Understanding the mechanism of crypto mining and the factors affecting its profitability

Basic Concepts

The process of mining cryptocurrencies is considered a vital mechanism in blockchain networks, serving two parallel roles: verifying the validity of transactions and organizing them into blocks, as well as issuing new units of currency. This process requires massive computational resources as it forms the protective shield for the entire network's security.

Miners collect pending transactions and organize them into unified blocks, which are then broadcast across the network. Once the block is accepted by the validating nodes, the miner receives a block reward. The profitability of this activity is influenced by multiple factors including the efficiency of the equipment used, electricity costs, price volatility, and any potential adjustments to the network protocols.

What is the mechanism of cryptocurrency mining?

Imagine a global digital ledger that records every cryptocurrency transaction. Mining ensures that this ledger remains accurate and secure from tampering. Miners use advanced computers to solve complex mathematical equations (hashing), and the first miner to succeed in the solution receives a reward in new cryptocurrencies.

Cryptocurrency mining provides the necessary layer of security for networks like Bitcoin (BTC) - which is currently trading at a price of $88.20K. The process involves validating transactions between users and adding them to the public ledger of the blockchain. This activity allows the network to operate in a completely decentralized manner without the need for a central authority.

Mining is also responsible for injecting new coins into the economic cycle. Although this may seem similar to printing money, the protocol includes strict coding rules governing this issuance and preventing chaos. These rules are enforced by the distributed network of nodes.

To produce new coins, miners invest their computing power in solving cryptographic puzzles. The miner who succeeds first gets the privilege of adding a new block of transactions to the chain and broadcasting it to the network.

The Main Steps of the Mining Process

aggregation and organization

When sending or receiving cryptocurrency, these pending transactions are collected in a “block” waiting for confirmation. This first step is crucial for organizing the flow of data.

solve the mathematical equation

Miners use their devices to guess a special number called the Nonce. When this number is combined with the block data, it must result in a value lower than the target set by the protocol. The process is similar to a digital lottery that contains a puzzle.

addition to the chain and verification

The first miner to find the correct solution gets the opportunity to add their block to the blockchain. The rest of the miners verify the validity of this block.

get the reward

The winner receives a reward that includes newly minted cryptocurrencies as well as the transaction fees associated with the block they mined.

The Technical Mechanism in Detail

Segmentation Stage

When a new transaction arrives at the network, it is sent to what is known as the mempool ( memory pool ). Validator nodes verify the validity of each transaction. The miner collects these pending transactions and organizes them into blocks.

A block of data acts like a page in a ledger, containing several transactions and additional data. The miner takes each transaction and passes it through a hashing function, resulting in a fixed-size output called a hash value. This value serves as a unique identifier for the transaction.

Building a Merkle Tree

After hashing each transaction, these values are arranged in what is known as a Merkle tree. The hashes are paired and hashed again, and this process is repeated until we obtain a single hash value at the top - which is the root. This root succinctly represents all the transactions in the block.

finding the correct hash

Each block has a unique hash value that acts as an identifier. The miner combines the hash of the previous block with the Merkle root of the current block and a random Nonce number. The goal is to find a block hash that starts with a certain number of zeros - this value is known as “mining difficulty”.

Previous hashes cannot be changed, so the miner must repeatedly change the Nonce value until the desired result is achieved. This requires immense computational power.

broadcasting on the network

Once the correct hash is found, the miner broadcasts the block to the network. All validating nodes verify its validity, and if it is valid, they add it to their copy of the chain. The block becomes confirmed, and all miners begin the race to mine the next block.

Competition Cases for Blocks

Sometimes miners may broadcast two valid blocks at the same time, causing a temporary split in the network. Each miner starts mining on the block they received first. The competition continues until a new block is mined on one of the chains, at which point the previous block becomes the winner. The rejected block is known as a “stale block,” and the miners who chose it switch to working on the winning chain.

Mining Difficulty and Equilibrium

The protocol regularly adjusts the mining difficulty to ensure a steady rate of new block and coin production, maintaining system stability. The adjustment corresponds to the amount of computing power invested in the network (hash rate).

When new miners join and competition increases, the mining difficulty rises. Conversely, if a large number of miners leave, the difficulty decreases. This dynamic balance maintains the stability of the average block time.

Different Types of Mining

mining with CPU (CPU)

In the early days of Bitcoin, mining with a CPU was possible and efficient. However, with the growth of the network and the emergence of specialized devices, it became economically unviable. Today, no one uses a CPU for serious mining.

mining with Graphics Processing Units (GPU)

These units are designed to handle multiple parallel tasks. Although they are relatively inexpensive and more flexible than specialized devices, their efficiency depends on the type of currency and the algorithm.

mining with ASIC circuits

These are integrated circuits designed exclusively for mining, and they are characterized by very high efficiency. However, they are quite expensive, and the rapid evolution of technology can quickly render older models unprofitable. Despite the high cost, they are the most efficient option for large-scale mining.

mining pools

Since the block reward is only granted to the first successful miner, the probability of winning is very low for individual miners. Mining pools solve this problem by combining the hashing power of multiple miners together. When successful, the reward is divided according to the contribution of each miner. Despite the economic benefit, these pools raise concerns about centralization and the possibility of 51% attacks.

cloud mining

Instead of purchasing expensive equipment, miners rent computing power from specialized service providers. This option is simpler but entails risks of fraud and economic instability. A reliable service provider should be chosen when opting for this route.

Bitcoin Mining and Its Mechanism

Bitcoin is the most famous and clear example of mineable currencies. It relies on the Proof of Work consensus algorithm (PoW) - the same mechanism introduced by Satoshi Nakamoto in the technical whitepaper in 2008.

PoW is a mechanism that allows a blockchain network to reach consensus among distributed participants without external mediation. This is achieved by requiring massive investments in electricity and computational power, which deters fraudulent behavior.

On a PoW network, pending transactions are organized into blocks by miners competing to solve puzzles. The first miner to find the solution broadcasts their block to the chain. If the validating nodes accept the block, the miner receives a block reward.

The amount of coins in the reward varies depending on the network. On Bitcoin, the miner receives 3.125 BTC as a reward ( starting from December 2024). This amount decreases by 50% every 210,000 blocks ( approximately every 4 years) according to the halving mechanism.

Is mining really profitable?

Although there is the possibility of making a profit from mining, it requires careful study and cautious risk management. The process involves potentially significant investments and several risks such as equipment costs, price volatility, and protocol adjustments.

Profitability depends on multiple factors:

Price Volatility: When currency prices rise, the value of rewards increases. The opposite is true - a drop in prices reduces profitability.

Equipment Efficiency: Mining devices are expensive, and the miner must balance the initial cost with the expected returns.

Electricity Costs: If costs are very high, they may eat up most of the profits and make mining economically unviable.

Equipment Obsolescence: The rapid advancement of technology means that modern devices will quickly outpace the old ones. Miners without the budget to upgrade their equipment may struggle to remain competitive.

Protocol Changes: Events such as Bitcoin halving reduce block rewards by 50%, which directly affects profitability. In some cases, the network may shift from PoW to other mechanisms, which may render mining unnecessary.

Summary

Cryptocurrency mining plays a vital role in blockchain networks that use PoW. It maintains network security and ensures the issuance of coins in a regular and stable manner.

The process has its benefits and challenges. The obvious benefit is the potential income from block rewards. However, profits are affected by various factors, especially energy costs and market fluctuations. Before starting any investment in mining, it is essential to conduct thorough research and a careful assessment of all potential risks associated with this activity.