How Does Bitcoin Mining Work?

Helen Yang, CFA, February 18, 2022, Advisor Perspectives

My biggest problem with bitcoin was that I had a hard time understanding bitcoin mining. How do you mine something that doesn’t exist?

I studied electrical engineering in college and my track, semiconductors, had a rigorous physics curriculum in addition to the usual classes. After quantum mechanics, there were three more levels. With that kind of training, I never hesitated to sacrifice a few brain cells to get to the bottom of something. But nobody could give me an explanation that made complete sense until I chanced into a YouTube video two years ago, which I will summarize for you.

Blockchain is a de-centralized record keeping system. Every 10 minutes, transactions are packaged into a block, which is chained with earlier blocks (hence the term blockchain), and the person who does the packaging is rewarded with bitcoins for their work.

When blockchain was first introduced in 2008, the packager was rewarded 50 bitcoins for each block. Every four years in May, the reward was cut in half. So, in 2012, it was halved to 25 bitcoins per block. In 2016, it was halved again to 12.5 bitcoins per block. On May 11, 2020, it was halved yet again to 6.25 bitcoins per block, with the next one expected to happen in 2024.

Who gets to be a packager? You will have to prove your worthiness by solving a math problem³. This is not the Math Olympiad where advanced math skills and brain power win. Instead, it takes repeated random guesses using a computer, and whoever gets it first or closest will have the right to package the block. An analogy would be to guess a password; there are no smart ways to do it; you will just need to guess the combinations one by one to see which one works.

When more miners join the network, the level of difficulty of the math problem needs to increase to select only one winner. Using the analogy of guessing a password, you can adjust the level of difficulty by simply adjusting the number of digits in the password.

The process of bitcoin mining is an artificial hurdle to select a winner. It delivers zero real value while wasting a lot of computing power and electricity.

For the first four years, 50 coins were created every 10 minutes, so the total number of bitcoins released during the first four years was:

50 bitcoins * 6 times each hour * 24 hours in a day * 365 days in a year * 4 years = 10,512,000

Every four years, this number halves, and the total is:

10,512,000 * (1 + 0.5 + 0.25 + 0.125 + …) = 10,512,000 * 2 = 21,024,000

Since the first four-year period was not a full four years⁴, the actual total was slightly less than 21 million, out of which 19 million bitcoins have already been mined.

This is not to say that people can’t have some fun with bitcoin as pure speculation. Buying bitcoin seems less foolish than buying lottery tickets, not to mention that being foolish can be a blessing sometimes.

As an entrepreneur, I can’t be more grateful for the foolishness of my friends who invested in my company when we had not much more than a set of ideas and mockups.

If the client is so inclined, it is fine to allocate a small percentage of their assets to a sandbox, where they can invest (play) in bitcoins, options, or anything they fancy, knowing that they could lose everything in the sandbox without jeopardizing their financial goals.

But if clients come to your office with a risk tolerance score in the 50s or even the 70s, you might make them aware that their bitcoin holdings are going to expose them to portfolio risks a few standard deviations off the far end of the spectrum.

Helen Yang, CFA, is the founder and CEO of Andes Risk, a Lexington, MA-based provider of technology solutions for financial advisors.

This article was originally published by Advisor Perspectives.