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Executive Summary

Bitcoin “mining” is the process of performing a computational effort to create the next valid block of transactions on the blockchain; a valid block being confirmed across the network sees the creator (miner) rewarded with newly issued BTC. However, taking a step back to understand blockchains, blocks, and transactions is helpful.

Blockchain is a distributed database that tracks the balances of Bitcoin users. Each "block" contains a transaction collection representing the transfer of bitcoins between users, with each transaction represented by an address. Network users broadcast these transactions to a shared network resource known as the mempool (memory pool). The network does not recognize transactions until they have been added from the mempool to the blockchain. To send bitcoins to an address, the sender must include transaction fees to incentivize miners to select their transactions from the mempool. Blocks have a maximum size; therefore, miners (typically) choose to include the transactions with the highest fees, generating maximum revenue for the miner. They then generate a block from these transactions and transmit it across the network so that the nodes may validate it.
 

A Miner's Work

• Group bitcoin transactions into blocks (since the block size is ~1 MB, each block can only fit so many transactions; should the mempool contain more transactions than can be fit into one block, the transaction overflow will be added to the next block)
• Perform computations to solve a cryptographic puzzle (performing the “proof of work”)
• Bitcoin miners pool ‘valid’ transactions into blocks; anyone can run a Bitcoin full-node and act as a ‘validator’ for proposed blocks; these people are typically miners since they have the incentive to invest in the network’s security
• Send the blocks out over the network to be cross-checked and verified, and they will validate other  proposed blocks 
• Propagate approved blocks across the network and move on to the next block of transactions

Miners

Miners are critical to the network's health, and the idea of including proof of work (PoW) as part of the consensus mechanism (i.e., a network’s process for agreeing on the order of valid transactions) represents a key innovation of the Bitcoin network. Bitcoin miners are responsible for block generation and committing blocks of confirmed transactions to the blockchain. Beyond that, mining aids in: 

• Securing the network and  preventing corruption from malicious actors 
• Minting new bitcoin into circulation in a predictable, predetermined manner
• Maintaining a historical record so that the chain remains auditable and transparent allowing global consensus to be reached 

Miners are the global network of computers that:

• Group bitcoin transactions into blocks (since the block size is ~1 MB, each block can only fit so many transactions; should the mempool contain more transactions than can be fit into one block, the transaction overflow will be added to the next block)
• Perform computations to solve a cryptographic puzzle (performing the “proof of work”)
• Bitcoin miners pool ‘valid’ transactions into blocks; anyone can run a Bitcoin full-node and act as a ‘validator’ for proposed blocks; these people are typically miners since they have the incentive to invest in the network’s security
• Send the blocks out over the network to be cross-checked and verified, and they will validate other  proposed blocks 
• Propagate approved blocks across the network and move on to the next block of transactions

Miners are the backbone of the Bitcoin network and are invested in the network in a way in which investment funds and Hodlers aren’t necessarily. As Bitcoin mining hardware has become highly specialized, and economies of scale have facilitated the advent of industrial Bitcoin mining in warehouses, professional miners have emerged, making major capital investments over long time horizons. This investment has led the Bitcoin mining industry to become a global, highly-competitive business.

ASIC Mining Rigs have 4+ year life cycles and can only be used to mine SHA-256 Protocols (almost entirely Bitcoin). Bitcoin mining facilities operate similarly and are typically restructured warehouses specially designed for cooling mining rigs. On average, it will take a miner 18 months to break even after deploying capital to mining rigs, facility buildout, and electricity expenses. To break even and realize a profit, miners must sell the BTC they mine, providing constant sell pressure on the bitcoin price. This sell pressure is especially acute in bear markets and times of distress. The mining industry is living through one of these periods as we speak. 

Proof of Work (PoW)

Mining is vital to the network security of Bitcoin. To eliminate the requirement for a trusted third party, Bitcoin must prohibit funds from being spent by an unauthorized user or an authorized user multiple times. Digital signatures, a 1970s cryptographic breakthrough, resolve the first problem. The pair of private and public keys offers a strong proof of control that allows only the owner of a private key to spend or transfer bitcoins. 

Source

However, digital signatures alone are insufficient to guarantee the recipients of a transaction that the bitcoins they have received have not been sent elsewhere. To provide this assurance, the network must devise a way to validate that the same person cannot spend the same BTC twice. This issue, known as the "double-spend problem," is resolved via PoW based on hash functions, initially conceived by Adam Back in 1997 to prevent email spam. Hash functions are discussed more in the following sections.

PoW enables transactions to be sorted into blocks and added to the chronological chain of blocks dating back to Bitcoin’s genesis block. Should conflicting transactions/blocks arise, the network of nodes reaches a consensus on the correct state by examining the chain with the most cumulative hashing power (“heaviest chain rule”). Because each new block contains a hash of all the older blocks that have existed, transactions are only reversible if a malevolent actor recomputes all previous PoW back to their attack point, as we will discuss later. Due to the network's continual production of new blocks, it is incredibly difficult for any actor ever to catch up.

Source: NYDIG Research

The Actual “Work” in PoW

Hash algorithms play a critical part in all cryptography, as well as in Bitcoin. Hashing any amount of data results in a fixed-length hash. Bitcoin and its PoW use the Secure Hash Algorithm, SHA-256, a mathematical function that takes an input of any size and produces a fixed-length output every time. Hash functions are critical private-public key cryptography and have several key characteristics:

• The input into a hash function cannot (realistically) be determined from the output i.e., it is a one-way function
• The same input into a hash function will always generate the same output
• The input can be any length, while the output is always the same length. Like all computer data, hashes are large numbers and usually written as hexadecimal.
• Any change to the input, no matter how trivial or minute, will change the output
• The output cannot be predicted. It must be guessed—or brute force calculated—by trial and error.

Source: Arcane

In the PoW Sybil-resistant scheme, Bitcoin miners must try and solve computationally-intense cryptographic puzzles. The mathematical problems can only be solved by “guess and test,” meaning there is no way to gain an edge over the competition other than increasing the number of guesses per second your computer/mining farm can facilitate. Every hash has the same probability of delivering the correct solution making the entire process similar to a lottery. 

To properly “solve” the puzzle and create a new block, a miner takes a set of pending transactions from the mempool and runs the data through a hashing function along with a number called a nonce. The "nonce" is simply a random value that miners adjust after each failed attempt. The goal is to discover the correct combination of transaction hash + nonce that is less than or equal to the current target of the network.

If the hash function's output is less than the target, a valid block is discovered, and the miner broadcasts it to the rest of the network. If not, the miner modifies the nonce and runs the identical data through the hash function again. 

There are several crucial takeaways from this procedure. First, because this is a high-speed guessing game involving random numbers, the probability that a miner will discover a legitimate block is proportional to its share of the network's hash rate. In Bitcoin mining, size matters, which is one of the reasons mining entities join so-called mining pools, which allow groups of miners to split the rewards of the lucky miner.

The winning miner with the correct nonce adds a new block of verified transactions to the blockchain. If there are more pending transactions than can fit into one block, the unconfirmed transactions wait in the Bitcoin mempool. After confirmation, the transactions form part of a block.

Mining explained.

Once miners have solved the puzzle and found the correct answer, they will send their work across the network to be checked by other miners. After all, the entire network must come to a consensus about whether or not this block (and the transactions inside) are indeed valid. 

The Proof of Work (PoW) model engrains real-world costs to the Bitcoin network, making spamming, attacking, or changing the network costly. The economic cost attached to the blocks (electricity, mining rigs, infrastructure, etc.) incentivizes miners to act honestly or else all their work and costs are for naught. PoW makes the Bitcoin blockchain a single, linear version of “truth” that users can trust will not be reversed while also issuing new bitcoins into the network in an unbiased and incorruptible manner. 

Would-be attackers who act maliciously have their blocks rejected (because they do not agree with the current shared global consensus) and lose out on the bitcoin reward. Not only that, but they also bear the cost associated with PoW mining, thus incurring the cost of electricity without compensation.

Why would miners run these huge computer farms just to solve a quirky puzzle? It’s because they get paid in bitcoin for every puzzle they solve that leads to the addition of the latest block to the blockchain. This reward is called a block reward. That’s how bitcoins are born.