Processing transactions on the Bitcoin blockchain requires individuals known as ‘miners’ to compete in solving mathematically complex problems. The miner who solves the problem first gains permission to mine a group of bitcoin transactions, known as a “block.” On the Bitcoin blockchain, the storage of blocks occurs in chronological order across the decentralized ledger. The process required to verify and add new blocks of data to the blockchain and create new digital asset tokens is called Proof of Work (PoW).
PoW is a permissionless decentralized consensus mechanism. Permissionless blockchains do not require permission to participate on-chain and, as such, are known as public blockchains. Prospective bitcoin miners adhere to a strict set of network protocols to compete for a chance to solve complex math puzzles and validate the legitimacy of a transaction. Successfully solving complex equations leads to an opportunity to add a block to the blockchain. Blockchain protocols are rulesets that combine cryptography and economic rewards to ensure blockchain security. Blockchain updates, or transaction validations, only occur when new information satisfies the protocol and is collectively agreed upon.
Blockchain (on-chain) transactions are pseudonymous addresses assigned to clients transacting on the blockchain. Transaction details are visible to the validator node processing the data. Anyone with an internet connection can access a node and explore recorded transaction details via a searchable web interface called a ‘block explorer.’ Validated transactions are then added to the historical blockchain ledger and broadcast to other computers, also known as validator nodes. Each computer in the blockchain network must be powerful enough to download the entire blockchain and capable of storing a copy of the blockchain’s entire transaction history––thus, the likelihood of hacking via successful alterations to the code across the network is insignificant. The blockchain’s stability and security increases as more computers compete for mining rewards and work to verify blockchain transactions. With no single point of failure or control, decentralized blockchains are celebrated for their secure, non-sovereign status.
RESOURCES REQUIRED TO MINE BITCOIN SUCCESSFULLY
PoW requires highly specialized, expensive mining hardware. Additionally, the hardware resources necessary to compete consume significant amounts of electricity. Hardware must be capable of continually generating 64-digit ‘hash’ number combinations in an attempt to quickly solve a unique equation that is ‘less than or equal to’ the puzzle’s winning hash. To regulate block creation––and ensure the value of bitcoin after halving events––the level of difficulty is adjusted roughly every 14 days in an effort to maintain an average of one block mined every ten minutes. The more miners competing, the more difficult and expensive it becomes to arrive at a solution. Miners with significant computational power have the best chance of solving these mathematical problems, verifying transactional data, and reaping mining rewards.
Pooling resources or working in mining pools offer prospective miners an opportunity to circumnavigate these barriers to entry. Though mining pools are best equipped to mine bitcoin successfully, they must weigh the cost-benefit analysis of such operations. Specifically, they must weigh whether the potential mining rewards and current market value of bitcoin justify energy and hardware requirements to mine bitcoin.
Bitcoin and all other digital asset rewards are treated as income by the IRS and subject to a capital gains tax if applicable when sold. Bitcoin earned through mining is valued at the rate of exchange at the time of reward, and a miner must provide documentation noting when any rewarded bitcoin was mined.
The decentralized Bitcoin blockchain and its native bitcoin currency emerged as a viable alternative to traditional fiat currencies regulated by governing bodies and centralized banking systems. Because bitcoin is predominantly a store of value and medium of exchange, the value of the Bitcoin ecosystem cannot be directly compared to the market capitalization of general-purpose blockchains like Ethereum. Bitcoin was designed solely to provide a secure way to transfer value between parties without a centralized banking system and government oversight. The network remains a valuable and important component of the broader crypto ecosystem.