What is Ethereum and how does it work?

Ethereum definition

If Bitcoin (BTC) is the alleged future of money, then what is Ethereum? For someone new to the cryptocurrency space, that’s the logical question to ask, considering they probably see Ethereum and its native Ether (ETH) cryptocurrency next to Bitcoin everywhere on exchanges and in the news. However, it’s not exactly fair to consider Ethereum to be in direct competition with Bitcoin. It has different goals, features and even technology.

Ethereum is a decentralized blockchain network powered by the Ether token that enables users to make transactions, earn interest on their holdings through staking, use and store nonfungible tokens (NFTs), trade cryptocurrencies, play games, use social media and so much more.

Many consider Ethereum to be the internet’s next step. If centralized platforms like Apple’s App Store represent Web 2.0, a decentralized, user-powered network like Ethereum is Web 3.0. This “next-generation web” supports decentralized applications (DApps), decentralized finance (DeFi) and decentralized exchanges (DEXs), for instance. 

This guide will provide you insights on the history of Ethereum, ethereum mining, how does Ethereum work, how to buy Ethereum, ETH vs BTC, Ethereum benefits and a glimpse of Ethereum 2.0. 

History of Ethereum

Ethereum wasn’t always the second-largest blockchain project in the world. Vitalik Buterin actually co-created the project to answer for Bitcoin’s shortcomings. Buterin published the Ethereum white paper in 2013, detailing smart contracts — automated immutable “if-then” statements — enabling the development of decentralized applications. While DApp development already existed in the blockchain space, platforms weren’t interoperable. Buterin intended Ethereum to unify them. To him, unifying the way DApps run and interact was the only way to maintain adoption.

Thus, Ethereum 1.0 was born. Think of it as Apple’s App Store: one space for tens of thousands of different applications, all abiding by the same ruleset. Only that ruleset is hardcoded into the network and enforced autonomously with developers able to enforce their own rules within DApps. There isn’t a central party, like with Apple changing and enforcing regulations. Instead, the power is in the hands of the people who act as a community.

Of course, building such a network isn’t cheap. So, Buterin and his co-founders — Gavin Wood, Jeffrey Wilcke, Charles Hoskinson, Mihai Alisie, Anthony Di Iorio and Amir Chetrit — held a token presale to raise $18,439,086 in Ether, funding Ethereum’s present and future developments.

The group also founded the Ethereum Foundation in Switzerland with the mission to maintain and develop the network. Soon after, Buterin announced that the foundation would run as a nonprofit, which caused some co-founders to leave.

Over time, developers came to Ethereum with their own decentralized ideas. In 2016, these users founded The DAO, a democratic group that voted on network changes and proposals. The organization was backed by a smart contract and circumvented the need for a CEO heralding power over Ethereum. Instead, a majority needed to vote on changes for them to be implemented.

However, this all went south when an unknown hacker stole $40 million in funds from The DAO’s holdings due to a security exploit. To reverse the theft, The DAO voted to “hard fork” Ethereum, diverging from the old network and upgrading to a new protocol, essentially undergoing a major software update. This new fork retained the name Ethereum, while the original network exists as Ethereum Classic.

How does Ethereum work?

Like Bitcoin, the Ethereum network exists on thousands of computers worldwide, thanks to users participating as “nodes,” rather than a centralized server. This makes the network decentralized and highly immune to attacks, and essentially unable to go down as a result. If one computer goes down, it doesn’t matter because thousands of others are holding the network up.

Ethereum is essentially a single decentralized system that runs a computer called the Ethereum Virtual Machine (EVM). Each node holds a copy of that computer, meaning that any interactions must be verified so everyone can update their copy.

Network interactions are otherwise considered “transactions” and are stored within blocks on the Ethereum blockchain. Miners validate these blocks before committing them to the network and acting as transaction history or a digital ledger. Mining to verify transactions is known as a proof-of-work (PoW) consensus method. Each block has a unique 64-digit code identifying it. Miners commit their computer power to find that code, proving that it’s unique. Their computer power is “proof” of that work, and miners are rewarded in ETH for their efforts.

Also, like Bitcoin, all Ethereum transactions are entirely public. Miners broadcast completed blocks to the rest of the network, confirming the change and adding the blocks to everyone’s copy of the ledger. Confirmed blocks cannot be tampered with, serving as a perfect history of all network transactions.

But, if miners are paid for their work, where does that ETH come from? Each transaction comes with a fee, called “gas,” which is paid by the user initiating the said transaction. That fee is paid to the miner who validates the transaction, incentivizing future mining and ensuring network security. Gas essentially serves as a limit, restricting the number of actions a user can make per transaction. It’s also in place to prevent network spam.

Because ETH is more of a utility token than a token of value, its supply is infinite. Ether consistently enters circulation in the form of miner rewards, and it will with staking rewards as well once the network moves to proof-of-stake (PoS). In theory, Ether will always be in demand, meaning inflation should never devalue the asset beyond use.

Unfortunately for many, Ethereum gas fees can run quite high based on network activity. This is because a block can only hold so much gas which varies based on transaction types and amounts. As a result, miners will choose transactions with the highest gas fees, meaning users are competing to validate transactions first. This competition pushes fees higher and higher, congesting the network during busy times.

Network congestion is a significant problem, though it’s being addressed in Ethereum 2.0 — a complete overhaul that will be discussed as a separate section.

Interacting with Ethereum requires cryptocurrency, which is stored in a wallet. That wallet connects to DApps, acting as a passport for the Ethereum ecosystem. From there, anyone can purchase items, play games, lend money and do all sorts of activities just as they do on the traditional internet. Only, the traditional web is free to users, as they’re giving away personal information. Centralized entities running websites then sell that data to make money.

Cryptocurrency takes the place of data here, meaning users are free to browse and interact anonymously. This also means DApp use is nondiscriminatory. For example, no lending or banking DApp can reject someone based on their race or financial status. An intermediary can’t block what they consider a “suspicious transaction.” Users control what they do and how they do it, which is why many consider Ethereum to be Web 3.0 — the future of web interaction.

What does Ethereum do?

Decentralized finance has arguably been the Ethereum network’s biggest achievement. DApps that can perform several functions within the ecosystem popped up around 2019 to 2020 and are growing in popularity by the day. The more DApps are used, the more the Ethereum network will be used as a result. Ethereum’s DeFi scene is the biggest one out there, with successful DApps bringing more awareness to the platform over the years.

Artists, for example, are making millions of dollars by bringing their work to the blockchain via nonfungible tokens, or NFTs. One might wonder, why buy digital art when we can just screenshot it? Collectors want ownership, that’s why. NFTs also hold proof of ownership and serve as a secure form of storage. It’s basically an all-in-one for collectors, so it’s not hard to see the appeal.

It’s the same reason that one would want the original “Mona Lisa” over just a copy, even if a copy is indistinguishable from the first. NFTs also represent usable items and accessories in online games. Players can decorate their houses and characters with unique assets from artists, providing yet another income stream for creatives.

Developers have built uncensorable social media apps, allowing users to tip one another for content. Games allow users to invest in assets, play to grow them and then sell for a profit, extracting actual value from their game time. There are prediction platforms that reward correct forecasts and freelance platforms that don’t take a huge cut of each payment. 

This is all managed autonomously through blockchain and smart contracts, with DeFi putting users more in control of their funds than ever before.

Ethereum Mining

The process of creating a block of transactions to be added to the Ethereum blockchain is referred to as mining. Ethereum currently uses a proof-of-work blockchain but is moving to proof-of-stake (PoS) with Ethereum 2.0 for scalability purposes and a more environmentally friendly approach.

Ethereum miners are computers that run the software and use their time and processing power to process transactions and create blocks. Network participants must ensure that everyone agrees on sequencing transactions in decentralized systems like Ethereum. Miners assist in this by generating blocks by solving computationally challenging riddles, thereby safeguarding the network from attackers.

Ethereum vs. Bitcoin

While Bitcoin is the most mainstream cryptocurrency, the Ethereum community has the ambition to expand the project. The former is meant to be digital money, and it serves that purpose reasonably well. But Bitcoin has its limitations. It’s a PoW network that’s struggling to scale, leading some to believe that it’s more of a store of value, similar to gold. Bitcoin also has a hard cap of 21 million coins, lending itself more to that argument.

Ethereum, on the other hand, intends to overtake our current internet infrastructure. It plans to automate many processes that still require intermediaries such as using an app store or working with fund managers. ETH is used more as a way to interact with the network than as a way to transfer money, though it can do that too.

Developers can build on Ethereum to create a unique Ether-compatible token for each DApp, called an ERC-20 token. While the process isn’t perfect, this means all Ethereum-based tokens are technically interoperable. Bitcoin’s network is just for Bitcoin.

Advantages of Ethereum

Aside from decentralization and anonymity, Ethereum also has various other benefits, such as a lack of censorship. For example, if someone tweets something offensive, Twitter can choose to take it down and punish that user. However, on an Ethereum-based social media platform, that can only happen if the community votes to do it. That way, users with different viewpoints can discuss as they see fit, and the people can decide what should and shouldn’t be said.

Community requirements also prevent bad actors from taking over. Someone with ill intentions would need to control 51% of the network to make a change, which is nearly impossible in most cases. It’s much safer than a simple server that can be broken into.

Then there are smart contracts, which automate many of the steps taken by central authorities on the traditional web. A freelancer on, for example, Upwork must use the platform to find clients and set up payment contracts. Upwork’s business model takes a percentage of each contract to pay its employees, server costs, etc. On Web 3.0, a client can simply write a smart contract that states, “If the work is turned in at X time, the funds will be released.” The rules are hard-coded into the contract and cannot be tampered with by either party once written.

It’s also getting easier than ever before to acquire Ether. Companies like PayPal and its Venmo subsidiary support purchasing crypto with fiat currency right within the application. Considering the millions of customers on each platform, they’re bound to get involved sooner rather than later.

Disadvantages of Ethereum

While it sounds like the perfect platform, Ethereum has a few key issues that need to be worked out.

The first is scalability. Buterin envisioned Ethereum the way the web is now, with millions of users interacting at once. Due to the PoW consensus algorithm, however, such interaction is limited by block validation times and gas fees. Furthermore, decentralization is a hindrance. A central entity, like Visa, manages everything and has perfected the transaction process.

Second, there is accessibility. As of the time of writing, Ethereum is expensive to develop on and challenging to interact with for users unfamiliar with its technology. Some platforms require specific wallets, which means that one must move ETH from their current wallet to the required wallet. That’s an unnecessary step for users ingrained in our current financial ecosystem and not beginner-friendly in the slightest.

Sure, PayPal is adding crypto support, but users can’t do much aside from holding it there. The platform needs to integrate with DeFi and DApps to increase accessibility in a meaningful way. 

The platform does have some well-written documentation on the matter — another key way to bring in more users. But the act of actually using Ethereum needs streamlining. Learning about blockchain is very different from using it.

What is Ethereum 2.0 (Eth2)?

Ethereum is slowly upgrading to its 2.0 version, which is expected to bring a proof-of-stake consensus algorithm. Planned to occur from 2020 to 2022, the traditional Ethereum network is working on merging with the Beacon Chain — Ethereum 2.0’s first new feature.

The Beacon Chain doesn’t change much at first glance, but it adds the foundational changes necessary for future upgrades, such as shard chains. Remember the scalability issue discussed earlier? Shard chains and the process of sharding are a big part of solving any scaling issues.

Sharding is the act of spreading transactions across multiple, smaller blockchain networks. These smaller networks can be run by users with weaker hardware, as they only need to store information from said shard, rather than the entire network. Essentially, sharding makes Ethereum validation more accessible and helps to decongest the main network.

Ethereum 2.0 has many cryptocurrency enthusiasts feeling bullish. Celebrities are taking advantage of NFTs, and the increase of general blockchain awareness is growing. However, all of this activity has resulted in high transaction fees and slower validation times, exemplifying the need for Ethereum 2.0. This can create a problem, as fees can cost more than half of transaction amounts at times. Fortunately, DApp developers are hard at work to make it more accessible for the pending mainstream adoption.

Part of that solution is in the proof-of-stake consensus, a core feature of Ethereum 2.0. Instead of mining, which is energy-intensive, Ethereum 2.0 marks the move to a PoS consensus algorithm. Proof-of-stake replaces miners with validators: users who store the Ethereum blockchain, validate transactions and more. They’re essentially another form of nodes.

To become a full validator, one must stake a minimum of 32 ETH, at least during the early period of Ethereum 2.0. By leaving a computer connected to the network, validators earn ETH as a reward for their efforts. The idea is that those who stake their ETH have the best network intentions in mind and will do whatever they can to ensure its success. Plus if a validator fails to participate or tries something malicious, they can lose said ETH.

The argument for proof-of-stake is that it is a faster more accessible form of blockchain consensus. It doesn’t require special hardware like mining does, meaning anyone with the funds and a device can participate. In theory, that accessibility should grow the network. The more validators, the more blocks get validated. Extra validators also decentralize Ethereum even more, increasing security as the role expands.

How to buy Ethereum

You won’t be able to buy cryptocurrencies from a bank or an online brokerage like Vanguard or Fidelity. Instead, you’ll need to use a cryptocurrency trading platform. There are numerous cryptocurrency exchanges available, ranging from simple to complicated dashboards for advanced traders. Different platforms have different pricing, security measures and other features, so doing some research before signing up is a good idea.

To open an account with a crypto exchange, you’ll almost certainly need to supply some personal information and have your identification verified. Then you’ll be able to fund your account by connecting your bank account or debit card. Fees will most likely vary depending on the option you choose.

Funding your account does not imply that you have acquired Ethereum, and as with any investment account, you don’t want your uninvested funds to remain idle. At this stage, you must purchase Ethereum in order to invest.

You’ll be able to trade your United States dollars for Ethereum after your account has been filled. Simply enter the dollar amount you want to swap for Ethereum. Depending on Ethereum’s pricing and how much you wish to buy, you’ll most likely be buying shares of a single Ethereum currency. Your purchase will be displayed as a percentage of a total ether coin.

It’s easier to leave your crypto investment in your exchange account if you only have a little quantity. However, if you wish to shift your holdings to a safer storage location, a digital wallet can provide extra security. There are numerous types of digital wallets, each with varying levels of protection such as a paper wallet or a mobile wallet. 

Related: Ethereum Wallets: A beginner’s guide to storing ETH

Should you buy Ethereum?

Ethereum is the second most valuable cryptocurrency by market capitalization, and it is regarded as the silver to Bitcoin’s gold. Like any investment, it’s feasible that Ethereum’s increased risk equates to larger rewards. In any case, it’s no longer 2009: Ethereum has sped past the proof-of-concept stage and now is the moment for investors who haven’t explored this asset class before to do so.

Given the uncertainty and volatility of the crypto market, before investing a significant amount of your retirement funds in Ethereum or any other cryptocurrency, do your own research. However, it may be worth considering as an aggressive growth choice in a diversified portfolio. Of course, don’t invest more than you can afford to lose.

The future of Ethereum

The Ethereum blockchain has seen a surge in popularity in recent months, as developers have used it to construct a slew of decentralized finance projects and NFTs. The emergence of new applications like these — among the first to run on a public blockchain — has already triggered a tremendous network effect, according to advocates, as increased activity attracts more and more developers to Ethereum.

However, basic issues remain about whether Ethereum, which is behind schedule with a complicated set of technological upgrades, will be able to compete with more agile competitors and whether any consensus on its long-term function will emerge as the crypto world grows.

On the contrary, investors like Garg warn that with Ethereum’s long-term significance, the cryptocurrency markets may be set for a reversal, with Bitcoin vaulting back to undisputed dominance.