Topics Crypto
Bybit Learn
Bybit Learn
Intermediate
Aug 8, 2022

What Is Crypto Mining and How Does It Work?

As crypto ownership increases internationally, more people are exploring ways to buy, earn and trade cryptocurrency. Buying crypto on centralized exchanges like Bybit is currently the predominant way of obtaining cryptocurrency. Decentralized exchanges are another popular option.

However, in addition to buying cryptocurrency, you might also earn it in several ways. One popular way to earn crypto is mining.

What Is Crypto Mining?

Cryptocurrency mining refers to the process of contributing your computer’s processing resources to securing the network consensus on a blockchain.

By participating in crypto mining, you can help a blockchain platform keep its operations free from hostile takeovers, spam, and attempts to centralize the operational control in the hands of a small number of network agents.

Best of all, you can earn significant crypto rewards from participation in the mining activity while contributing your resources to these noble goals.

Although crypto mining is a very competitive process, its potential rewards are nothing to sneeze at. For instance, the current reward for mining a block on the Bitcoin (BTC) blockchain is 6.25 BTC (over $140,000 at the coin’s current market price). The reward is designed to be halved approximately every four years, although BTC’s increase in monetary value over time helps compensate for the reduced award.

Bitcoin’s block rewards and halving dates

Bitcoin’s block rewards and halving dates

Image source: Blockchain.news

To become a crypto miner on a blockchain platform, you’ll need to have the requisite mining hardware. By now, given the competitive nature of crypto mining, the standard hardware required is usually an application-specific integrated circuit (ASIC) machine, a powerful computer specifically designed for mining purposes. On some chains, powerful GPUs on a PC might also be used.

How Does Crypto Mining Work?

There are two main blockchain types based on the method of transaction verification used, either proof of work (PoW) or the alternative proof of stake (PoS) verification. Mining is an activity associated with transaction verification on PoW blockchains.

The PoW chains employing the mining procedure include, among others, the world’s two leading networks – Bitcoin and Ethereum (ETH).

Proof of Work (PoW)

PoW is a computational procedure used to validate and add blocks of transactions to a blockchain’s permanent ledger of records. On blockchains using the PoW method, special network nodes called miners package transactions into batches/blocks, and then use their computers’ hash power to try to “solve” a computational puzzle that will “validate” the block. The validated block is then added permanently to the blockchain.

PoW’s short description does sound like a concept from a rocket science textbook, doesn’t it? While PoW is indeed a rather technical process, it can be easily understood when you look at its execution step by step. For our step-by-step description, we'll show how Bitcoin mining works, though the overall principle applies to all PoW chains.

Step 1 — A new (unconfirmed) transaction is initiated on the network.

Initially, all Bitcoin transactions receive an unconfirmed transaction status. When two users transact on the blockchain, e.g., one sends some crypto funds to the other, a new unconfirmed transaction is generated on the network. The transaction contains the key records, such as the sender address, the receiver address and the amount sent. The transaction is broadcast across the entire network.

Step 2 — The unconfirmed transaction enters the waiting area(s) called a mempool(s).

Bitcoin miners continually monitor the network for new activity. Each miner has a temporary area on their machine where unconfirmed transactions pop up after appearing on the network per Step 1. This temporary area is called a mempool (memory pool).

Contrary to popular belief, there is no single mempool on the network. Each miner has their own mempool. Two miners’ mempools may differ slightly, as each node is built differently and receives the unconfirmed transactions at a different time, though by default the mempool size cannot exceed 300 MB.

Step 3 — Miners package transactions into candidate blocks.

Miners regularly pick transactions from their mempools and package them into so-called “candidate blocks.” On Bitcoin, the average candidate block is around 2MB in size, which fits approximately 2,000 transactions.

Since miners may have somewhat different mempool contents, the composition of the candidate blocks between different miners also differs.

Step 4 — Miners race to solve a computational puzzle to make their candidate block the winner.

The actual PoW process starts at step 4. After packaging up their candidate blocks, each miner uses their machine to repeatedly add a small number, called a nonce, to a different number generated by the network’s software. The resulting number is then run through the hashing algorithm used by Bitcoin, called SHA-256.

The hashing algorithm is designed to modify the input cryptographically and provide a modified output value. This output value must equal or be less than a certain system-generated target value, which is continually updated by the blockchain’s code. If that happens, the candidate block is said to have been “solved,” i.e., its status moves from candidate to fully verified block.

The verified block is then added to the blockchain as the next record in the ledger. The miner who has solved the block receives their reward, which for Bitcoin is currently 6.25 BTC.

Each miner races to be the first one to find a match for the target value and make their candidate block the winner. To do so, miners, or rather their computers, repeat the process of adding the nonce value a massive number of times, and try to do it as fast as possible.

The more nonce substitutions (hashes) you can make per second, the higher your statistical chance of winning the race. Modern powerful ASIC computers (see above) are capable of adding hundreds of trillions of hashes per second.

This race to solve the next block on the chain is repeated on Bitcoin every 10 minutes. When a winning block emerges, miners promptly drop their attempts to solve their current candidate block, update their mempools to remove the now confirmed transactions, package another candidate block from the available unconfirmed transactions, and restart their race to be the first miner to add the next block to the chain.

The Rationale Behind Proof of Work

The computational battle among miners to solve new blocks on the chain is an extremely energy-intensive process. It also slows down the processing capacity of the network significantly. You might be wondering why the network is subjected to this seemingly pointless and laborious procedure.

The key rationale behind using PoW is to protect the network from spam transactions and, importantly, from attempts to take over the network, i.e., to violate its decentralized nature.

On the scale of the entire blockchain, PoW requires so much energy and hash power expenditure that no single entity, person or group can realistically solve all or most blocks on the network.

Thus, PoW is the key element to ensuring that blockchains remain decentralized and free from the control of a small number of actors.

Among the popular blockchains based on PoW are Bitcoin, Ethereum, Dogecoin (DOGE), Ethereum Classic (ETC), Litecoin (LTC), Bitcoin Cash (BCH) and Monero (XMR).

The top 5 proof-of-work cryptocurrencies by market cap (in billions of USD) as of August 4, 2022:

Top 5 PoW cryptocurrencies by market cap as of August 4, 2022

Data source: CoinMarketCap.com

Proof of Stake (PoS)

PoS is the main alternative to PoW for validating transactions on a blockchain. With the PoS model, there is no computationally intensive race to solve transaction blocks. Each new unprocessed block on the network is allocated to a validator node, who verifies it and adds the block to the chain.

Under the most basic PoS model, this allocation to a validator node is random, and the validator’s probability of getting the next block to process is directly dependent on the share of the chain’s native cryptocurrency held or staked by that node.

For example, if you hold 3% of all the crypto funds on the network, you’ll get the chance to validate around 3% of all the blocks.

Unlike PoW, PoS neither requires significant energy expenditure nor appreciably slows down the network’s operations. Some of the popular blockchains using PoS include Binance Chain (BNB), Cardano (ADA), Solana (SOL), Tron (TRX) and Avalanche (AVAX).

The world’s second-largest chain, Ethereum, is planning to move from its current PoW version to the new PoS platform, Ethereum 2.0, within the next few weeks or months.

The top 5 proof-of-stake cryptocurrencies by market cap (in billions of USD) as of August 4, 2022:

Top 5 PoS cryptocurrencies by market cap as of August 4, 2022

Data source: CoinMarketCap.com

Crypto Mining Methods

There are three principal methods of mining cryptocurrency to validate transactions and earn crypto rewards in the process:

  1. Solo mining
  2. Pooled mining
  3. Cloud mining

Solo Mining

Solo mining is just what its name implies: You purchase the necessary mining hardware, join a blockchain network as a node, download the requisite software and attempt to mine blocks on your own. If you manage to mine a block, you’ll receive the mining reward without having to share it with any other network participant.

While (theoretically) you can use your PC’s CPU or GPU to mine crypto, this is no longer practical or profitable, given the intense competition between miners on most popular PoW chains. For profitable mining, your realistic choice is limited to ASIC machines.

On popular chains like Bitcoin, solo mining — even with a powerful ASIC machine — could be challenging due to the competition from mining pools. These are groups of network participants who pool resources from many individual miners in order to dominate mining activity.

Online calculators (such as WhatToMine.com) can help you estimate the mining difficulty and profitability for various networks. These websites allow you to enter the specifications of your ASIC rig, your electricity rates, the chain on which you’d like to mine and other relevant parameters. They then produce profitability estimates.

Pooled Mining

A mining pool refers to a large group of individual miners who pool their computing resources together to increase the chance of solving the next block on the chain. Large mining pools can have many thousands of individuals contributing their hash power to the joint operation.

The distribution of Bitcoin mining activity by pools — 30 days to August 4, 2022

The distribution of Bitcoin mining activity by pools — 30 days to August 4, 2022

Image source: BTC.com

When a block is solved by any member of the pool, the mining reward is split between all the pool participants proportional to their hash power contribution. Due to the resource pooling from a large number of computers, mining pools have a significantly higher chance of solving blocks than solo miners.

If you’re considering mining Bitcoin or other popular cryptos like Dogecoin and Litecoin, it’s highly recommended that you join a sufficiently large online crypto mining pool rather than try to go solo. A good pool can make your Bitcoin mining profitable even if you don’t own the most powerful mining rig on the network. While your rewards will trickle in in smaller amounts, at least they’ll arrive with some degree of consistency.

Conversely, if you mine solo, your rewards might become very infrequent or not materialize at all, given the fierce competition on the leading PoW chains.

Cloud Mining

Solo mining and pooled mining both require you to own mining hardware. Instead of buying the hardware, you could also participate by joining a cloud mining platform. Cloud mining platforms charge users a monthly or yearly fee for the opportunity to rent their internal mining hardware resources.

In exchange for the fee, the cloud platform runs the mining operations on your behalf on a blockchain network. Any rewards obtained from the mining activity are shared with you. The higher the fee you pay, the more hash power you can rent, and, therefore, the higher your rewards are likely to be.

The cloud mining model looks very attractive since it frees you from the requirement of owning a mining rig. However, before committing to it, carefully research the fees and reputation of the cloud mining providers on the market. Finding a reliable long-term provider with low fees might be a challenging task in this niche.

Pros and Cons of Mining

The Pros of Crypto Mining

The biggest advantage of crypto mining is, undoubtedly, the potential to earn cryptocurrency rewards. Mining crypto might be an energy-intensive process, but it’s usually done in a hands-off way, i.e., you don’t need to be actively monitoring what’s going on on the network.

In a practical sense, you simply keep your rig functioning on autopilot. As such, mining could be a great way to earn a passive income.

Another benefit of mining is more of an altruistic nature — you get the chance to contribute to keeping the network decentralized and free from hostile takeovers.

The Cons of Crypto Mining

Along with its advantages, crypto mining has certain drawbacks and risks associated with it. One of them is the volatility of mining profitability. The competition between miners on the leading PoW platforms is fierce, making crypto mining an uncertain and volatile activity in terms of profitability. You might be turning a profit today, but if the competition on the network suddenly spikes, you could be in the red tomorrow.

Another drawback is the upfront cost of the equipment to participate in crypto mining. Powerful ASIC rigs that could give you a good chance to mine crypto profitably cost at least $3,000, quite a bit more than your typical PC. Regardless of the price you pay for your mining rig, do remember that profitability will fluctuate and there are no profit guarantees in this game, not even with powerful machines.

Furthermore, its extremely energy-intensive nature might create environmental issues. The Bitcoin blockchain consumes more energy per year than a country as large as Argentina, the second largest South American economy. By participating in crypto mining, you are definitely not going to make friends with environmental activists.

Besides the environmental impact of the entire blockchain, the energy-hungry crypto mining process will add some serious figures to your own energy bills.

Is Crypto Mining Legal?

While cryptocurrencies and crypto trade are banned by a number of countries, very few countries around the world have explicitly banned crypto mining. The most well-known example of a country where crypto mining is banned is China. The Chinese authorities have repeatedly cracked down on mining activity in the People’s Republic. Any form of crypto-related activity, including mining, is illegal in the country.

Another rare country that has made crypto mining illegal is Kosovo. The ban was largely driven by the energy shortages in the Balkan state.

Venezuela has made crypto mining illegal, but only if the mining activity originates from state-owned public housing. Crypto mining outside of these premises is not illegal. For example, dedicated crypto mining facilities used on industrial premises are free from this ban.

In the last couple of years, Iran has introduced temporary multi-month bans on crypto mining. The last of these bans was in effect until March 2022. However, in general, crypto mining is not illegal in the country.

Other than the nations above, no other country has explicitly made crypto mining illegal as of early August 2022. India and Russia are considering legislation that might restrict most crypto-related operations, including mining. However, this has not yet been passed into law.

The Bottom Line

Crypto mining could be a rewarding activity if you have powerful mining equipment and choose profitable coins/networks. However, it’s a volatile game with increasingly fierce competition between miners on popular chains. This competition continually raises the benchmark for the minimum hardware specifications to turn a profit. For most people looking to reap profits from crypto, it might be easier to find other sources of crypto passive income or simply engage in crypto trading.

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Given the speed and energy inefficiencies of the PoW validation procedure, most new blockchains are choosing the alternative PoS format. This limits the number of platforms where crypto mining could be used. Ethereum’s imminent move to PoS is also a telling sign that the PoW validation, and the mining process associated with it, is growing increasingly archaic in the blockchain industry.

However, while the world’s largest blockchain, Bitcoin, continues to use the PoW validation method, crypto mining will stay with us, and there will be no shortage of people willing to join this trade.