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Deep dive into what crypto coin mining is and why it matters

Date: 2022-09-28

Mining is a concept very commonly seen in the Crypto industry but very poorly understood

crypto coin mining

Photo by Bastian Riccardi on Unsplash

And here we are.

Answering a question that sits at the very foundation of Crypto technology, a trillion dollar asset class, but it's still probably a top-3 on most misunderstood concepts, which goes to prove how poorly research the space is today.

Mining is a concept very commonly seen in the Crypto industry.

At the same time, as mentioned, it is one of the most misunderstood, as it is rarely addressed.

In fact, the majority of society intrinsically relates Crypto to mining, which is a bare-faced lie.

Actually, the majority of existing blockchains aren't even mining blockchains, but staking blockchains.

Understanding crucial concepts like these can make all the difference for you when it comes to making wise investment decisions in such a volatile, high-risk/high-reward space.

What is cryptocurrency mining and why does it matter so much?

But before answering that question, we must take a trip through context lane to understand the basics.

What is a blockchain?

A blockchain, in very simple terms, is a distributed database; a database with no central entity to define what is stored and what not.

No buzzwords, no complex definitions, it's as simple as that, at least at its core.

Is that all to it? Why is everyone making a fuss of simple so simple?

Actually, is a little more complex than that. The complexity of blockchain technology resides in two elements:

  • How these distributed databases agree on a particular state (version)
  • How people and entities get to participate in the blockchain

How these distributed databases agree on a particular state

Making the blockchain truly distributed means, as described before, that no central authority is in charge of making decisions.

Consequently, all participating nodes of the blockchain need to agree on what is the latest version of the ledger.

But how do they do this?

All nodes, when deciding to participate as part of the maintenance team of the ledger, download the entire history of transactions (stored information) of that particular blockchain.

Thus, all stored data needs to be public to all the network.

Then, we need to take into consideration another really relevant feature of blockchains: they are deterministic. That is, if all nodes execute the same sequence of operations, they arrive at the same result.

This is the only way nodes can agree about the latest state of the transactions in the network.

Without this consensus mechanism, blockchains are completely unreliable as data storage systems.

Thanks to this capacity, they become the ultimate traceable, trustless - the capacity to guarantee the approved state of the blockchain is valid without the intervention of central entities - system.

Adding the distributed nature of blockchains to the recipe (no single point of failure) we have the ultimate data security and privacy system.

A system that has the security features to become the infrastructure of all future digital systems.

This is all great, right? But how do we get people and entities to participate?

How people and entities get to participate in the blockchain

We have a technology that works on automatic and secures our data and makes it immutable, the ultimate source of truth. However, there's a problem. Someone has to maintain the network.

How do we incentivize people to actively participate and consume private resources to sustain the blockchain's operations?

This is where the concept of a digital crypto coin appears.

To reward participating nodes the blockchain rewards them with money. But not ordinary fiat money like euros or dollars, digital blockchain-based money known as a cryptocurrency.

Therefore, the "raison d'être" of cryptocurrencies, another of Crypto's most misunderstood concepts, is to incentivize the adoption and the participation of nodes in a blockchain.

We're making progress!

We now understand what a blockchain is in simple terms, and we also understand how we incentivize the usage of the network.

Thus, we just need to define how to participate in the network.

It can be done one of two ways. Well, actually, there are many other options, but the status quo tells us that 99% of blockchains use one of two options:

  • Proof-of-Work
  • Proof-of-Stake

And, surprise surprise, only one of them requires mining.

The paradigm of participation

How do we incentivize participation?

Blockchains need systems that incentivize honest participation (by punishing bad behavior) while remaining sufficiently attractive and with a low barrier of entry to lure more and more people into participating in it, thereby creating truly decentralized systems.

As you may imagine, this isn't a simple thing to do. In fact, it's one of the most common disputes inside the Crypto space.

Which mechanism is the best to rule the participation of nodes in a distributed network?

Of course, not only you must foster adoption, but you also have to take into consideration external factors that also matter.

Macro-external factors like ESG, geopolitics and many others considerably affect everything, including blockchain technology adoption.

Nevertheless, one of these external factors, the leading school of thought known as ESG, has caused the biggest transition in the history of Crypto, as Ethereum migrated from Proof-of-Work to Proof-of-Stake, thereby completely changing the underlying 'rules of the game' to participate in that blockchain.

Consequently, what are Proof-of-Stake and Proof-of-Work, and why does choosing one or the other matter so much?

Proof-of-Work blockchains; the mining blockchains

As mentioned before, we incentivize participation in a blockchain with the native cryptocurrency of that blockchain.

crypto coin mining

Photo by Olya Kobruseva:

More specifically, we reward the node that introduces the next block - group - of information to the blockchain.

For instance, as of today, Bitcoin node participants, known as miners, receive 6.25 Bitcoins, more than 130,000 dollars at September 2022 Bitcoin price.

And how does a node earn the right to introduce the next block?

Here is where the concept of Proof-of-Work (PoW) comes in. To better understand the concept we are going to use Bitcoin, a PoW blockchain, as example.

To decide which node - we might as well call it miner at this point - gets to introduce the next block of transactions, they all participating in a mathematical game.

The game consists of finding a number that, when hashed, results in a number below a threshold limit.

But what is the concept of hashing?

All data in blockchains is hashed. What this means is that all data gets mathematically transformed, by means of a hashing function, to a number that is complete gibberish, in an irreversible process.

What this means is that you can't obtain the original value from its hashed value, and each number generates a unique hash, and the same hash value is obtained from that number always.

Hashing is a critical concept in blockchains as it helps to rapidly detect tampering, as any modification of data is quickly detected as the resulting hash of not only the transaction, but the whole block containing it, will change.

Additionally, as described, this concept is also used as part of deciding who gets to introduce the next block.

The first miner to find this value gets rewarded with introducing the next block.

However, solving this game takes considerable effort from miners, resulting in competition between miners. Hence, miners will use very advanced GPUs known as ASIC miners, which essentially guess numbers until they find the value required.

And here resides the problem.

To execute such a huge number of guesses in such a short amount of time, this hardware consumes insane amounts of energy. For example, Bitcoin has consumed in its peak more energy than entire countries such as Denmark or Austria.

It's that big of an issue if the sources aren't renewable.

If that's the case, this implies huge emissions of greenhouse gases to the atmosphere, a huge NO-NO nowadays considering climate change.

However, not everything is bad when it comes to mining. Due to the highly competitive industry mining has become, it's quite easy for mining hubs to become unprofitable.

What do you think happens when this happens?

Easy, they simply switch off the hub. But why is this important?

It happens that mining hubs are excellent demand response systems, systems used to manage and control energy consumption in renewable-based energy grids.

But why do we need that?

Simple. Because renewable is great, but it sucks in one aspect, it's completely unpredictable (especially wind and solar). Considering our energy sources are considerable skewing toward renewable energy, the need for proper demand systems is just necessary.

In fact, in Texas, mining hubs are already being used as demand response systems when electricity sources aren't enough.

Talking about justifying their consumption.

Proof-of-Stake blockchains; the staking blockchains

We then arrive to Proof-of-Stake blockchains, a complete change in how nodes participate in a blockchain.

In this mechanism, nodes stake their cryptocurrencies to have the chance to participate and earn rewards.

So what's the difference?

Instead of competing for rewards by solving mathematical guessing competitions by consuming a lot of energy, nodes get chosen by weighted probability proportional to their staking.

In other words, the more crypto coins you stake, the higher the chances you get chosen.

Some argue that this causes centralization among the rich, which have higher stakes so they get chosen more. This, in fact, is true as of right now, with Coinbase and Lido introducing around 40% of new blocks on Ethereum after The Merge, for instance.

However, there is a way to solve this, with Proposer/Builder Separation. This method separates block builders and block proposers into two different entities, reducing requirements ane the power actual stakers have with regards to the chain.

Another fact that improves decentralization is the barrier of entry. With Proof-of-Work, as described, you need considerable investment in hardware to be able to mine blocks.

In Proof-of-Stake blockchains you have liquidity pools that enable you to participate in the network with any stake you have.

Take-away points for you with regards to mining

By this point in the article, you should be fairly aware of what mining really is, and how to differentiate those blockchains that do make use of mining and those that don't.

The main conclusions are:

  • The energy consumption negative narrative for Crypto only stands true with Proof-of-Work blockchains like Bitcoin.
  • Although PoW blockchains do consume a lot of energy, they are progressively moving into renewable sources, rendering the emission discussion obsolete
  • Also, mining can be used as demand response systems, and it is already being used in Texas as a practical example
  • The majority of new blockchains choose Proof-of-Stake due to this ESG narrative, although PoS have another issues especially concerning growing centralization. This will be solved with PBS (Proposer/Builder Separation)

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