Bitcoin Mining and Mining Pools

Mining Basics

Bitcoin “mining” is the process of performing computations to create the next valid block of transactions on the blockchain. A miner that solves for/creates the next valid block that’s confirmed across the network is rewarded with newly issued BTC. However, first, it’s important to understand blockchains, blocks, and transactions.

The Bitcoin blockchain is a global, permissionless, and distributed database that tracks the balances of Bitcoin users. Each "block" contains a collection of transactions representing the transfer of bitcoin between users, with each transaction represented by a unique address. These transactions are broadcast by network users to a shared network resource known as the mempool (memory pool). The network doesn’t recognize transactions until they’ve been added from the mempool to the blockchain. To send bitcoin to an address, the sender must include transaction fees to incentivize miners to select their transactions from the mempool. Blocks have a maximum size, therefore miners choose the transactions from the mempool that will generate the most revenue: those with the highest fees per block space. They then generate a block from these transactions and transmit it across the network so the nodes may validate it.

All of this is done with the goal of achieving global, decentralized consensus without relying on a middleman (i.e., governments or banks) as the sole source of truth.

Miners

Miners are extremely important to the health of the Bitcoin network, and the idea of including the Proof-of-Work (PoW) consensus mechanism (i.e., a network’s process for agreeing on the order of valid transactions) represents a key innovation of the Bitcoin network. Bitcoin miners are responsible for block generation and committing blocks of confirmed transactions to the blockchain. Beyond that, mining aids in:

Securing the network and preventing corruption from malicious actors
Minting new bitcoin into circulation in a predictable, predetermined manner
Maintaining a historical record so the chain remains auditable and transparent, allowing global consensus to be reached

Miners are the global network of computers that:

Group bitcoin transactions into blocks. (Bitcoin limits its blocks to a block size of ~1 MB. Therefore, each block can only fit a limited number of transactions. So, if the mempool contains more transactions than can fit into one block, the remaining transactions will be added to the next block).
Perform computations to solve a cryptographic puzzle (performing the “Proof-of-Work”)
Bitcoin miners combine ‘valid’ transactions into blocks; anyone can run a Bitcoin full-node and act as a ‘validator’ for proposed blocks. These people are typically miners since they have an incentive to invest in the network’s security
Send the blocks over the network to be cross-checked and verified by other nodes and miners
Propagate approved blocks across the network and move on to the next block of transactions

Miners are the backbone of the Bitcoin network and are invested in the network in a way in which investment funds and hodlers aren’t necessarily. As Bitcoin mining hardware has become highly specialized and economies of scale have facilitated the advent of industrial Bitcoin mining in warehouses, professional miners have emerged, making major capital investments over long time horizons. ASIC mining rigs have 3+ year life cycles and can only be used to mine SHA-256 protocols (almost entirely Bitcoin).

Mining Pools

Bitcoin mining is fundamentally a probabilistic activity. There’s no guarantee or predictability around solving the next block, which makes running a profitable mining company that much more difficult. However, mining pools can help reduce that uncertainty.

A Bitcoin mining pool is essentially a consortium of miners that pool their computing resources (specifically, hash power) together to collectively perform proofs of work. Pools are composed many individual miners that collaborate to locate the next block and divide the resulting profits (image below).

Coinbase sharing among individual miners. Source: CoinMetrics

Pools have a much larger collective proportion of the network's hashrate (see: Foundry USA below) and are, therefore, able to mine new blocks much more frequently and at a more predictable rate. When a mining pool discovers a new valid block, it’s rewarded with the new BTC (currently 6.25) plus the transaction fees paid by users for each transaction included in the block. This gives mining pools the benefit of providing a relatively steady revenue stream for small participants. By coordinating and sharing earnings with other participants in the pool, a single miner can significantly reduce payout volatility. In exchange for the more consistent revenue, the miner pays a small percentage of revenue to the pool's operator.

The first Bitcoin mining pool, Slush Pool, emerged in 2010. Since then, pools have grown significantly. In its nascent stages, Slush Pool was essentially powered by CPUs and a few early-stage GPU miners and there was an aggregate hash power of the order of 600 MH/s. This grew to the order of EH/s, representing an increase of almost a factor of 10 billion in less than a decade.

The top-four mining pools now control over 50% of the hash rate. This is one of the major critiques of PoW mining: the business model prospers from the “economies of scale,” meaning the bigger your operation, the more you can profit. This obviously squeezes out the hobbyist and leads to greater centralization around a few large players.

Mining pool distribution, as measured by hashrate share, Q3 2022. Source: BTC.com

However, mining pools consist of multiple entities who are free to leave at any time . If a mining pool begins to act against the wishes of its customers (say, attack the network), users could leave the mining pool, reducing the pool’s power. A competitive global mining market rewards high performers that act in the best interests of its users. A major contributor to the rise of mining pools is a standardized protocol, such as Stratum.

Stratum V1

The Stratum V1 communication protocol provides a standardized means for mining pools to connect with their miners. It’s been implemented by every major pool since its 2012 creation by Marek “Slush” Palatinus, the Founder of Slush Pool. Stratum V1 improved the efficiency between a mining pool’s two primary entities:

The pool operators: select and order transactions and assign block templates
The miners: perform the actual PoW

Prior to V1, Bitcoin mining was small, obscure, and a hobbyist activity. Because of this, mining and the infrastructure around it were fairly rudimentary and disorganized. As Bitcoin caught on, mining became more profitable and the industry started to professionalize. Stratum V1 was part of this emphasis on streamlining and maturing. Standardization of mining pool communications helps improve the user experience and make onboarding new miners/mining pools more efficient. Similarly, Stratum is designed to be flexible to facilitate a hobbyist contributing to the pool in addition to those with industrial capacity.

Stratum V1 standardizes communication between the servers run by the mining pool and proxies run by miners. The division of labor and roles are explained below.

Servers organize the miners by choosing and arranging transactions into a block template
They then select the miners to produce PoW attestations for this template
Miners attempt to (and eventually do) solve the assigned POW
Servers compensate miners based on the amount of work contributed

*Note that the miners that don’t solve the puzzle still submit their “unsuccessful” PoW in exchange for shares. This allows miners to be compensated depending on the labor they performed, as opposed to their luck in the hash lottery.

Security

Security has historically been a major consideration for pools since there’s a major incentive to hijack hash power and misappropriate block rewards. Man-in-the-Middle (MitM) attacks do precisely this, which encourages strong encryption and rigorous authentication for pool communications. If an attacker can monitor communications between miners and the pool server, they might be able to intercept packets between the two, alter credentials, and claim hash power as their own. Additionally, pools need to be transparent and held to thorough scrutiny to prevent Pool Skimming attacks, in which a pool steals a miner’s payout.

Similarly, a pool needs to act in a way that’s consistent with the Bitcoin network’s security and integrity. When only a handful of pools collectively contribute >51% of the network’s overall hashrate, the sort of conspiracy between miners that seems infeasible in a highly decentralized network seems more feasible. If a number of pools were to coordinate to launch a 51% attack on the Bitcoin network, they would significantly devalue Bitcoin should their activity become public, leaving little incentive to perform such an attack.

Stratum V2

Stratum developers are building a second version of the protocol called Stratum V2 that looks to improve upon V1 issues, such as:

Poor documentation
Inflexibility
Suboptimal security guarantees (unecrypted communication channels)
Inefficiencies and complexities due to poor standardization

V2 aims to reduce the physical infrastructure required for mining, increase data transfer efficiency, and improve security around the miner-mining pool dynamic. Its modified architecture would shift the responsibility of transaction ordering to miners to avoid the conflict of interest implicit in the protocol’s first version. With V2, miners construct their own block templates and determine which specific transactions go into blocks. This increases the difficulty for a bad actor trying to censor transactions by applying pressure to pools (like a regulator or government). This results in V2 being able to protect miners from malicious actors/pools and improve Bitcoin’s resiliency and security at the mining pool level.

Comparing Mining Protocols. Source: Braiins.com

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