What Is Bitcoin Mining? Why Should You Care?

by: Kurt Dew

Summary

The banks have awakened to the importance of cryptocurrencies.

They have spent billions.

But if they don’t include cryptocurrency miners, your account will be secured the old way.

Could these bank investments in cryptocurrencies without miners be a waste?

Or is there another plan?

I've got nothing but money, honey.

And I wanna spend it all on you.

- WILL.I.AM

One of several difficult-to-comprehend, yet important, aspects of cryptocurrencies is the role of mining and miners in the function of the primary cryptocurrencies - bitcoin and ethereum. Mining is the enabler of the original innovation, the distributed ledger that makes the bitcoin/blockchain/distributed ledger (BBDL) process interesting and potentially revolutionary.

What is the potential of BBDL? The possibility of an un-hackable, instantly-available, costless record of all the world's transactions, that may be doled out where appropriate - a means of exchange that lives in the cloud, not a bank. We will never reach this first ideal, but BBDL promises to set that course. Blowing up the banks is well within the possible, if the banks are not aware.

Understanding what mining does is the key to understanding which of the many BBDL startups will ultimately succeed. For example, mining explains my skepticism about the future of the various "permissioned" bank-sponsored versions of BBDL that do not include mining. Without mining, you have a cheap method of keeping your books and transferring funds internally. Not a bad thing, but not a revolution.

Mining bitcoin.

If I were responsible for the future of a major bank, or an owner of the stock, I would consider learning the economics of BBDL mining. Ditto if I had monetary policy responsibilities.

Why Cryptocurrencies Are Revolutionary

There is more than one motive for interest in the BBDL phenomenon. But to get my agenda up front, my interest is this. In BBDL lies the potential for two revolutions:

  1. BBDL has the potential to revolutionize ordinary transactions. It has the potential to reduce the cost of holding and using transaction balances to near-zero. This applies to any transaction. For example, there is no location to a BBDL transaction, so spending in Russia should take no more time or expense than spending in Japan - even if you are located in India. Clearing such transactions is done automatically when the trade is made in BBDL, making clearing redundant and eliminating T+3 day delays.
  2. BBDL has the potential to revolutionize record-keeping. The potential exists to provide corporate financial statements in real time, eliminating quarterly reports and any need for credit agencies. Ultimately, the entire accounting profession could be automated.

If these two events came to pass, there would be fewer bank branches. The process of clearing transactions and securities trades would be dramatically altered. It is interesting to speculate about how the process of tax collection would change. Also, how would monetary policy work?

I am among the few who believe the BBDL revolution would make governmental functions, like prevention of drug trafficking, tax collection, and monetary policy easier. This is not the impression that has been left by cryptocurrency history to date. The early use of bitcoin by illegal enterprises such as The Silk Road suggested that bitcoin facilitated illegal transactions, as do US $100 bills. And the cryptocurrencies may be used as a store of value themselves. Thus, cryptocurrencies, like gold, are an alternative to fiat money. But that is cryptocurrency's past, not its future.

The Role of BBDL Miners

BBDL is the sum of two innovations - the distributed ledger and the miner. Distributed ledgers, sometimes called blockchains, are basically a chain of spreadsheets. The first of these spreadsheets describes bitcoin ownership at the very beginning of each cryptocurrency.

Then from time-to-time, roughly once every ten minutes, another spreadsheet of new verified transactions is "validated" by the miners. Validation produces the ultimate spreadsheet, which describes the ownership of bitcoins right now. The individual spreadsheets that characterize bitcoin ownership at a particular point in time are called blocks. Hence, the collection of all these blocks, ordered by the time of verification, is a chain of blocks - a blockchain.

The distributed ledger, or blockchain, is meaningless without "verification." Verification is what miners do. It is no small feat. To "verify" a distributed ledger is to create a record of every block since the process began, including the most recent block. The verifying miner then submits this "proof of work" to the other miners to be confirmed. When a majority of the miners confirm its contents, the blockchain is updated with the newest block. The miner that provided the original proof of work is paid in new bitcoins.

The amount of computer power required to complete a new block is considerable. Generation of computer power is the cost of mining. Bitcoins are the revenues from mining.

But the economic function of mining is worthy of its considerable cost. The economic function of mining is minimization of any possibility of hacking Bitcoin. To "hack" a BBDL network is to gain control, however temporary, of the ability to create cryptocurrency. In other words, the true fiduciary game-changer of BBDL is the extreme difficulty of altering the ownership of bitcoins by a means other than the voluntary transfer of bitcoins from seller to buyer, or the award of bitcoins to miners for proof of work.

To hack, it is to necessary to gain control of the validation process. That requires the expenditure of computer power greater than that routinely expended by the miners in verification of a block. In other words, to successfully hack the bitcoin network, the hacker would need to verify an altered block without cooperation from other miners. And for this to remain successful, it would also be necessary to escape the attention of the other miners later. The cost would be enormous, and it grows over time and with the size of bitcoin's blocks. Suffice it to say, there are continuous attempts, and so far, no successes. Every day the possibility of hacking bitcoin becomes more remote with bitcoin's growth.

Thus, the function of the miners is to make bitcoin incredibly difficult to hack. What makes this socially - not just economically - significant is that trusting bitcoin security does not involve trusting miners. Miners do not seek to gain bitcoin user's trust. Their objective is the same as a hacker's - to make the largest possible profit from use of computer power. In other words, not only do miners make hacking difficult, they make it irrational.

How Many Cryptocurrencies Should There Be?

This question returns us directly to the economics of finance. There are two opposing economic forces at work driving the size of, and the number of, cryptocurrency networks like bitcoin. There are other cryptocurrencies, most notably the second by dollar value, ethereum. The desirability of competition suggests a need for many cryptocurrencies. The economies of scale created by the miners' provision of security suggest only one cryptocurrency is ideal.

So what matters more today, competition or security?

The second cryptocurrency, ethereum, exists for competitive reasons. Potentially, it is a superior cryptocurrency. The three differences between ethereum and bitcoin networks until a month ago were:

  1. Ethereum code has more capabilities. Ethereum is supposedly smarter. A description of this difference rapidly becomes technical. But the key difference is simple. Bitcoin is simpler and bitcoin's leadership is more experienced. Bitcoin's code is simple, but it has now been doing what it was designed to do for years. Ethereum's code is newer and more complicated. It can do more than bitcoin's code. But it is likely to need changes before it functions as intended.
  2. Ethereum is smaller in total value. It requires less computer power to hack it. It's less secure than bitcoin.
  3. Ethereum has not been associated with illegal enterprises to the extent bitcoin has. This makes it more acceptable to image-sensitive large corporations.

However, ethereum has experienced a life-threatening problem in the past month. And that experience has led me to conclude that for now, the world has room for only one cryptocurrency, bitcoin. Ethereum is experimental.

An over-ambitious project, known as The DAO (Distributed Autonomous Organization) was launched using the ethereum network. What made this launch problematic was that value in the tens of millions of dollars was placed in DAO's hands for investment purposes. And then it was "hacked" (in quotes because it is not yet clear what actually happened). What is clear is that something of great value within The DAO was transferred into a new account in a way that the DAO designers had not anticipated.

It is also clear that The DAO had no "plan B" when "plan A" failed, which immediately raises the question, was a crime committed by DAO itself? In a banker's mind, the phrase "breach of fiduciary responsibility" rises to the surface, unimpeded.

But in the aftermath, the whereabouts of the funds seems sufficiently obscure, and the rules of the game that was "The DAO" sufficiently unclear, that it seems fair to say that no one involved in the project was aware that they were leaving the world of code and entering the world of finance.

The whole event is, I believe, best described as the clash of two worlds - the world of code writers and the world of fiduciary managers. It is somewhat bizarre that before DAO accepted investor funds, the code writers of The DAO/ethereum community never consulted fiduciary managers. How was this possible, when the values at stake were in the tens of millions of dollars? There were certainly worldly wise people observing events.

The result seems clear. For now, the world has only one viable cryptocurrency, bitcoin. Ethereum needs to be put in "time out."

Who Are the Miners?

This article explains what miners do. It does not dig into the complex economics of the mining process. To make a rough beginning with the economics, the cost side of mining is relatively simple to describe. The computer power required has become the cost of the energy required to run the computers, as the cost of computers themselves becomes ever less. The cost of energy itself is driven by the miners' physical location.

For this reason, the miners seem to physically locate, for the most part, either in Iceland or China: Iceland, because of its essentially free thermal energy; China, because its energy production is so poorly planned that there are phenomena such as a Chinese hydroelectric power plant built by mistake, with no users other than the bitcoin miners. A secondary attraction of location in China is that the Chinese find investment in bitcoin appealing - no surprise if you follow the domestic Chinese stock market. Much of global buy-and-hold interest in bitcoin is by Chinese investors.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.