Explaining the Bitcoin Block RewardLaura
Difficulty is one of the most important aspects of Proof-of-Work mining. It is derived using the network hashrate and determines the speed at which miners are able to validate an encrypted block. In the context of bitcoin mining, the difficulty adjusts every 2016 blocks and aims to maintain an average block time of 10 minutes.
This article provides an in-depth analysis of the Bitcoin Block reward, overviews its constraints, and lastly, its challenges.
What is the Bitcoin Block Reward?
The bitcoin block reward is made up of two components: newly generated coins, and transaction fees. The number of newly generated coins represents the supply of new bitcoins and is governed by a halvening event that takes place every 4 years. This halvening event cuts the supply of newly generated bitcoins in half and aims to tighten the issuance of supply until all 21 million bitcoins have been mined.
The current bitcoin block reward is composed of 6.25 newly generated coins in addition to transaction fees. In regards to transaction fees, they can fluctuate due to multiple factors. However, before diving deeper into the reasons that cause transaction fees to fluctuate, it is important to understand what happens when a transaction is initiated.
Whenever a user initiates a transaction, the transaction is broadcasted to the network and then placed into the memory pool (also known as mempool; a waiting area for transactions) before being included in a block. Miners will then examine all the transactions in the mempool and will filter them by transaction fee and will choose to include as many as possible while prioritizing transactions with higher fees.
Constraints of the Bitcoin Blockchain
Each block in the bitcoin blockchain can only contain 1 MB of data which limits miners on the number of transactions that they are able to include.
This creates a sense of competition between users.
The higher the fees associated with their transaction, the faster their transaction will be processed. There are certain triggers that cause the network to slow down, forcing users to anxiously increase their transaction fees in order to speed up the processing of their transaction.
Some of these triggers include:
- Network Congestion due to high volume: This happens due to an increase in volume. Higher volume simply means more transactions to process and due to the memory limitations of bitcoin’s block size, users must increase their transaction fee in order to ensure their transaction is shortlisted from the mempool and included in a block.
- Variance in average block time: While the average block time should be approximately 10 minutes, variance in the live network hashrate can have a significant effect on the performance of the network, causing it to slow down or speed up.
As mentioned earlier, mining difficulty adjusts every 2016 blocks and uses the average network hashrate for the previous 2016 blocks to calculate the difficulty required to maintain an average block time of 10 minutes for the following 2016 blocks. However, if the live network hashrate is much higher or lower than the network hashrate used for difficulty adjustment, the network performance will be affected, causing it to deviate from the targeted 10 minute average block time. This affects the speed at which transactions are processed and will trigger lower or higher transaction fees depending on whether the network is under or over-performing.
Essentially, if the difference between live network hashrate and network hashrate used for difficulty adjustment is positive, there is more hashrate than projected by the difficulty. This allows blocks to be confirmed faster than the targeted 10 minute average block time and users do not need to compete to have their transaction included in a block.
Likewise, if the difference between live network hashrate and network hashrate used for difficulty adjustment is negative, there is less hashrate than projected by the difficulty and thus, blocks are confirmed slower than the targeted 10 minute average block time. This causes a rush in competition between users as they increase their transaction fees to ensure that their transaction is included in a block.
The chart below portrays the correlation between ΔHashrate (%) (right-y) (the difference between live network hashrate and network hashrate used for difficulty adjustment) and average transaction fee (left-y). The correlation coefficient of this relationship is –0.5 and represents a moderately negative correlation.
While the portion of newly generated coins in the bitcoin block reward is very predictable, the portion made up of transaction fees fluctuates quite significantly and can be very unpredictable.
A very good example that saw the average block time increase by 30% due to a significant drop in hashrate is the incident that took place late April 2021 due to bitcoin mining being banned in Inner Mongolia. This event caused 10% of the bitcoin hashrate to drop and the average bitcoin block time increased to 14 minutes. Because of this, users had to increase their transaction fees by an average of 30% to ensure their transactions were processed in a timely manner.
Despite the fluctuations in transaction fees, it is important to note that over the past 10 months, transaction fees have averaged for only ~11% of the entire bitcoin block reward. Until now, the majority of bitcoin mining revenue is generated by minting newly generated coins. However, after the next halvening, the number of newly generated coins will be reduced to 3.125 and it is expected that transaction fees will account for a bigger percentage of the bitcoin block reward. Nevertheless, beyond the next halving, and as more time passes and more halvenings take place, the ratio of newly generated coins and transactions is slowly going to skew towards parity and will eventually skew in favour of transaction fees until all 21 million bitcoins are mined. At that point, transaction fees will account for 100% of the bitcoin block reward.
Abdulrahman Hamdy is the Technical Systems Manager at Argo Blockchain. He holds a B.Sc. in Computer Science w/ a specialization in Artificial Intelligence from the University of Manitoba. He is an early adopter of blockchain technology and has been involved in industrial-scale cryptocurrency mining since mid-2017.
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