Explaining the Bitcoin Block Reward

Explaining the Bitcoin Block Reward

The Bitcoin block reward is a critical part of the Bitcoin network. It is a core piece of the incentive structure that ensures Bitcoin miners continue to validate and secure the blockchain.

Below is a summary of how it works, starting with a brief definition of the Bitcoin block reward, followed by a look at the process itself. Finally, we will venture into the possible outcomes of the reward system. 

What is the Bitcoin Block Reward?

What is the Bitcoin Block Reward?The bitcoin block reward is made up of two components: newly generated coins and transaction fees. They are given to miners for successfully securing the network by validating blocks.

The current bitcoin block reward is composed of 6.25 newly generated coins per block. The number of newly generated coins is governed by a halvening event that takes place roughly 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 Last Bitcoin is Scheduled to Be Mined in the Year 2140

While the block reward is stable and predictable, fees can fluctuate due to multiple factors, such as increased activity on the network and transaction size. Unlike newly generated coins, which are minted by the protocol, transaction fees are paid by users from their own existing coins.

For illustrative purposes, it’s best to walk through the process of how a Bitcoin transaction takes place and understand the dynamics of how the block reward affects the entire system. A transaction begins with a wallet.

How Are Block Rewards Created?

First You Need a Bitcoin Wallet

To initiate a transaction, all you need is the public key address of the intended recipient. A public key would, of course, be paired with a private key- which in essence is proof of ownership that an entity does, in fact, own and have the right to spend the coins they have. 

The repository that stores Bitcoin is a piece of software known as a wallet. Wallets can come in various forms but for the purposes of this article, there are three major types: hard wallets, software wallets, and paper wallets. All wallets have one thing in common, they have a public and private key and hold a record of your Bitcoin.

A public key is very similar to your bank account number. It’s just a set of numbers and letters that are formatted in a specific way to be identified as a Bitcoin wallet address. A private key is similar to the combination of  a vault. There’s only one password that opens the vault and if you lose it there’s virtually no feasible way of breaking in to retrieve its contents.

Initiating a Bitcoin Transaction and the Network Signature Validation Process

When the transaction is initiated, the details are transmitted to a decentralized network of computers around the world. These specialized computers are known as nodes. A node is simply a computer that is connected to a network of other computers on the internet for the purposes of relaying information to one another. Since all nodes transmit near identical information at the same time, they enable the network to be decentralized.

One of the most important components of the Bitcoin network is the fact that nodes must come to a unanimous consensus in order to validate information.

The details of the transactions include the Bitcoin wallet address from which the sender will debit from, the public key of the receiver (wallet address), and the amount the sender would like to send. That information is transmitted to the Bitcoin network where a node verifies that the sender does, in fact, own the Bitcoin they wish to send and that the alleged receiver's wallet address is properly formatted.

The process of authentication ensures the source wallet has custody of that wallet's entire history of transactions, and can therefore flag any instance that suggests a wallet is attempting to send Bitcoin it doesn't actually have.

What Role Do Nodes Play in Securing Bitcoin's Blockchain Network?

Nodes, in essence, provide oversight and public reporting, much like 3rd-party financial institutions play in our current traditional financial system. The only difference is that nodes are decentralized and are virtually impossible to shut down, since each node is independent of the other. One dramatic instance of this resilience occurred in 2021 when a significant portion of the network went offline. 

The node that picks up the transaction is typically a 'light node,' which is only meant to validate the signature and authenticity of a transaction. Once authenticated, it is transmitted to a full node, which carries the full history of the Blockchain ledger. The transaction data is then moved into that full node’s mempool (memory pool) where it awaits until a specialized node called mining node assembles it into a candidate block. 

At this point, the transaction between two parties has been broadcast on the network, it has not yet been validated. So far neither party has benefited from the security and oversight provided by a mining node. Without the guarantee and validation of settlement provided by solving the proof-of-work algorithm, a transaction cannot be settled. It is for this guarantee of confirmed financial settlement that miners are rewarded a block reward. 

Deeper Dive: Bitcoin Miners & Mining Nodes

Transactions that are moved into a mempool are still in a "pending" state and remain unconfirmed. A miner node, also known as a Bitcoin miner, will examine all the transactions, sort them by transaction fee, and assemble them into what's known as a candidate block. A candidate block is a block that has yet to be validated and added to the blockchain.

Bitcoin miners around the world race to validate their candidate block before the other miner nodes in the system. Validation of a block requires the computer to solve a series of complex puzzles, ultimately generating a unique code called a hash. The first miner to transmit their valid hash has their candidate block added to the blockchain itself. The incentive to validate a miners candidate block as fast as possible is earning a Bitcoin block reward.

A Block Reward is a reward of a predetermined amount of newly minted Bitcoin and the sum total of transaction fees associated with a mining node’s candidate block. The first mining node to validate their block and add it to the blockchain earns the block reward. This repeats roughly every 10 minutes.

When a miner node identifies the correct hash, finally validating a block of transactions, it is transmitted back to the Blockchain network, which immediately verifies that the miner followed Bitcoin's core protocol. This process is transparent and immutable thanks to distributed ledger technology (DLT). The DLT is managed by thousands of participants (nodes) that verify that the blockchain is accurate and that miners who organized the blocks executed Bitcoin's core protocol correctly.

Bitcoins Protocol: Transaction Fee & Difficulty Adjustments

How Game Theory and Crypto-Economics Support the Block Reward

For the purpose of this article, we will simply describe game theory as a mathematical model of human behavior within a dynamic environment. Participants in the game will endeavor to find a path that leads to the best possible outcome in every instance of the game. 

In the case of Bitcoin’s blockchain network, the players in the game are Bitcoin miners. Roughly every 10 minutes the game starts over when a winner receives the block reward for successfully validating their candidate block and adding it to the blockchain.

Each candidate block in the bitcoin blockchain can only contain 1 MB of data. This limits the number of transactions that miners are able to include per block, creating a sense of competition between users and an incentive to assemble a candidate block that will yield the greatest monetary reward. The sum total of the reward for validating a block is a transaction fee from the initiator of the transaction and the block reward provided by the protocol.

Dynamics That Affect the Throttling & Validation Speed of the Blockchain Network

There are certain protocols that cause the network to slow down, forcing users to increase their transaction fees in order to speed up the processing time for their transactions. The following will explain what they are and how they affect the economics of Bitcoin block reward and sustainability of the Bitcoin blockchain network.

Network Congestion Due to High Volume 

The memory limit on block sizes creates a natural bottleneck in the processing speed of transactions. The Bitcoin protocol allows the initiator of a transaction to adjust the fee they are willing to pay in order to increase the likelihood that their transaction will be added in the next block to be validated. In other words, there’s a built in market based system that determines the ultimate length it takes to process a transaction.

The dynamics of transaction fees play an important role in incentivizing miners to support the block chain's costly proof-of-work validation system. Miners are incentivized to fill their block with transactions that will lead to the greatest aggregate reward (block reward + transaction fee) for their efforts.

Changes in Average Time to Validate a New Block

The core Bitcoin protocol was written to aim for an average block to be validated every 10 minutes. Variances in the aggregate live network hashrate can have a significant effect on the performance of the network, and economics of the price of Bitcoin over time. The protocol has another built-in mechanism that adjusts the difficulty of solving the puzzle Bitcoin miners must solve in order to manage the average time it takes to validate a new block in the blockchain. If left unchecked, the sustainability and reliability of the Bitcoin network would be at risk and ultimately collapse.

The Mechanics of Bitcoin’s Network Difficulty and Sustainability of the Block Reward

Mining difficulty automatically adjusts every 2,016 blocks. The protocol calculates the adjustment to the difficulty of solving for a hash by taking the average time it took to validate all 2,016 blocks in that period. The goal over time is to maintain an average length to validate a block to approximately 10 minutes.

Destabilizing Effects on Crypto-Economics

If the difficulty adjustment were not present, the system would deteriorate as the economic principles of supply and demand would take over. Transaction fees decrease as more miners enter the system in an effort to earn a block reward. The rate of newly minted coins would rise exponentially leading to a supply/demand imbalance in the market for coins. The value per coin would fall until an equilibrium between the cost of mining a new coin meets the demand of investors to purchase the new supply of Bitcoin.

It’s easy to see that, without the periodic difficulty adjustment, the value of the block reward would collapse. Eventually, Bitcoin miners would have little to no incentive to continue to validate the Bitcoin’s blockchain network. 

Mechanics & Sensitivity of Change in the Network Hash Rate to Difficulty Adjustments

The difference between the live network hashrate and network hashrate used for difficulty adjustment is transparent and can be easily calculated by using the average discussed in the prior section.

Positive Network Difficulty Adjustments would suggest an imbalance where there was a net increase in the average network hash rate. Less network hash rate is representative of either more Bitcoin miners entering the network or less demand for transaction validation. This would lead to lower average transaction fee per block, and a decrease in time it takes to validate a block. 

Users benefit from the lower costs and performance speed of the network at the expense of miners' incentive to continue keeping up with the increased difficulty of earning a block reward.

Negative Network Difficulty Adjustments would suggest an imbalance where there was a net decrease in the average network hash rate. Less network hash rate is representative of either less Bitcoin miners entering (or existing miners going offline) the network than the demand for transactions to be validated. This would lead to a higher average transaction fee per block, and an increase in time it takes to validate a block. 

Increases in costs and slower network performance comes at the expense of users where the remaining miners on the network benefit from expending less resources to earn a block reward.

Users from the lower costs and performance speed of the network at the expense of miners' incentive to continue keeping up with the increased difficulty of earning a block reward.

What Happens When The Bitcoin Block Reward is Gone?

No New Bitcoin Will Be Added to the Total Number of Bitcoin in Existence. Once the total global supply has reached approximately 21 Million, the show is over for earning Bitcoin from a block reward.

However, Bitcoin transactions will continue to be pooled, blocks will be processed on the blockchain, and bitcoin miners will continue to be compensated at the market value of each transaction fee. The question really becomes, will the transaction fees be enough to justify the cost of solving a proof-of-work algorithm which is needed to validate a new block?

Effects on the Crypto-Economics of Bitcoin Mining Without a Block Reward

The last Bitcoin is expected to be mined in the year 2140. There will be a fundamental transition in the incentive structure for mining bitcoin. If the Bitcoin Network continues to be supported by Bitcoin miners validating transactions, miners will continue to earn transaction fees. However, cost per transaction to users and the reward to miners for validating blocks will have a critical role in determining the sustainability of Bitcoin’s network. 

The Evolution of the Bitcoin Mining Industry

The end of the Bitcoin Block Reward as we know it today is not a prediction, it is a certainty. Having over 100 years to prepare for the end of your primary source of revenue is ample time to invest in technologies that may even support the adoption of utilizing the Blockchain network, thereby driving the value of each transaction higher and justifying greater transaction fees for miners. 

Innovation and adoption in the use of blockchain technology will support the economics of Bitcoin mining and potentially help keep the network up and running forever. 

Predictions for Bitcoin in the Year 2140 Without a Block Reward

Disclaimer: we are now entering the realm of science fiction. Anybody who claims to know the future of Bitcoin is most certainly spinning a yarn. 

There are some interesting possibilities that are grounded in science. We can extrapolate on some trends we are seeing play out today. Let us briefly explore a few of those possibilities and end this article with a sense of hope for the future and possibilities for Bitcoin.

The Value of a Bitcoin

Right up front, nobody will know the value of Bitcoin in 2140 let alone next month or next year. Anyone who has ever tried has miserably failed. So the best we can do is make a simple assumption that if Bitcoin is successful as a store of value, the economics of supply and demand will suggest exponential growth in the value of each coin.

If Bitcoin fails to meet its intended potential or is surpassed by a superior cryptocurrency, it will most likely be used in niche use cases and the value will largely be dictated by the value provided to the end user in those transactions.

Bitcoin’s Blockchain Network

Current trends in evolution and use cases for Bitcoin’s blockchain network are very exciting and evolving at light speed. Future applications of the network are 100% science fiction. However, we can assume there will be effects on the democratization and decentralization of the traditional financial system providing access to the under or unbanked populations of the world. The speed, security, transparency, and efficiency of the transference of value all around the world would improve compared to today’s fiat based system. Entrepreneurs will most likely innovate by creating layers that live on top of Bitcoins blockchain exponentially increasing the utility of Bitcoin all around the world.

[fs-toc-h2]Related Articles

Proof of Work vs. Proof of Stake | Blockchain Security Consensus Mechanism

5 Features That Make Bitcoin a Unique Asset Class

What is the DeFi Revolution & Explaining Decentralized Finance

At this point, we hope you’ve developed a deeper understanding of the Bitcoin block reward and the implications of its role in the blockchain network. We’ve helped define what a block reward is,  the mechanics of how it is rewarded, and its role in the incentive structure that balances the entire network. Yes, there will come a time in the distant future when the block reward will go away. However, lest we not forget, Bitcoin is barely a decade old as of this writing and look how far we’ve come. There is so much more to discover as the pioneers and titans of industry start to wake up to Bitcoin’s true potential.

___________

AUTHORS

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.

Michael Bogosian is a Bitcoin & Blockchain Analyst that holds an MBA from Loyola University Chicago’s Quinlan School of Business. He has been researching and writing about Bitcoin & Blockchain technology since 2018.