How Bitcoin Mining Pools Work

What Is Bitcoin Mining?

Bitcoin Mining is the process by which new Bitcoin blocks are added to the blockchain. Bitcoin mining is a costly, energy intensive process due to Bitcoin’s Proof-of-Work requirement and the difficulty adjustment. As more miners join the network, and as mining technology becomes more efficient, the work required to mine a block increases, ensuring that blocks are produced every ten minutes on average.

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To compensate miners for the large costs of mining, miners are awarded new bitcoin each time they produce a block. Additionally, miners receive the sum of all transaction fees in the block they mined. This is how miners produce revenue and pay their energy and equipment costs.

Challenges of Bitcoin Mining

Bitcoin mining is a fiercely competitive industry, and profitability is hard to maintain. Factors such as geography, energy costs, weather, and political jurisdiction can all harm or benefit Bitcoin miners.

The Difficulty Adjustment

Bitcoin’s mining mechanism was intentionally designed to continuously drive the profitability of mining towards zero. If mining is profitable, more miners will join the network, causing the difficulty to rise, reducing profits for miners.

Miners who wish to make a profit must constantly innovate or find cheaper energy sources in order to preserve or increase profitability. Indeed, the industry has innovated at an extraordinary pace, and the Bitcoin mining industry is pushing technological limits in order to further increase efficiency.

Random and Unpredictable Revenue

Bitcoin miners are only rewarded when they find a block. Bitcoin’s Proof-of-Work mechanism is based on the SHA-256 hash function and is random. Because of this, miners can mine for long periods of time with no guarantee that they will find a block, or that they are any closer to finding one. This makes it impossible for individual miners to predict when they will find a new block and produce revenue.

For large mining companies, this is a slight inconvenience, and is overcome by the size of their operation. Large mining companies can maintain relatively smooth revenue, and their reserved capital can compensate for unexpected drops in revenue.

However, small, independent Bitcoin miners are exposed to extremely uneven and uncertain revenue. An individual miner may go months without finding a block, and thus receive zero revenue. If they do find a block though, the payout would be extraordinary, but maintaining a small operation with high costs and zero revenue for months at a time is extremely difficult.

In order to help smaller miners smooth out their revenue, miners can aggregate their resources and distribute the rewards they receive. This is the idea behind mining pools.

What Are Bitcoin Mining Pools?

Bitcoin mining pools are networks of distributed Bitcoin miners who cooperate to mine blocks together and distribute the payments based on each entity’s contribution to the pool. This allows miners to smooth out their revenue at the cost of a fee paid to the pool coordinator.

Contribution to a mining pool is measured in terms of hash rate, which is a measure of the number of hashes or attempts to find a new block per second.

The role of the pool coordinator is to ensure that participants in the pool are not overlapping in their efforts, and are always generating different hashes to maximize the chances of their pool finding a block.

Whenever any miner in the pool finds a block, they pay the block reward to the mining pool coordinator. After taking a small fee, the coordinator pays each member of the pool based on their hash rate contribution.

For a small miner who has impossibly low chances of finding a block on their own, joining a mining pool will provide a steady stream of revenue. This revenue will be proportional with the miner’s size, so it will still be small, but the consistency of revenue helps the miner continue to cover operating costs and profit.

Why Do Mining Pools Exist?

Mining pools exist because as an industry, Bitcoin mining has inherent economies of scale. However, energy, and cheap energy in particular, is geographically distributed, meaning that mining takes place across the globe. Thus, mining operations have an incentive to operate in different physical locations but cooperatively share hash rate and block rewards.

Bitcoin Mining Economies of Scale

One of the most significant economies of scale in Bitcoin mining is the consistency of revenue ensured by larger operations. With more certain revenue streams, larger operations are less risky ventures.

Bitcoin miners produce large amounts of heat during operation and thus require sophisticated cooling systems to maximize their efficiency and longevity. Larger operations achieve economies of scale with regards to cooling, machine maintenance, and other operating costs.

Renting large spaces, such as warehouses or shipping containers, and negotiating large purchases of energy from utility companies also yield economies of scale. Individual miners are usually not in a position to negotiate directly with utility companies, but larger operations can secure discounted energy rates by guaranteeing consistent and large volumes.

Geographic Energy Distribution

Bitcoin mining can be accomplished with any form of electric energy. Oil, natural gas, nuclear power, wind, hydroelectric, or even geothermal can power Bitcoin mining. With this in mind, sources of energy are dispersed across the globe in varying amounts.

Additionally, each energy source has a different cost associated with its extraction and conversion to electricity. For example, Saudi Arabian oil is extremely cheap to extract and use, while Venezuelan, Canadian, and American oil are, to varying degrees, more expensive. The same dynamic exists with all energy sources across the globe.

As Bitcoin miners face slim profit margins, they are forced to find the cheapest sources of energy in order to remain profitable. This is why Bitcoin mining takes advantage of geothermal energy in Iceland, excess energy in Germany produced by government subsidies, stranded oil in the Permian Basin in Texas, and hydroelectric energy during the rainy season in China.

The Benefits of Bitcoin Mining Pools

The existence of Bitcoin mining pools allows individuals and smaller entities to mine profitably and enjoy reliable revenue. This prevents Bitcoin mining from being solely controlled by massive corporations, and preserves Bitcoin decentralization.

Mining pools themselves might be considered a centralizing force, but since they are composed of many decentralized entities, they are much harder to coerce, and they must constantly compete to offer their members higher profits than other mining pools. If a mining pool acts in bad faith, charges high fees, or starts censoring transactions and thus missing out on profit, members can easily join a different pool with better practices.

Nonetheless, efforts are being made to ensure decentralization of mining pools. Stratum v2 is one such example. This new mining pool protocol places more control in the hands of mining pool members, rather than the coordinator, and thus decentralizes control over which transactions are included in blocks.