The core activity that provides the basis for the Bitcoin economy is the production of coins. Bitcoins are produced through a process that emulates real world mining in principle. Bitcoin mining has been simplified for everyone to be able to understand and enter the market. However it takes some research and learning to master the topic. With the wealth of information available online, it is important to structure the information and use brick and mortar examples to internalize the mechanics of Bitcoin.
First of all, it is important to understand that Bitcoin resembles other commodities. As much as it is logical to infer that most of the people who use oil or its derivatives around the world, don’t extract it from the earth, it is safe to assume that most Bitcoin users don’t produce or mine Bitcoin. In fact, mining Bitcoins may not be profitable for most Bitcoin users, just like drilling for oil is mostly an endeavor that will be profitable for a reduced number of institutions and individuals. Therefore most Bitcoins are sold through exchanges and peer to peer systems for wider public use.
Much like the extraction of oil, determining whether it is economically viable for the individual to mine or not is a function of how much the initial investment will cost, how much energy will that miner spend over how much time, and how much are Bitcoins worth or will be worth at some given point in the future. Bitcoin calculators allow the individuals and the institutions to understand the amount of money they will earn by mining Bitcoin depending on some of these variables.
The fact that all these costs were factored into Bitcoin mining, shows how Satoshi Nakamoto translated the logic of natural resource extraction to make it part of the online world. Nakamoto went even a step further and determined exactly how scarce Bitcoin will be – once the 21 millionth Bitcoin is mined, the resource will be exhausted and the economy will be left with a fixed amount of coins henceforth. Additionally, Bitcoins become increasingly difficult to mine as more of them are mined and more miners enter the market, just like oil.
To make sure that Bitcoin will behave exactly like a scarce resource that is difficult to extract, the mining system works by having computers solve complex mathematical problems. When a computer or several computers solve one of these mathematical problems correctly, they uncover a block. A block serves as a record of transactions. Each new block has a record of what took place during the minutes before it was created, as well as a reference to the block that came before it. The barrier of entry into mining is the energy (electricity) and computing power needed to solve these mathematical problems, uncover a block and get credited with the coins in it. Since the system will automatically halve the amount of Bitcoins per block once a certain number of blocks have been mined, and it will slow down the rate of block mining to computer power as well, the Bitcoin reward for the mining efforts will decrease periodically. This decrease will be steeper once more miners join the mining effort.
Since mining Bitcoins becomes progressively more difficult, so has the mining scale increased, just like with other minerals on earth. This in turn increases the scarcity rate, and serves to make small scale mining even less rewarding. This means that to enter the Bitcoin market at this point, it is probably more profitable to buy Bitcoins and not to mine them, especially if you are going to mine at a small scale. Large scale miners, have set up mining ‘farms’ with considerable amounts of computing power dedicated to mining Bitcoins. This is an expensive endeavor and the electricity costs might be quite high. Just like with oil, mining Bitcoins depends on certain geographic advantages. If an individual is in a country in which electricity costs are relatively low, land is relatively cheap, and internet connections are good enough, then it might be a sound investment to set up a Bitcoin operation. Any such investment should be carefully considered under any circumstance.
Just like investments in any other commodity, at any point from production to the final use, volatility tends to be high. Bitcoin is not the exception. Going back to oil for example, investment in exploration and extraction are made with a given price target for each barrel of oil in mind. Changes in the price of oil while the extraction operation is being set up and until it starts working, can seriously affect the return on investment. In the case of Bitcoin it is the same, especially given that delivery times for coin mining hardware are not necessarily short.
These barriers to entry have driven many Bitcoin enthusiasts to search for different ways to participate in the mining process. Some have pulled their mining resources together in ‘mining pools’. These pools pay each of the members a proportional amount of Bitcoins to their ‘mining efforts’. Another option is to buy into large scale mining operations with instruments like cloud mining. Companies that offer such services generally sign individuals to yearly contracts in which they transfer a fixed amount of money to these companies every month. In return the cloud mining company should compensate the investor with a given number of Bitcoins.
Cloud mining operations should be taken with a lot of caution. Many scammers have taken advantage of investors.
The following are some of the risks involved in cloud mining:
- Cloud miners can withhold Bitcoin payments if Bitcoin price is deemed unfavorable
- It is very difficult to verify these Bitcoin mining operations
- Profits might be lower since the mining company will capture a part of the profit
Another variable to keep in mind regarding Bitcoin mining, is the degree at which the coin can be substituted. If Bitcoin can be substituted relatively easily, its future price could be negatively impacted, much like oil price can be affected by the advent of alternative energy sources.
Bitcoin can be seen as a ‘virtual’ commodity, despite the fact that it is used as a currency. Bitcoin production mimics mineral/industrial metal mining or oil extraction in the brick and mortar world, which means there are barriers to entry at the production level. Individuals are probably better off by entering the world of Bitcoin through financial transactions rather than mining, especially given that Bitcoin can be used as a currency. Products and services that can be purchased with Bitcoin are growing, making the demand for the currency more dynamic, while mining gets progressively more difficult. Eventually Bitcoin reserves will be depleted, and a fixed amount of coins will remain in circulation, just like other commodities. Before you attempt to enter any kind of Bitcoin mining operation, keep in mind all the variables and draw an appropriate business plan, unless you plan to mine for leisure.
Disclaimer: This article is intended for purely informational purposes. This article does not attempt to provide investment advice. The reader is solely responsible for any investment done on the basis of the information provided above.