The cryptocurrency market was absolutely on fire in 2017, delivering what might be the best year for any asset class on record. After beginning the year with an aggregate market cap of just $17.7 billion, digital currencies combined to finish the year at $613 billion, representing an increase in value of more than 3,300%.
Yet most people don't understand much about virtual currencies. Sure, more people than ever have probably heard about bitcoin, and they may have heard about some of its closest rivals by market cap, such as Ethereum and Ripple, but they don't have the faintest idea what purpose they serve or how they really work.
Back in January, we covered some of these basics by examining what cryptocurrencies are, and why they were developed, then proceeded to examine the advantages and disadvantages of the blockchain technology that underpins most digital currencies. Today, we're going to tackle another common head-scratching issue: cryptocurrency mining.
What is cryptocurrency mining?
Cryptocurrency mining is one of the most commonly used methods of validating transactions that have been executed over a blockchain network. Not only does blockchain work to protect transaction data through encryption, as well as store this data in a decentralized manner (i.e., on hard drives and servers all over the world) so as to keep a single entity from gaining control of a network, but also the primary goal is to ensure that the same crypto token isn't spent twice. In effect, "mining" is one means of making sure that cryptocurrency transactions are accurate and true, such that they can never be compromised in the future.
How cryptocurrency mining works
Cryptocurrency mining itself refers to a type of validation model known as "proof-of-work" (PoW). There are two common validation types, and we'll look at the other, known as proof-of-stake, in a moment.
In the PoW model -- which bitcoin, Ethereum, Bitcoin Cash, and Litecoin use, to name a few -- individuals, groups, or businesses compete with one another with high-powered computers to be the first to solve complex mathematical equations that are essentially part of the encryption mechanism. These equations correspond to a group of transactions, which is known as a block. The first individual, group, or business that solves these transactions, and in the process validates the accuracy of these transactions within a block, receives a "block reward." A block reward is paid out as digital tokens of the currency that's being validated.
As an example, the current block reward for bitcoin is 12.5 tokens. That means whoever is the first to correctly solve equations for a block is paid 12.5 tokens. With bitcoin near $9,500 per coin, that works out to a nearly $119,000 haul.
Are there disadvantages to the PoW model?
There are two major concerns attached to the PoW model. First, it's an extremely electricity-intensive practice. To mine virtual currencies, massive mining centers with graphics processing units and/or ASIC (application-specific integrated circuit) chips are set up to handle this validation and processing. The electricity costs, depending on where an operation is located, can be enormous. It could also, in theory, be a drain on local or national electric grids, depending on how large digital networks and mining farms become.
The other issue is that the PoW model has a security vulnerability, at least for smaller digital currencies. Any individual or group that can gain control of 51% of a networks computing power could essentially hold that network and digital currency hostage. Networks the size of bitcoin, Ethereum, and Litecoin have next to nothing to worry about. However, newly issued coins with fewer participants could be susceptible.
Is all PoW mining the same?
Though cryptocurrency mining might often be lumped in as one big free-for-all, there are differences in the equipment being used to validate transactions. For bitcoin, miners need to use highly specialized and expensive ASIC chips because of the difficulty in validating bitcoin transactions. Meanwhile, most other virtual currencies allow miners to use some variation of graphics processing units from the likes of NVIDIA or Advanced Micro Devices to proof transactions. However, the difficulty in this mining can still vary from one cryptocurrency to the next.
What's the alternative?
Even though there are technically a number of proofing alternatives, the biggest competitor to the PoW model is the proof-of-stake (PoS) model. With PoS, there are no high-powered computers and mining farms sucking up electricity to validate transactions. Instead, stakeholders of a digital currency receive the randomized right to validate transactions. In plainer terms, the more of a cryptocurrency that you own, the more likely it is that you'll be chosen to validate a block of transactions. Those who are chosen don't receive a "block reward" when complete. Instead, they receive the aggregate fees from the transactions that were proofed.
The obvious advantage of this platform is that it's considerably lower cost. There's also no worry that hackers will gain control of 51% of a network's computing power with the PoS model. For hackers to gain control of a PoS-backed network, they'd need to control 51% of all outstanding virtual coins, which could get quite expensive.
Then again, it's not perfect. Arguably the biggest issue with the PoS model is that major stakeholders can have a much larger say in the future path of a digital network. Whereas PoW networks are massive and incorporate the opinions of a lot of people, PoS networks lose some of the decentralization that makes cryptocurrencies special, thusly allowing larger players to shape future technical and economic pathways for a cryptocurrency.
It's tough to say which method developers will prefer in the years to come, but at least when someone talks about "cryptocurrency mining" in the future, you'll know exactly what they mean.
Sean Williams has no position in any of the stocks or cryptocurrencies mentioned. The Motley Fool owns shares of and recommends Nvidia, but has no position in any cryptocurrencies mentioned. The Motley Fool has a disclosure policy.