex mathematical problem.  This is akin to them racing to figure out the solution to a combination lock.  It’s difficult to decipher the solution, but once solved, it is then easy to verify that the answer is correct.

This process is also accomplishing the hashing of the data of each transaction.  This means it timestamps the data and converts it into a string of alphanumeric characters called a hash.  Each hash contains part of the hash from the previous block.  Altering any past data would result in a change in the hash.  If someone altered the data on their own copy of the ledger in an attempt to defraud the system, their hash data would be different than everyone else’s and fraud would immediately be detected.  To defraud the system one would need at least 51% control of the network (“51% attack”). However, the amount of computing power and energy it would take to amass that control, as well as the time and energy to redo all the hashing computations of the previous blocks, would likely be much costlier than the amount being defrauded.  Due to these factors, it is much more beneficial to honestly participate in the system and earn rewards than it would be to defraud it.  This structure significantly reduces the possibility of the system being hacked.

The first node to figure out the correct hash solution broadcasts it out to the rest of the network.  When 51% of the network agrees that the answer is correct, this node gets to add the verified block to the blockchain.  For doing so, that miner is rewarded with newly minted Bitcoin, as well as all the bitcoin fees that are associated with each transaction in that block.  All the other nodes then update their ledgers to match the one with the new block.  Mining new Bitcoin goes hand in hand with securing the network. Miners earn compensation for helping to validate, process and record the transactions occurring on this payment network, similar to credit card processors.

A Finite Supply of Bitcoin

The early mining participants were rewarded with 50 bitcoin every time a new block was added, (every 10 minutes).  When the complex mathematical problem starts becoming easier to solve, the bitcoin algorithm automatically adjusts the difficulty so that this process continues to take about 10 minutes, controlling the flow of newly minted bitcoin.

There is a finite supply of 21 million Bitcoin that will ultimately be mined by the year 2140.  Every four years, the amount of newly minted Bitcoin halves.  In the first four years miners earned 50 Bitcoin.  In 2012, Bitcoin rewards decreased to 25.  In 2016, they halved again to 12.5 and in 2020 it will halve to 6.25, and so on.  This will continue until there are no more Bitcoin left to mine.  There are currently over 16.7 million Bitcoin that have already been mined.

You might now be wondering what the incentive will be to continue to participate in this network once there are little or no more new Bitcoin to be mined.  By that time, it is expected that the number of transactions being done on the network, and the fees associated with each transaction, will provide enough incentive to continue to participate and maintain the ledger.  Perhaps in the future, miners will start being called transaction processors of the new payment rails, performing functions and earning fees, similar to Visa and MasterCard.

Mining Bitcoin is an expensive activity.  The more participants on the network the more competition there is to solve the equation and verify each block, leading to the need for stronger and more powerful processing chips and computing power.  Additionally, mining, using the Proof of Work consensus protocol, is a very energy intensive process.  Many point out the wastefulness of this particular consensus protocol since the work done by all but 1 node becomes worthless.

This leads me to some of the issues involving the technology.  Bitcoin and Blockchain technology may not be where they ultimately need to or will be, but I recall the same kind of technological evolution occurring with the Internet.  I am not a technologist and I don’t have the solutions for how to improve the current technology.  However, based on history, what I have witnessed with the evolution of the Internet, and the fact that there are so many talented and creative developers devoting time to Blockchain technology, I am incredibly confident that all the technological issues will be solved.

I believe Bitcoin is not a fraud.  The idea of digital money makes sense in our digital world.  It is not to say Bitcoin is without risk.  There is the potential for another cryptocurrency, a better version of Bitcoin, to be developed. Yet, that would require the new currency to garner as much community support and network effect as Bitcoin and there is no way to foresee that now.  In the meantime, I am focused on the fact that Bitcoin has been around for 9 years and is resilient and anti-fragile.  Despite the fact that many have tried to hack it, Bitcoin itself has not been hacked.  Exchanges and wallets, due to poor technology and security, have been hacked, but not Bitcoin itself.  Much in the same way banks have been robbed, that doesn’t diminish the value of owning cash.  With each of the many price corrections that have taken place during the last several years as the value of Bitcoin has surged, the price of Bitcoin has reached new subsequent highs.  As more people globally use Bitcoin for various use cases, the demand should continue to lead the price higher.

Bitcoin is our first look at how a decentralized distributed network could impact lives.  Bitcoin is a disruptive technology which addresses the needs of those not serviced by the traditional financial system by lowering the barriers to access a financial system for anyone with a smart phone and an Internet connection.  This is already improving lives all over the world.  What’s more exciting is that Bitcoin is just one of many applications of Blockchain technology which will positively transform lives and businesses.

About the Author, Sheri Kaiserman

 

Futures trading involves the substantial risk of loss and is not suitable for all investors. Each investor must consider whether this is a suitable investment since you may lose all of or more than your initial investment.  Bitcoin futures require much higher margins than other futures contracts, and Wedbush may require higher minimum account balances for those clients who trade these contracts.