Mining Pools in Cryptocurrency
In the previous article, we have already learned about the Proof of Work mechanism which underpins Bitcoin and many other major cryptocurrencies across the world. In any proof of work-based cryptocurrency, every transaction is validated by a miner. The transaction gets added to the blockchain only after such a validation takes place. However, we also know that mining requires computers with advanced computing capabilities. Therefore, retail investors who do not have access to such advanced computing equipment find themselves at a disadvantage. Their chances of ever being able to successfully submit proof of work and then gain rewards are quite limited given the technical challenges they face. In order to overcome these challenges, mining pools have been created.
In this article, we will have a closer look at the concept of mining pools as well as their advantages and disadvantages.
What is a Mining Pool?
Each individual miner may not have the computing power required to successfully mine bitcoin. Hence, it is common for miners to form a group wherein they all merge their computing powers. This is done in order to ensure that their chances of submitting proof of work and earning rewards increase. Pool miners collaborate with each other in order to earn these rewards. Later, the rewards are split proportionately amongst the various contributors. In laymans terms, it can be considered to be a kind of mutual fund for cryptocurrencies. Instead of combining their funds, investors mine their computing powers in a bid to improve their return on investment.
Mining pools are really the only effective way for small investors to get in the game. Cryptocurrencies that use proof of work mechanisms favor miners with more computing power. Hence, retail investors have almost no chance of being successfully able to mine currency on their own. There are online calculators which show that if individual miners were to mine on their own without joining a pool, they would obtain their first reward many years later!
This is the reason why mining pools attract regular investors who do not have deep pockets or are not very tech-savvy.
How do Mining Pools Work?
Mining pools are an effective way of converting idle computing power into a productive force. The steps to joining a mining pool have been explained below:
- A new joiner visits a website and downloads software in order to join a mining pool
- The downloaded software creates a connection between the server and the investors computer. The investors computer ends up becoming an extension of the digital node of the mining pool
- The spare unused processing space of the computer is periodically pulled in by the mining pool in order to help with proof of work operations being performed during the mining
- The fees earned from successfully mining the Bitcoin are stored in a common pool. These funds are transferred to the investors equitably based on the computing power supplied by each of them
- The rewards may be denominated in the cryptocurrency which has been mined. Alternatively, the rewards could be converted into a more acceptable cryptocurrency like Bitcoin or even cash before transferring it to the investors.
How Rewards are Distributed Amongst Miners?
Different mining pools have different mechanisms which allow them to distribute rewards amongst various miners. Some of the commonly used distribution mechanisms have been explained below:
- Pay Per Share: This is probably the most popular method of distributing rewards amongst miners. This is because the rewards distributed are instant as well as guaranteed. The pool does not have to wait for new revenue to come in. Instead, miners can be paid out of the existing pool of money. Miners also like this method since it has minimum variance in payments. The pool pays out based on an average. Sometimes the pool earns more than the average and other times it earns less. However, over the long term, the compensation ends up being fair.
- Proportional: Under this method, miners only get paid when a new block is actually mined. The payment is made in the same proportion which was used to contribute computing power to the pool. This method distributes the rewards just like a joint-stock company.
- Pay Per Last N Shares: This method is an improvement over the proportional method mentioned above. Instead of distributing based on the number of shares held when the transaction was mined, the system uses the average of n times. The number of shares keeps fluctuating because of the probabilistic nature of mining. This method considers an average and hence reduces the randomness inherent in the process
- Score Based System: A score-based system rewards people who keep their shares for longer. The proportion in which rewards are split is based on a formula that considers many factors. The amount of time for which the share was held in the mining pool is a major factor that determines how the reward needs to be distributed.
The bottom line is that the mining pool provides the retail investor with a mechanism to participate in the Bitcoin mining process and earn rewards. This is the reason why this mechanism has become extremely popular and has attracted a large number of investors.
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The article is Written By Prachi Juneja and Reviewed By Management Study Guide Content Team. MSG Content Team comprises experienced Faculty Member, Professionals and Subject Matter Experts. We are a ISO 2001:2015 Certified Education Provider. To Know more, click on About Us. The use of this material is free for learning and education purpose. Please reference authorship of content used, including link(s) to ManagementStudyGuide.com and the content page url.
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