Bitcoin Explained – Chapter 5: Bitcoin Mining

In the fifth part of the Bitcoin Explained series we look at the second half of the technical Bitcoin characteristics. After examining the basic functionality of the blockchain, we now examine what makes this technology so unique.

Sourcee: Vontobel Investment Banking

3. Mining Process

Nowadays there are mainly 3 ways to earn Bitcoins: You can buy them on a Bitcoin exchange, you can accept them in exchange for goods or you can «mine» them. Mining Bitcoins is a necessary process to keep the Bitcoin protocol running. Mining is the process responsible for adding new transactions to the blockchain in the form of information blocks. Only through this process, transactions can be confirmed and the problem of double spending avoided.

After a block of transactions has been generated, it is processed by the «miners» through a process specific to the blockchain. To start the process, the transaction information of the block is mathematically encoded into a sequence of numbers. This converts a large amount of information into a much smaller «hash» - a sequence of numbers. The special aspect about the hashing process in the Bitcoin blockchain is that the hash to be generated merges the information of the transactions performed as well as the hash of the last block. While it is relatively easy to generate a hash from information, it is virtually impossible to know what data was used for the generation of the hash.

Each hash is completely unique and different. If even a minimal change to the previous blockchain information or the current transaction information were made, it would be noticed immediately within the mining process. Falsified transactions or attempts to «trick» the blockchain are thus protected by the mining process and the hash function of the algorithm.

For a better visualization of a hash process, some sample hashes are listed in the following diagram. This clearly shows how impossible it is to recognize from the output what kind of information is actually in the hash, what was used as input and how unique each hash is:

Source: Vontobel Investment Banking

As you can see from these examples, it doesn't matter how much data is delivered as input - the length of the hash always remains the same. This is a computing mechanism that guarantees security and fraud prevention even within a decentralized blockchain.

4. Incentives in the Mining Process and «Proof of Work»

Miner, as the name implies, provide computers and also entire data centers to carry out the mining process at any time, thereby processing every Bitcoin transaction and guaranteeing its legitimacy. All miners are in competition with each other, because every miner who provides his or her computing power for this purpose is rewarded - if the miner has managed to generate the correct hash of the current block first.

Since October 2017 the reward per hashed block is 12.5 Bitcoins. This value decreases over time as the reward is halved every 210,000 blocks. At the current pace, it is expected that the next reward halving will take place on 22 May 2020, which means that the reward per block will be only 6.75 Bitcoins. In theory, the value of the reward should remain the same despite everything. Although the reward per block is decreasing, the growth rate and availability of new Bitcoins is also decreasing, which should increase their value.

Normally the production of a hash is very simple and does not require much computing power. In order to make this process more difficult and to prevent miners from mining all Bitcoins within a few hours, the Bitcoin algorithm is subject to a constantly increasing level of difficulty in the hashing process.

This difficulty level is controlled by «Proof of Work» («PoW»). This is a process that requires work from the users of the system - in the case of Bitcoin, this is the computing power of the computers. In general, the PoW of the hash algorithm consists of a lot of trial and error work. This difficulty level is calculated every 2016 blocks and is designed so that the processing of a single block takes about 10 minutes. The more miners the higher the difficulty level and vice versa.

This process makes it possible to conduct anonymous transactions around the clock in a decentralized, public system, while at the same time generating new Bitcoins in the form of rewards for the miners. It is referred to as the «mining process» because the generation and proof of work approach is similar to the mining rate and hard work involved in mining precious metals or raw materials.

Once again summarized

The technical basics of the Bitcoin blockchain are deeply anchored in the algorithm of the Bitcoin protocol. They provide the foundation for Bitcoin and guarantee the continuous functioning of the system. All changes to the algorithm and any expansion of the technology are based on this fundamental foundation, which means that the basis of the Bitcoin blockchain will always remain the same in the future.

The following diagram shows the entire process of a Bitcoin transaction once again:

Next in Bitcoin Explained

On the basis of the elaborated basics it is now possible to investigate certain special cases within the blockchain. One of these special cases are so called «forks» of the blockchain.