Bitcoin has grown from a hobby project to a multi-billion dollar alternative asset class over the past decade. While most people are familiar with the concept of a digital currency, the inner workings of cryptocurrencies remain a mystery the non-tech savvy. The concept of 'mining' a cryptocurrency is an especially difficult concept for many to grasp.
Let's take a look at how cryptocurrency mining works under the surface and how it has evolved in recent years.
How Cryptocurrencies Work
Bitcoin and other cryptocurrencies provide a medium of exchange that leverages cryptography to record transactions. In particular, blockchain technology makes cryptocurrencies decentralized, transparent and immutable by nature. There is no central authority that controls money flow and transactions occur without financial intermediaries.
Suppose that Alice wants to send one Bitcoin to Bob. While the process seems relatively straightforward, there are several different steps that must take place to prevent fraud and securely add the transaction to the blockchain. These steps may differ somewhat between cryptocurrencies, but the basic process applies to all blockchain-based technologies.
- Alice announces the transaction to a local node that has a current copy of the entire blockchain.
- The node verifies that Alice isn't double-spending by sending the same coin to multiple people.
- If the transaction checks out, the node broadcasts it across the entire Bitcoin network (although it remains unverified).
- Miners aggregate these transactions into blocks every ten minutes by competing to complete an algorithm.
- The first miner to solve a block receives a Bitcoin as a reward and the new block is added to the blockchain.
The biggest differences between cryptocurrencies is how transactions are added to the blockchain. While Bitcoin uses miners, other cryptocurrencies use trusted parties (e.g. large banks), unique incentives (e.g. fines) or other techniques to ensure transactions are valid. It's important to understand these differences before investing in a cryptocurrency.
How Mining Works
Cryptocurrency mining involves completing what's known as a proof-of-work problem in cryptography.
The best way to conceptualize this is to think of a game of dice where you must roll two dice that add up to less than a certain number. While rolling below 12 is incredibly easy, the game becomes much more difficult if the number is three. The former means rolling anything but double sixes, while the latter means that you can only roll snake eyes.
In order to understand how this applies to cryptocurrencies, let's suppose that you want to add the word "hello" to a blockchain using a proof-of-work algorithm.
A proof-of-work algorithm might require you to find the lowest number that can be added to the end of the word "hello" that generates a hash beginning with four zeros and below a certain size. Hashes are generated using one-way hash functions, such as SHA-256, which means that they cannot be reverse-engineered to calculate the number — it's all trial-and-error.
The actual Bitcoin operates in a similar fashion, except it varies the target number (e.g. the number of zeros) to adjust the difficulty and control the rate of block generation. The addition of more zeros to the beginning of the block makes the problem exponentially more difficult to solve, and eventually, there are no more possible solutions.
Evolution of Mining
Bitcoin mining began with conventional CPUs capable of performing calculations. Since early calculations were easy, it was possible to generate cryptocurrency with little processing power. Faster CPUs helped increase the rate of problem solving, but there were limits to how quickly computing power was growing over time (e.g. the number of transistors).
Graphic processing units, or GPUs, were introduced to meet the demands of video games requiring complex rendering calculations on the fly. Rather than increasing the speed of each calculation, these chips focused on making calculations in parallel to improve throughput. These same principles translated to much faster crypto mining.
More recently, GPUs have been replaced by Application Specific Integrated Circuits, or ASICs, that are specifically designed to make cryptocurrency mining calculations. These devices are often located in thermally-regulated data centers with access to low-cost electricity. In other words, they are uniquely designed for efficiency crypto mining purposes.
New cryptocurrencies are abandoning mining altogether and moving to a proof-of-stake model. Rather than requiring massive computational power, these cryptocurrencies leverage unique incentive structures to ensure trust and process transactions with minimal time and power requirements. The goal is to make cryptocurrencies more sustainable long-term.
Mining as a Business
Cryptocurrency mining has evolved from a crypto enthusiast hobby to a multi-billion dollar business. As Bitcoin and other cryptocurrency prices have risen, miners have invested millions in cutting-edge hardware, server farms and other technologies designed to increase computing power and lower energy costs. It's nearly impossible for small hobbyists to compete.
In most cases, mining pools are the only option left for small cryptocurrency miners. These pools make it easy to contribute modest computing power to a larger cause and receive a fractional payout when mining is successful. Contrary to crypto's original goals, these dynamics have put more power in the hands of relatively few mining groups.
Cryptocurrency miners must also pay ordinary income tax on the fair value of any cryptocurrencies that they mine at the time that they receive it — even if it's not sold. If these cryptocurrencies appreciate in value, miners must pay short or long-term capital gains tax on these gains. The good news is that hardware and energy costs can be a tax write-off.
ZenLedger makes it easy to track cryptocurrency gains and losses for miners, consumers, traders and investors. By aggregating transaction data across exchanges and wallets, we make it easy to pre-fill popular IRS forms, like Form 1040 Schedule D and Form 8949. You can provide these forms to your accountant to reduce tax prep costs and ensure a paper trail.
Sign up for ZenLedger today and see how easy it is to stay on top of your cryptocurrency taxes.
The Bottom Line
Cryptocurrencies have become tremendously popular over the past decade, and along with the trend, mining has grown from a niche hobby to a multi-billion dollar business.
If you're involved with cryptocurrency mining or investing, ZenLedger can help aggregate your transactions to ensure that your records are accurate during tax season.