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When most people first hear about Bitcoin mining, it’s in the context of the decentralized monetary network using a lot of electricity.
However, beyond that, much like electricity, cryptocurrency mining is a complete mystery to most people.
Frankly, the term “mining” isn’t the best metaphor for what’s happening under the hood of the Bitcoin monetary network.
The short of it is that Bitcoin miners earn money by providing computer power to process transactions and update the ledgers.
In case you’re not familiar with Bitcoin, a quick oversimplification is that the Bitcoin network is essentially a banking application with its own native currency, Bitcoin.
The network is run by a worldwide consortium of “miners” who have a stake in the network rather than being run by a corporation or government.
The Bitcoin network facilitates the sending of money peer-to-peer without the need for a trusted 3rd party (such as a bank).
The ledger of accounts for the Bank of Bitcoin, if you will, is maintained and distributed across thousands of privately owned mining computers around the globe.
To fully understand Bitcoin mining it’s important to understand what a blockchain is.
To oversimplify once again, a block is a collection of thousands of transactions that are processed together. As each block is processed, it’s added to the blockchain.
When this happens, the record becomes permanent and immutable.
Because it’s spread across a network of thousands of computers worldwide, it can’t be changed by any one person, organization, or government, ever.
Let’s take a deeper look at how Bitcoin mining works, the advantages and the disadvantages of the process, what steps you need to take to mine Bitcoin, and more.
What is Bitcoin Mining?
As we mentioned, Bitcoin transactions are collected into blocks. Each block contains approximately 2,500 transactions, give or take.
On the Bitcoin network, blocks are mined at a constant rate.
One block is mined every ten minutes or so and the party that mined the block is rewarded in Bitcoin.
In order to be awarded a block to mine, miners must compete head-to-head to determine worthiness — that is, which offers the most hash power.
Hashpower essentially means computing power, and hash rate is the speed at which blocks are mined.
Each block is encrypted with a complex mathematical algorithm. The miner that cracks that encryption algorithm first is awarded a block to mine.
Hash rate and mining difficulty
As you might guess, as Bitcoin becomes more valuable, the incentive to mine Bitcoin becomes greater, thus attracting more miners with more powerful computers.
And more hash power means a faster hash rate.
However, as we mentioned, Bitcoin blocks need to be mined at a constant rate.
In order to compensate for rising and falling hash rate, the difficulty level of the hashing algorithm is increased or decreased.
A faster hash rate and a higher level of difficulty translate to a more secure network.
As the network grows it becomes more secure.
The proof-of-work mechanism
This process of hashing encrypted blocks is known as a proof-of-work mechanism (PoW).
Other schemes also exist such as proof-of-stake (PoS) where miners put up money for the right to mine, and proof-of-authority (PoA) where miners must prove their worthiness by consensus.
(The Ethereum network uses a PoS mechanism to mine blocks and VeChain uses PoA, for example.)
Advantages of Bitcoin Mining
The main advantage of applying a proof-of-work mechanism to mine blocks is, plain and simple — security.
As the network grows, a proof-of-work blockchain becomes more and more decentralized and more secure.
The more decentralized and secure the Bitcoin network becomes, the more trust it earns from investors.
The more investors that want in, the higher the price goes.
The higher the price, the more incentive to mine and the network grows.
Disadvantages of Bitcoin Mining
The main disadvantage of a proof-of-work strategy is that it is highly energy-intensive.
As the network grows, it requires more and more electricity to process the transactions.
You might have heard that the Bitcoin network uses as much electricity as a small country. However, there are two things that need to be kept in mind.
First, global banks also use quite a lot of electricity. Unlike banks, Bitcoin miners don’t need to power marble and glass skyscrapers in Manhattan full of thousands of employees that need to burn fossil fuels to commute to work.
And second, because electricity is the commodity on which the network runs, there is a huge incentive for Bitcoin miners to use the least expensive electricity available.
This incentivizes miners to locate their facilities near inexpensive renewable energy sources.
How to Start Bitcoin Mining in 4 Steps
While Bitcoin mining isn’t difficult, it can be expensive to get started.
Although in the early days, any computer could be used to mine Bitcoin, today, the difficulty level is so high that mining Bitcoin requires computer processors that have been designed specifically for this purpose called ASIC chips (application-specific integrated circuit).
Bitcoin mining computers cost thousands of dollars each. Add to that the cost of joining a mining pool.
However, once up and running, mining profits can be tremendous.
Here’s how it works:
Step 1: Acquire Bitcoin mining equipment
Step one is obvious — get your hands on a Bitcoin mining rig.
Plug it in.
Turn it on.
And connect it to the internet.
Step 2: Install the Bitcoin mining software
Once a Bitcoin mining rig is set up, the next step is to download the software needed to connect to the blockchain and mine the blocks.
The latest Bitcoin mining software — called Bitcoin Core — can be downloaded at Bitcoin.org for free.
Once the miner is up and running with the latest software, initial synchronization with the blockchain will take some time.
It needs to download a massive amount of blockchain data (about 7GB).
Step 3: set up a Bitcoin wallet
You’ll need a place for your Bitcoin rewards to be deposited.
Once earned, Bitcoins are deposited into electronic wallets that connect to the network.
There is a myriad of options to choose from.
This brings us to Step 4.
Step 4: Join a Bitcoin mining pool
Having the latest, greatest mining rig isn’t enough to be awarded blocks to mine.
In order to be competitive, the miner needs to join what’s called a Bitcoin mining pool in which miners pool their computing power together.
Mining pools charge a royalty fee of between 1% and 2% of Bitcoin awarded.
Once you have a Bitcoin rig up and running with the proper software and have joined a mining pool, you’re ready to start mining.
Taxes on Bitcoin Mining
Bitcoin mining is a for-profit enterprise with overhead expenses and financial rewards.
Bitcoin mining profits are taxed just like any business — on the profit that’s leftover after expenses are deducted.
However, there’s a major difference.
Until a miner converts their Bitcoin into cash, it’s not considered income.
This provides some incentive for miners to hold onto their Bitcoin as an asset rather than sell it.
If capital needs to be raised to expand a mining operation, Bitcoin can be sold or put up as collateral for loans.
The Bottom Line: Bitcoin Mining
Bitcoin, like any bank, requires computers to process transactions. However, rather than being centralized under one corporation, Bitcoin miners are a consortium of data centers, mining pools, and independently-owned mining rigs.
Their reward for keeping the network running and secure is paid in Bitcoin.
As this network of miners grows, so too does the security and value of the network. Mining becomes more and more profitable. This in turn increases the incentive for more miners to get involved.
To maximize profits, miners are incentivized to seek out inexpensive, renewable energy sources.
As we explained, anyone can become a Bitcoin miner if they can get their hands on a Bitcoin mining rig and become part of the world’s first and biggest decentralized monetary network.
