Crypto Dip-Toe – Part 5: Proof-of-Work

“I’m a great believer in luck, and I find that the harder I work, the more I have of it.” – Thomas Jefferson

In the last edition of Alt Blend, we broadly examined the landscape of digital currencies, and the plan for this current update was to start learning about how some prominent cryptocurrencies function. Coincidentally, there have recently been some substantial challenges within crypto markets over the past couple of weeks (at the time of writing), and I think we’re only one or two editions from really being able to grasp what’s going on. Thus, if you haven’t followed the news or it’s just too confusing, stay tuned, and we’ll get to all of it by early summer.

In parts 1 and 2 of this series, we covered the origins of Bitcoin (BTC), the crypto space in general, and why distributed ledger technology (DLT) and cryptography are so crucial to this movement. We then explored currency attributes in parts 3 and 4 to give context for where Bitcoin fits (or doesn’t fit) within the currency use-case discussion. Still, we haven’t learned how Bitcoin works in a more practical sense, and that’s what we’re now ready to dive into. Here we go!

What’s Mined is Yours

You’ve probably heard of bitcoin “mining” or “miners” in the press. Per Investopedia, “mining is the process of validating transactions and creating a new block on the blockchain.” It is conceptually straightforward: the node (computer) on the network that first solves an equation to create the next block in the blockchain is awarded a specific amount of Bitcoin. Kind of like mining for metals or materials, these nodes are doing work in hopes of being rewarded. The mining approach prevents blockchain domination while incentivizing people (and their sophisticated computers) to manage the Bitcoin blockchain process.

With Thomas Jefferson’s quote in mind, a node that can “work harder” (i.e., do computations more quickly) increases the probability it will win the next block; thus, more work => more luck. However, of vital importance is that a win is by no means guaranteed, so one player cannot control or manipulate the blockchain. One can venture down a rabbit hole of hashes and target hashes, trying to understand the hashing computations in more detail, but here’s my main takeaway: varying the difficulty of the mathematical function (aka “cryptocurrency difficulty”) helps to regulate the rate of block-creation.

737,049 Problems, but a BTC Ain’t One

At the time of writing, that’s how many blocks were in the Bitcoin blockchain, meaning that’s how many problems have been successfully solved so far (and here’s the real-time monitor for the most up-to-date number, if you’re interested). I envision the equation difficulty to be the blockchain throttle, as it can be used to keep the blockchain at a target pace of a block about every 10 minutes. It is adjusted every 2,016 blocks (or about every two weeks) to regulate newly added blocks, which, in turn, controls the rate at which Bitcoins are minted. The target pace aligns with the number of BTC awarded over time until reaching a total of 21 million in 2140. 

Halving Fun Yet?

If you’re a math whiz and realized that the above numbers don’t make any sense, that’s only because I left out an essential piece of information. The other critical factor in that “year-2140 timeline” is the concept of “halving,” where the number of BTC awarded per block gets cut in half about every four years. For example, it was 50 BTC/block back in 2009, but then dropped to 25 BTC/block in 2012, 12.5 BTC/block in 2016, and has been 6.25 BTC/block since 2020. Accounting for a new block every 10 minutes and combining it with the halving protocol leads to the 2140 target date for all BTC to ultimately be mined. Thus far, over 19 million BTC have been mined, which is over 90% of the total, but it’s going to take almost 120 years to mine the rest.

But why 21 million coins? Because that’s what Satoshi Nakamoto (see Part 1 if you need a refresher) decided when Bitcoin was created. Why would miners keep pouring resources into maintaining the blockchain once all 21 million BTC are mined? I had the same question. One reason is they could still earn income from transaction fees. Another possible explanation (and mere speculation of mine) is self-preservation: if miners own Bitcoin, they’ll probably want to ensure Bitcoin exists to protect their investment. But also, keep in mind that fewer miners (or less computing power) will mean easier equations, so there’s some ability for the network to compensate for reduced future mining interest. And how about some potentially negative scenarios? According to Investopedia, perhaps miner cartels or selfish mining (collusion for trying to increase processing fees) would be possible.

Show Your Work!

One thing we haven’t yet directly covered is “proof-of-work” (PoW), which sort of ties this all together but is not specific to Bitcoin. You can read more in-depth about it here, but here are some of (what I think are) the main ideas.

  • Proof-of-work was created back in 2004, by Hal Finney, as a “proposed solution to the growing problem of spam email” (and clearly, it didn’t succeed in that goal). However, it is a vital part of Bitcoin being made possible.
  • Finney received the first BTC transaction, so could he also be Satoshi Nakamoto (or part of the group that is Satoshi Nakamoto)? I have no idea. I’m just asking the question, as it sounds a bit (or really) suspicious.
  • Like showing your work on a test in school, proof of work is a mechanism for avoiding cheating. It’s at the root of cryptocurrency difficulty and why substantial computing power (aka “work”) must be expended to mine a block on the blockchain.
  • It essentially prevents gaming the system, is integral to validating transactions, and makes the security of DLTs possible. It also is a “method that makes it too resource-intensive to try and overtake the network.”
  • BUT, PoW is not the only way of accomplishing all the above objectives.

PoW Alts

Primarily because of the energy-intensive nature of PoW, other alternative methods are being developed for more efficiently securing and validating a blockchain. One of the most prominent is proof-of-stake (PoS). In that method, a cryptocurrency owner has to stake a specific number of tokens for eligibility in a selection process of who will validate/mine a transaction. Thus, it’s not a competition of leveraging computing power (or energy consumption) to increase the probability of winning a block, like with PoW. Instead, PoS miners are randomly selected. Also, if a cohort purchased a majority of tokens in an attempt to control a given network (known as a 51% attack), PoS should result in such bad actors losing all of their staked coins. And some fun facts to wrap this all up:

  • There have been successful 51% attacks on smaller networks (see the above link), but this is considered highly unlikely on larger networks like Bitcoin and Ethereum.
  • Ethereum is in the midst of a long-term project, converting from PoW to PoS methodology.
  • Some believe we could see a conversion of Bitcoin from PoW to PoS (or even another method) in the future.

Next Time

The next goal is to better understand Ethereum – the other very prominent player in cryptocurrency –and how it’s completely different from Bitcoin. And then we can move into Stablecoins.

Until next time, this is the end of alt.Blend.

Thanks for reading,

Steve

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About the Author

Steven Tresnan, CAIA®, CFP®

Private Wealth Advisor

Steve is a Certified Financial Planner as well as a Chartered Alternative Investment Analyst®. He is also an Accredited Investment Fiduciary, which helps him offer guidance to clients with fiduciary responsibilities, such as board members of trusts, foundations, and endowments. Steve earned a Bachelor of Science degree in Industrial Engineering from Penn State University.

Steve serves on the board and finance committee of New Music USA – a national nonprofit devoted to the development and appreciation of new music in the U.S. – and volunteers as the Treasurer for Campus Fun & Learn, a child development center on the campus of Rockland Community College in New York.