The Beginner’s Guide
With traditional government currencies like the U.S. dollar or euro, users must trust in a central authority to manage and regulate the circulation of money and to persecute those who break the rules of the system.
Bitcoin, on the other hand, relies on software – and a network of users – to manage its money.
Information that, with government monies, would be housed in a centralized server or system of databases (such as in the transaction records of central banks) is instead maintained by users, making the system decentralized, or free from any one party’s control.
But how does this work in practice?
In order to keep its distributed network secure and regulate the supply of new money that gets released into its economy, Bitcoin uses a process called “mining.”
The first bitcoins were created through mining by Bitcoin’s creator Satoshi Nakamoto in 2009 by using dedicated machines to convert electricity into Bitcoins.
Today, there are many more miners around the world who operate and maintain large data centers expressly for the purpose of powering the network.
How Does Bitcoin Mining Work?
Mining is one of the key elements that allows Bitcoin to regulate the distributed network of computers that helps make its software possible.
By racing to complete cryptographic puzzles, miners propose the blocks that make up the Bitcoin blockchain and that house the history of network transactions.
When a block is discovered by a miner, they announce that block to the network where it is verified and approved by other nodes.
In exchange for this service, new Bitcoins are sent to the winning miners.
Proof of Work (PoW)
The mechanism that keeps this process in sync is called (PoW), and it does so by mandating that miners expend computational energy to add blocks to the blockchain.
it is important to note that many financial-related activities consume significantly more energy than Bitcoin mining, including gold mining and fiat currency production.
To solve the cryptographic puzzles and find valid blocks, miners must uncover the right string of pseudorandom numbers, called a hash, which must match conditions set out by the protocol. Essentially, it is a lottery system where miners' odds of finding new blocks increase depending on how much energy they expend.
Hashing is a mathematical operation that takes in any arbitrary quantity of data and produces a fixed size output. To propose blocks in the Bitcoin protocol, computers race to generate hashes until one of the hashes has a small enough value.
The winning hash is then broadcasted to other computers for them to verify whether the solution is true or not. If it is valid, the user who broadcasted the block is awarded new Bitcoin.
However, the competition for finding blocks gets increasingly difficult with every new miner that enters the network. As it increases so too does the price of production, followed by the price of the underlying commodity, in this case, Bitcoin.
Put more technically, the probability of finding a hash is roughly equal to a miner’s total mining power on the network. This means that the more computing power a miner is able to provide, the greater his or her chances of finding the hash, and thus receiving the block reward.
Since miners with a small percentage of the mining power are unlikely to discover the next block, and thus will rarely get compensated, miners sometimes pool their efforts.
Today, most mining is done by “mining pools,” groups of cryptocurrency miners who share their processing power over a network, and share the block reward amongst themselves.
Bitcoin’s Monetary Policy
Of course, while this process benefits Bitcoin’s miners it provides a far more valuable service by enforcing Bitcoin’s monetary policy.
Miners regulate the rate at which new bitcoins are made available to users, and help trigger and enforce rules about the Bitcoin money supply set forth by the software itself.
For example, the number of Bitcoin (BTC) released in each block is cut in half after 210,000 blocks are produced to keep the total supply finite. This event, called the “halving,” ensures Bitcoins continue to get more scarce over time.
In fact, according to the software rules, there will only ever be 21 million BTC introduced to the network’s economy. Satoshi put a lot of importance on Bitcoin having a fixed supply in order for Bitcoin to become more valuable over time in an effort to hedge against fiat currencies.
As of 2020, more than 18.5 million BTC has been made available to users. The last block is projected to be mined in the year 2140.
Due to the inflation, and thus Bitcoin’s focus on long-term stability and transparency, confidence in the protocol has remained high for developers. Furthermore, the fixed monetary policy is also the reason why the number of investors has been steadily increasing.