Crypto Mining Explained: What Is Crypto Mining and How Does It Work? | LiteFinance (2024)

Between 2019 and 2021, mining became such a popular phenomenon among crypto fans that it resulted in a multiple increase in the demand for GPUs (graphics processing units). Back then, many crypto enthusiasts wanted to own their own mining farm. By 2024, the hype for digital mining had decreased significantly. However, profitable mining is still possible, and the potential income from mining will exceed the cost of electricity. Although the gold rush has passed, issuing tokens can still be successful if done wisely.

From this review, you will learn how the blockchain is built, what Proof of Work is, and why every miner needs it. You will also know how transactions are processed, and new blocks of virtual currencies are confirmed. In addition, you will read about the main fear of all professional miners - increasing mining difficulty and what it can lead to.

Key Takeaways

Cryptocurrency mining is a technically complex process that requires large investments and constant maintenance. The payback of mining greatly depends on the exchange rate of the mined coins and the cost of the equipment.

What Crypto Mining Involves

In simple terms, cryptocurrency mining, including Bitcoin or any other coin operating on PoW consensus protocol, involves the following stages:

• the mining farm is involved in validating transactions and bundle transactions;

• the farm performs calculations;

• Having completed the calculation exercise, the miner gets the right to add a block to the blockchain chain;

• Bitcoin miners receive a reward for a freshly mined block and its inclusion in the chain.

Miners perform specialized computing operations and solve complex math puzzles to mint tokens. The first miner who finds a solution adds a new block to the blockchain and receives cryptocurrency as a reward. This algorithm is called Proof-of-Work or PoW.

The second most common consensus in blockchains is Proof-of-Stake (PoS). For this type of mining, low-power computing equipment is sufficient. The advantage of receiving rewards goes not to the one who quickly solves more problems but to the one who has staked the largest share of the blockchain coins. The most famous blockchain with a PoS consensus protocol is Ethereum.

In blockchains, regardless of the consensus mechanism, mining is necessary to confirm transactions, group transactions, and add them to the public ledger. That is, through the efforts of miners, the necessary permissions are provided for the cryptocurrency's functioning. This mechanism is used by Bitcoin and other popular altcoins like Ethereum Classic, Litecoin, and Monero.

The number of blocks depends on the total computing power of the mining equipment, which is usually measured by a universal indicator of performance, hash rate. The graphics processor, which is used for mining, plays a crucial role in the performance of mining farms. The higher the power of the mining installation, the higher the reward, that is, the extraction of tokens.

Not all cryptocurrencies can be mined. For example, the well-known Ripple works on the RPCA consensus protocol and does not provide for mining at all. Another famous example is the USDT or Tether token. It works on several blockchains at once: Ethereum, TRON, BNB, and others. It does not have its own consensus; it is printed or withdrawn from circulation centrally to ensure 1:1 parity with the USD.

Mining Process and Incentives

It is difficult for an inexperienced user to understand how something comes out of nothing, that is, digital financial values that can be exchanged for fiat money. It is completely unclear what network security has to do with mining farms. To understand the mining process, let's look at a few terms:

• A wallet is a unique pair of public and private keys, and wallet addresses are cryptographic hashes of public keys.

• The transaction is a record of the date, sender, recipient, and volume of an asset created when transferring funds from wallet to wallet. Transaction hashes are signed with the sender's private key and sent to all blockchain participants who are awaiting nonce confirmation. This is a 32-bit random number that miners are trying to figure out. Nonce ensures double spend prevention. Metaphorically, a blockchain is like a ledger in which all transactions are recorded. However, it is impossible to crack the code and read the records without the keys.

Before a transaction receives confirmation, it is stored in a transaction pool. The confirmation itself occurs when a new block is found. This is where cryptocurrency miners connect and receive distributed rewards for their work.

Let's look at the work of miners using the example of the progenitor of all cryptocurrencies, Bitcoin. All mining farms are combined into one common pool, which supports the operation of the entire blockchain. Each miner stores a copy of the blockchain, that is, a copy of the sequence of the entire chain of blocks. This means that mining farms provide protection against counterfeiting of a decentralized system.

Mining farms also confirm transactions by adding new blocks to the Bitcoin network. The first miner to find a block receives block rewards in the form of Satoshi. A crypto miner is to verify transactions registered in the network. That is, the blockchain network will not work without solving equations by mining farms and creating new blocks.

Methods of Mining Cryptocurrencies

Miners use several different methods to mine a digital currency based on blockchain technology:

• cloud computing;

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• ASIC miners;

• mining using mining farms with a pool of video cards;

• CPU chips mining;

• launch of master nodes.

You don't even need a mining farm to start receiving mining rewards for blocks and adding them to the blockchain. Calculations can be transferred to the computer equipment of a Data Center located thousands of kilometers away.

Cloud mining is convenient because the future miner does not need to immediately invest a lot of money to buy a mining farm, design cooling systems, maintain equipment, and try to increase profitability. Instead, you can rent a certain hash rate (hashes per second) or even ASIC miners, which are separate physical rigs.

Mining with the power of cloud services can be more profitable than a mining farm. Data centers incur lower energy costs and purchase components at supplier prices, significantly reducing operating costs. A crypto miner can access vast amounts of computing power, which can be used if the mining difficulty increases. There are no problems with outdated equipment. Most of the risks and possible losses are borne by the lessor, and your losses cannot exceed the cost of renting mining farms or ASICs in a data center.

ASIC mining – computing units for mining Bitcoin and its forks. Mining farms consisting of ASICs are productive. However, the disadvantage of such mining farms is that they are usually tailored to a separate algorithm. That is, it is an application-specific integrated circuit. For example, if a mining farm operates on the SHA-256 algorithm, then it produces cryptocurrencies like Bitcoin, Bitcoin Cash, Bitcoin SV, and about three dozen other digital currencies. It is difficult to reprogram such mining farms for other algorithms.

The next most popular method of mining Bitcoin and other cryptocurrencies is GPU mining. Mining farms based on GPUs have lower noise levels than ASICs, which is why they can be installed even in apartments. You can configure video cards for any algorithm and mine hundreds of cryptocurrencies.

CPU mining is efficient for a few cryptocurrencies. The most famous algorithm that uses CPU resources is RandomX. For example, the Monero blockchain, the XMR token, runs on it. To receive a significant reward for mining when working on this algorithm, a crypto miner will need a multi-processor mining rig built on a powerful server platform.

After the start of the Chia project in 2021, mining farms with an array of HDDs appeared. The Chia blockchain allows cryptocurrency miners to generate new blocks using hard drives. However, crypto miners have already forgotten about this project. Therefore, it is better to postpone the idea of ​​building a mining farm on a large HDD for now.

Based on the number of participants, a distinction is made between solo cryptocurrency mining and pools – associations of miners. Mining pools allow thousands of users to combine their computational resources with their own mining farms. A collective approach increases the chances of successfully adding blocks for new transactions, reducing the financial risk of each participant.

Launching a master node allows you to receive rewards in the form of commission at the miner level. These are master nodes with advanced powers, without which some networks will not work. For example, the DASH network is supported by master nodes. Running a master node is equated to mining virtual currency, although technically, this is not entirely true. For investors, master nodes offer good business opportunities.

Mining Hardware

Having discussed methods of mining cryptocurrency, let's move on to a technical issue. Which mining rig will be more effective for certain tasks?

ASICs are a solution for the pros. ASIC-based mining rigs are noisy and, therefore, completely unsuitable for home use. They have good energy efficiency and high hashing speed but sky-high prices and are tailored to specific algorithms. Also, with the increasing complexity of mathematical problems, ASIC mining farms quickly become outdated, and it will be difficult for an ordinary crypto miner to resell obsolete equipment.

GPUs are designed for moderate cryptocurrency mining and provide a good return on investment. Mining farms on server platforms with multiple video cards are productive and can be reconfigured for any algorithm.

When choosing equipment, pay attention to the ratio of hashing power and electricity consumption. Also, design good cooling to extend the hardware's life cycle. As mining difficulty increases, the equipment could be sold on the secondary market.

Mining Pools and Profitability Considerations

Let's take ten miners, each of whom owns a mining farm with a capacity of 1% of the total network power. At the same time, 280 blocks of cryptocurrency are mined per day. This means that each solo miner can mine about 14 blocks in a week. If these ten people pooled together, combining resources, the capacity of the network would be 10%. Such a pool will mine 28 blocks per day, 196 per week. That is, an average of 19.6 blocks will be mined per miner, which is 5.6 blocks more than with solo mining. The pooling of resources is relevant as the difficulty level increases.

Each pool is led by one or more coordinators who maintain the reliability of the system, ensure that miners do not waste power and electricity consumption decrypting the same blocks, and distribute rewards fairly.

Profitability factors for participation in the pool are the number of participants and the reward distribution model:

• PPS – miners receive a commission for each share, a valid attempt to solve the problem.

• FPPS – the reward is distributed upon completion of the search for a new cryptocurrency block. Commissions are also paid for conducting cryptocurrency transactions in the found block.

• PPLNS – proportional payouts depending on the miner’s contribution to the last N attempts to decrypt a block.

Mobile Phone and Personal Computer Mining

From a purely technical standpoint, mobile mining is possible, and several applications turn almost any smartphone into a mini mining rig. For registration, permanent or one-time numbers are purchased, and cryptocurrency is mined from 10, 20, or 100 phones at the same time.

However, the earnings of such a mining farm are questionable as smartphones are not resource intensive or energy efficient. The resistance of phones to high loads is also questionable. Owners of mining farms worry about GPU wear due to high temperatures; a smartphone is even more unable to work for a long time in conditions of constant overheating. Using phones for mining entails an increased impact on the environment due to the need to regularly replace batteries.

Pros and Cons of Cryptocurrency Mining

Let's take a closer look at the advantages and disadvantages of cryptocurrency mining.

Pros of Cryptocurrency Mining

Crypto mining is simply necessary. Most blockchain models are designed so that without the work of miners, it is impossible to maintain the network's security and functionality in general.

Mining farms are a source of income for the miners themselves. For crypto enthusiasts and investors, rewards are the main motivation to use the power of their equipment to find new blocks. However, in order to recoup the purchase of equipment and, after some time, receive net income from the mining farm, you will need to develop an investment plan that considers the long-term exchange rate forecast and the system's hash rate.

Cons of Cryptocurrency Mining

Buying a mining farm once does not guarantee the same profit in two or three years. Mining difficulty is constantly increasing. Equipment that just yesterday earned thousands of dollars a month will produce many times less after increasing difficulty. Therefore, crypto mining is an ongoing and carefully thought-out process of investing in equipment.

In many countries, profits from cryptocurrency mining are subject to taxes. This fact must also be considered in the investment strategy. Miners across the globe are also faced with a ban on cryptocurrency mining by the authorities and other risks that can bring significant losses.

Legality and Regulatory Uncertainty

China is the first in terms of cryptocurrency bans. In this country, you can’t open a mining farm and will face legal prohibitions on transactions for the exchange and sale of digital currencies.

Iran has also begun to seriously restrict crypto mining. Until recently, this country attracted mining farm owners in an effort to gain access to international trade. But there were so many miners that the energy sector could no longer cope with the increased load.

A similar situation has developed in cold Iceland. Initially, the government offered miners to mine digital “gold” using green energy from geothermal sources. However, due to the general rush, metallurgists began to run out of electricity. Therefore, the country has a ban on opening new mining farms. However, miners who are already working have not yet been expelled.

Regarding the legality of cryptocurrencies and mining, all countries are divided into:

• banned countries;

• countries with regulatory uncertainty;

• countries where the circulation of crypto is legal and taken under government control.

There is also Vietnam, where mining and crypto payments are prohibited by law, but money transmitters and crypto-mats operate freely.

Sustainability and the Future of Crypto Mining

The founder of EMCD, Michael Jerlis, believes that Bitcoin mining should not be expected to end in the foreseeable future. At the current rate, coin production will end in 2140. Miners should be constantly learning and adapting to changing conditions. It will allow them to receive stable profits even after decades.

The sustainability of Bitcoin is also insured against multiple increases in the number of miners and the capacity of mining farms. As production increases, the complexity of the network and calculations will increase proportionally. According to the expert, the difficulty redistribution mechanism is activated every two weeks. Also, the three past Bitcoin halvings were not the last in the cryptocurrency's history. This means that the next one will not be the end of Bitcoin.

Another industry expert, a financial analyst at the Currency crypto exchange Mikhail Karkhalev, also believes that crypto mining is unlikely to ever become unprofitable. If financial rewards and other kinds of incentives gradually fade away, then miners in the future:

• could charge additional transaction fees to speed up transactions;

• will implement mechanisms for re-mining lost bitcoins;

• will update the blockchain validation procedure;

• will make it more difficult to prove a share with increased commissions.

These ideas are relevant for Bitcoin and altcoins mined using the proof of work and proof of stake protocols. However, fossil fuels concerns and mining's environmental impact should not be ruled out. These concerns and competition among digital currencies put pressure on the regulator and provoke new bans on releasing coins.

The Bottom Line

Decentralized consensus allows the blockchain to function only with the activity of participants who continuously supplement the chain with new blocks. With their contribution, they replace centralized issuing centers, ensuring new coin release and blockchain validation.

The motivation of active miners is a financial reward for adding new blocks. Therefore, crypto mining has a general benefit in the form of network development and is personally beneficial for each miner.

At the same time, mining is no different from any other market or business activity but is associated with additional risks due to legal uncertainty and the high volatility of token prices that fluctuate up and down in a wide range. Every would-be miner should weigh the pros and cons very carefully before getting started. It may turn out that opening a real farm is not such a bad alternative to a mining one.

The content of this article reflects the author’s opinion and does not necessarily reflect the official position of LiteFinance. The material published on this page is provided for informational purposes only and should not be considered as the provision of investment advice for the purposes of Directive 2004/39/EC.