Bitcoin Blockchain: Components, Mining, Inflation and Algo Trading – Part II


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Learn about Blockchain with Part I in this series.

Bitcoin Mining and Proof of Work

The Proof-of-Work (PoW) algorithm is designed so that one block is mined every 10 minutes. In order to ensure this time limit, the network sets a difficulty level for the puzzle.

The difficulty level is set by setting a target for the final hash of the block. In the case of Bitcoin, it means specifying the number of leading zeroes in the final hash of the block.

Now each node has the hash of the previous block and the current block of transactions. They need to calculate the nonce (a number used only once), which generates a hash with the given number of leading zeroes when combined with the above values.

Simplified Proof-of-Work diagram

When one leading zero is added to the target hash, the work is doubled, increasing the problem’s difficulty. The Bitcoin network automatically configures the problem so that it takes approximately ten minutes to mine each block.

The first miner who finds a valid nonce (golden nonce) is rewarded, and the nonce is broadcast to the network for validation. The block is added to the Bitcoin blockchain after verification.

Mining a block is computationally-expensive work, so sometimes a group of miners come together and form a mining pool to increase their chances of mining a block.

Transaction fee

When miners mine a block, they receive a reward. They also get transaction fees which is a sum of the transaction fees for all the transactions in the block. The transaction fees incentivize the miners to continue to process the transactions by mining blocks. Else they may not continue to mine the blocks due to the high mining costs.

It is not mandatory for miners to pick up the transactions on a first-come-first-serve basis in the Bitcoin network. So the miners are free to choose the transaction they want to add to a block.

A block can hold only a finite number of transactions- each block size has a soft limit of 1MB. A higher transaction fee will make the transaction more attractive for a miner. Hence, a higher transaction fee block is more likely to get mined and added to the blockchain sooner than one with a lower transaction fee.

Note that a transaction becomes valid only once it is added to the blockchain. You can think of it as a simple money transfer transaction that remains in the processing stage unless the bank confirms it.

Bitcoin transaction fees depend on the network traffic. If more people are using the blockchain, the number of transactions to be confirmed goes up, pushing the transaction fees higher.

Bitcoin transaction fees depend on the network traffic. If there are more people using the blockchain, the number of transactions to be confirmed goes up, pushing the transaction fees higher.

Bitcoin Average Transaction Fee – Source

Bitcoin and inflation

Nakamoto designed Bitcoin as a deflationary cryptocurrency. The logic behind this was that fiat currencies are in infinite supply as more and more money keeps getting added to the system by the central banks and governments, leading to a decrease in the value of money over time. This is inflation.

To counter this, Nakamoto capped the total number of Bitcoins that will be created at 21 million. So, like gold, Bitcoins supply will decrease over time and hence become scarcer, increasing their price.

After every 210,000 blocks are mined, the block reward is halved until it becomes nearly zero in 2140. It is currently 6.25 coins per block. As the block rewards continue to reduce, the transaction fees may be the primary incentive for miners.

Bitcoin Inflation vs Time – Source

Stay tuned for the next installment in which Udisha Alok will discuss trading Bitcoin using a crossover strategy.

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