Mining Explained: A Detailed Guide on How Cryptocurrency Mining Works

Mining Explained: A Detailed Guide on How Cryptocurrency Mining Works

At its peak, cryptocurrency mining was an arms race that led to increased demand for graphics processing units (GPUs). In fact, Advanced Micro Devices, a GPU manufacturer, posted impressive financial results as demand for the company’s stock skyrocketed and shares traded at their highest level in a decade.

Despite the increased demand for GPUs, the crypto mining gold rush quickly came to an end, as the difficulty of mining top cryptocurrencies like Bitcoin increased just as quickly.

Mining cryptocurrencies, however, can still be profitable. So, what is crypto mining, is it legal, and how can you get started?   This article takes a closer look at these questions.

For more information and topics, visit  Freeman Law’s Blockchain and Cryptocurrency Resource Page.

What Is Crypto Mining?

Most people think of crypto mining simply as a way of creating new coins. Crypto mining, however, also involves validating cryptocurrency transactions on a blockchain network and adding them to a distributed ledger.  Most importantly, crypto mining prevents the double-spending of digital currency on a distributed network.

Like physical currencies, when one member spends cryptocurrency, the digital ledger must be updated by debiting one account and crediting the other. However, the challenge of a digital currency is that digital platforms are easily manipulated. Bitcoin’s distributed ledger, therefore, only allows verified miners to update transactions on the digital ledger. This gives miners the extra responsibility of securing the network from double-spending.

Meanwhile, new coins are generated to reward miners for their work in securing the network. Since distributed ledgers lack a centralized authority, the mining process is crucial for validating transactions. Miners are, therefore, incentivized to secure the network by participating in the transaction validation process that increases their chances of winning newly minted coins.

In order to ensure that only verified crypto miners can mine and validate transactions, a proof-of-work (PoW) consensus protocol has been put into place. PoW also secures the network from any external attacks.

Proof-of-Work

Crypto mining is somewhat similar to mining precious metals. While miners of precious metals will unearth gold, silver, or diamonds, crypto miners will trigger the release of new coins into circulation. For miners to be rewarded with new coins, they need to deploy machines that solve complex mathematical equations in the form of cryptographic hashes. A hash is a truncated digital signature of a chunk of data. Hashes are generated to secure data transferred on a public network. Miners compete with their peers to zero in on a hash value generated by a crypto coin transaction, and the first miner to crack the code gets to add the block to the ledger and receive the reward.

Each block uses a hash function to refer to the previous block, forming an unbroken chain of blocks that leads back to the first block. For this reason, peers on the network can easily verify whether certain blocks are valid and whether the miners who validated each block properly solved the hash to receive the reward.

Over time, as miners deploy more advanced machines to solve PoW, the difficulty of equations on the network increases. At the same time, competition among miners rises, increasing the scarcity of cryptocurrency as a result.

How to Start Mining Cryptocurrencies

Mining cryptocurrencies requires computers with special software specifically designed to solve complicated, cryptographic mathematic equations. In the technology’s early days, cryptocurrencies like Bitcoin could be mined with a simple CPU chip on a home computer. Over the years, however, CPU chips have become impractical for mining most cryptocurrencies due to the increasing difficulty levels.

Today, mining cryptocurrencies requires a specialized GPU or an application-specific integrated circuit (ASIC) miner. In addition, the GPUs in the mining rig must be connected to a reliable internet connection at all times. Each crypto miner is also required to be a member of an online crypto mining pool as well.

Different Methods of Mining Cryptocurrencies

Different methods of mining cryptocurrencies require different amounts of time. In the technology’s early days, for example, CPU mining was the go-to option for most miners. However, many find CPU mining to be too slow and impractical today because it takes months to accrue even a small amount of profit, given the high electrical and cooling costs and increased difficulty across the board.

GPU mining is another method of mining cryptocurrencies. It maximizes computational power by bringing together a set of GPUs under one mining rig. For GPU mining, a motherboard and cooling system is required for the rig.

Similarly, ASIC mining is yet another method of mining cryptocurrencies. Unlike GPU miners, ASIC miners are specifically designed to mine cryptocurrencies, so they produce more cryptocurrency units than GPUs. However, they are expensive, meaning that, as mining difficulty increases, they quickly become obsolete.

Given the ever-increasing costs of GPU  and ASIC mining, cloud mining is becoming increasingly popular. Cloud mining allows individual miners to leverage the power of major corporations and dedicated crypto-mining facilities.

Individual crypto miners can identify both free and paid cloud mining hosts online and rent a mining rig for a specific amount of time. This method is the most hands-free way to mine cryptocurrencies.

Mining Pools

Mining pools allow miners to combine their computational resources in order to increase their chances of finding and mining blocks on a blockchain. If a mining pool succeeds, the reward is distributed across the mining pool, in proportion to the amount of resources that each miner contributed to the pool.

Most crypto mining applications come with a mining pool; however, crypto enthusiasts now also join together online to create their own mining pools. Because some pools earn more rewards than others, miners are free to change pools whenever they need to.

Miners consider official crypto mining pools more reliable since they receive frequent upgrades by their host companies, as well as regular technical support. The best place to find mining pools is CryptoCompare, where miners can compare different mining pools based on their reliability, profitability, and the coin that they want to mine.

Is Crypto Mining Worth It?

Determining whether crypto mining is worthwhile depends on several factors. Whether a prospective miner chooses a CPU, GPU, ASIC miner, or cloud mining, the most important factors to consider are the mining rig’s hash rate, electric power consumption, and overall costs. Generally, crypto-mining machines consume a considerable amount of electricity and emit significant heat.

For instance, the average ASIC miner will use about 72 terawatts of power to create a bitcoin in about ten minutes. These figures continue to change as technology advances and mining difficulty increases.

Even though the price of the machine matters, it is just as important to consider electricity consumption, electricity costs in the area, and cooling costs, especially with GPU and ASIC mining rigs.

It is also important to consider the level of difficulty for the cryptocurrency that an individual wants to mine, in order to determine whether the operation would even be profitable.

The Tax Implications of Crypto Mining

The taxation of crypto mining remains an important consideration.

Crypto miners will generally face tax consequences (1) when they are rewarded with cryptocurrency for performing mining activities, and (2) when they sell or exchange the reward tokens. With respect to (1), the IRS has issued Notice 2014-21 which directly addresses the tax implications of crypto mining. Under the Notice, a miner will recognize gross income upon receipt of the reward tokens in an amount equal to the fair market value of the coins at the time of receipt. Additionally, if a taxpayer’s mining activities constitute a trade or business or the taxpayer undertakes such activities as an independent contractor, the reward tokens/virtual currency payments are deemed to be self-employment income and accordingly, subject to self-employment taxes. Similarly, if a taxpayer performs mining activities as an employee, payments made in cryptocurrency are treated as wages subject to federal income tax withholding of Social Security/Medicare and unemployment taxes.

For a more detailed analysis of crypto mining tax implications, see Taxation of Crypto Mining.  For crypto tax planning resources, see Charitable Remainder Unit Trusts (“CRUTs”) and Cryptocurrencies, Taxation of Crypto Margin Trading, and Estate Planning and Cryptocurrency.  And for the latest on IRS Voluntary Disclosures for previously unreported cryptocurrency gains, see The IRS’s Voluntary Disclosure Practice.

Is Crypto Mining Legal?

Most jurisdictions and authorities have yet to enact laws governing cryptocurrencies, meaning that, for most countries, the legality of crypto mining remains unclear.

Under the Financial Crimes Enforcement Network (FinCEN), crypto miners are considered money transmitters, so they may be subject to the laws that govern that activity. In Israel, for instance, crypto mining is treated as a business and is subject to corporate income tax. In India and elsewhere, regulatory uncertainty persists, although Canada and the United States appear friendly to crypto mining.

However, apart from jurisdictions that have specifically banned cryptocurrency-related activities, very few countries prohibit crypto mining.

Our Freeman Law Cryptocurrency Law Resource page provides a summary of the legal status of cryptocurrency for each country across the globe with statutory or regulatory provisions governing cryptocurrency.

The globe below provides links to country-by-country summaries:

In addition, see our Freeman Law State-by-State Resources:

State-By-State Digital Currency Laws and Regulations

Digital Currency Transmission Laws State-by-State

Conclusion: The Sustainability of Crypto Mining

For aspiring crypto miners, curiosity and a strong desire to learn are simply a must. The crypto mining space is constantly changing as new technologies emerge. The professional miners who receive the best rewards are constantly studying the space and optimizing their mining strategies to improve their performance.

On the other hand, climate change advocates have become increasingly concerned, as more and more fossil fuels are burned to fuel the mining process.

Such concerns have pushed cryptocurrency communities like Ethereum to consider switching from PoW frameworks to more sustainable frameworks, such as proof-of-stake frameworks.

For more information on related topics, see:

Blockchain and Cryptocurrency

The Computer Fraud and Abuse Act (CFAA)

Bitcoin and Beyond: The Reality of Taxing and Regulating Virtual Currency

The Build Back Better Act – Tax Implications for Cryptocurrencies

FinCEN Intends to Amend FBAR Regulations to Include Virtual Currency

Can You Go To Jail for Failing to Disclose Virtual Currency on a Tax Return or as Part of an Offer for a Collection Alternative?

Charitable Remainder Unit Trusts (“CRUTs”) and Cryptocurrencies