Hardly known fact: Bitcoin mining means verifying transactions
To understand bitcoins, whether it’s out of intellectual purpose or out of investment purpose, it is important to understand what are the real meanings of some jargons, namely, mining and block chain etc. Among them, block chain is the most critical one that should be fully understood.
What is block chain?
A block chain is a transaction database shared by all nodes (users or owners of bitcoin) participating in a system based on the Bitcoin protocol. A full copy of Bitcoin’s block chain contains every transaction ever executed in it. With this information, one can find out how much value belonged to each address at any point in history.
Every block contains a hash of the previous block. This has the effect of creating a chain of blocks from the genesis block to the current block. Each block is guaranteed to come after the previous block chronologically because the previous block’s hash would otherwise not be known. Each block is also computationally impractical to modify once it has been in the chain for a while because every block after it would also have to be regenerated. These properties are what make double-spending of bitcoins very difficult. The block chain is the main innovation of Bitcoin. In a nutshell, you can see block chain as an encrypted public ledger, where all the transaction information is booked.
What is mining?
What comes consequently is the question: “What does the block chain really do? Mining?” There is tons of news and reports on the Internet addressed “mining” as solving mathematic puzzles. Loosely speaking, those are correct statements; however, they are not accurate enough. In order to really understand the meaning of mining, one has to delve deep into the code and protocols of Bitcoin. Here, I will skip details that are too deep for potential users and investors and attempt to give a holistic view on mining. For more details regarding codes and protocols of Bitcoin, please contact Payment21 Consultancy Services.
Mining is the “process of adding transaction records to Bitcoin’s public ledger of past transactions.” As I have mentioned in the explanations of block chain, block chains store all the previous transactions and thereby also serves to confirm transactions to the rest of the network as having taken place. Bitcoin nodes (users or owners) use the block chain to distinguish legitimate Bitcoin transactions from attempts to re-spend coins that have already been spent elsewhere.
What is proof-of-work?
So why do I say those statements are loosely correct? Because in order to avoid double spending, the system has to create incentives for nodes to validating a transaction and to (artificially) make it computationally costly for network users to validate transactions; such an idea is called proof-of-work. When one nodes in the system broadcasted his/her transaction with counterparty, all the nodes in the community will try to validate it, which can be seen as solving a hard computational puzzle. The probability of one node solving the puzzle depends on how many percentages of computational power he/she has in the community. For example, if node A has 1 % of the computational power in the entire community, then the probability of A solving the puzzle would be approx. 1%. Mining is intentionally designed to be resource-intensive and difficult so that number of blocks found every day by miners remains steady.
Growing surrounding businesses
Having said that mining is a process requiring great computational efforts, there are several Bitcoin surrounding industries with potential of scalability. Among them, cloud mining is a combination between two innovative technologies, namely mining and clouding. It works in the following way. By signing contract with cloud mining services providers, users can also participate in mining without investing in hardware and paying bills for utilities. Instead, user can rent mining capacity from cloud mining services providers, the proceeds from mining can be reinvested in buying more computational power from providers or users can use the bitcoins at their discretion.
Here I will provide a simple calculation example based on the prices and other conditions on 09.01.2014:
Current Bitcoin price: 815.2$/BTC (unit of Bitcoin)
Mining Speed: 20GH/S (giga hash per second)
|Per annum||Cost||BTC mined||Revenue||Profit/Loss|
From the naïve calculation, we can get results that the value of mined bitcoins generated is higher than the annual fees you paid to service provider. However, some issues are missing here, namely the continually changing difficulty level, the ever changing price of bitcoin and if providers allow reinvestment.
First of all, let’s assume that the difficulty level will keep increasing. According to the estimation of the Bitcoin community the next difficulty adjustment will bring a 29% increase of difficulty level (the difficulty level will be adjusted in normally every nine days and it could be lowered and increased, under current market sentiment, keep increasing the difficulty level is the case most likely to be). Then the revenue and profit will become, if the bitcoin price remains at 815.2$/BTC:
|Per annum||Cost||BTC mined||Revenue||Profit/Loss|
However, in this scenario, the bitcoin’s price is assumed as fixed, which is not realistic. However, until now, there is no consensus regarding the movement of bitcoins’ prices, whether it’s a Brownian motion or there’s strong autocorrelation between previous price(s) and today’s price. And such topics are already far beyond the range of this article, for more details on such topics, please contact Payment21 Consultancy Services. Currently, there are also providers supporting the reinvestment function, meaning user can use the proceeds to purchase incremental capacities per certain period. The return of such service, on one hand is subjected to the purchasing power of bitcoins, for example if the purchasing power is defined by service provider discretionally or is totally subject to the market, and on the other hand is subject to the reinvestment rates and market depth. The only certainty is that such services are targeting at long term users and the revenue for users remains uncertain and varies from case to case.
1. Hash is results of algorithm functions; such an arbitrary function turns a block of data in to a fixed length of bit string. Hash is a dependent variable that is very sensitive to the input of the hash function. This property of hash is one of the reasons that bitcoins can be traded in public market safely. BitCoin uses the SHA-256 hash algorithm to generate verifiably “random” numbers in a way that requires a predictable amount of CPU effort.
2.The Bitcoin protocol defines the average time needed to found a right puzzle is approx. 10 minutes.