What Is Ethereum and How Does It Work?

TL;DR

Ethereum is the second most popular blockchain network with a native cryptocurrency ETH, which is the second largest crypto in terms of market capitalization after Bitcoin.
Ethereum network transitioned from Proof-of-Work consensus mechanism to Proof-of-Stake in 2022 to improve the network's capabilities.
Vitalik Buterin's vision for Ethereum focuses on utility, providing developers with the infrastructure to build diverse decentralized applications
Ethereum's ecosystem spans DeFi, gaming, NFTs, DAOs, and more, bolstering its position as a foundational pillar in the digital economy

What Is Ethereum?

Ethereum, conceptualized in 2014 by programmer Vitalik Buterin, stands as a monumental pillar in the world of blockchain technology. At its essence, Ethereum is a decentralized, open-source platform powered by its native cryptocurrency, Ether (ETH). Unlike traditional systems that operate on centralized servers, Ethereum runs on a vast, interconnected network of computers, known as nodes. This globally dispersed setup ensures that the platform remains resilient against single points of failure and censorship.

While Ethereum and Bitcoin, the inaugural blockchain protocol, both function as platforms facilitating digital money transfers, Ethereum's distinction lies in its broader utility. Ethereum serves as a platform for deploying "smart contracts," which are autonomous computer programs that automatically execute actions when certain conditions are met, reducing the need for intermediaries and enhancing transactional transparency.

This feature has made Ethereum an indispensable tool for developers, offering them a canvas to create decentralized applications (DApps). These DApps can range from decentralized finance (DeFi) platforms to games, each tapping into Ethereum's robust infrastructure. As blockchain technology continues its ascent in the modern digital age, Ethereum's role as a facilitator for DApps underscores its relevance and potential for transformative impacts across various industries.

How Is Ethereum Different From Bitcoin?

Despite sharing the foundational principle (blockchain technology) with Bitcoin, Ethereum serves distinct purposes and is built on divergent philosophies. The key differences between Ethereum and Bitcoin are:

1. Origin and purpose

Bitcoin, introduced in 2009 by the enigmatic Satoshi Nakamoto, was conceived primarily as a digital alternative to traditional currencies. Bitcoin is envisioned as a decentralized form of money immune to governmental interference or inflation. Its primary function is to serve as a medium of exchange, store of value, and, for some, a unit of account.

Ethereum, on the other hand, was created in 2014 by Vitalik Buterin with a broader vision. While it does have its own cryptocurrency, Ether (ETH), Ethereum's true purpose extends beyond just facilitating transactions. It's designed as a platform for developers to build and deploy smart contracts and decentralized applications (DApps). These allow for programmable transactions and a multitude of applications beyond mere currency transfers.

2. Smart contracts and DApps

Ethereum's aforementioned capability to facilitate smart contracts and DApps is its defining distinction. While Bitcoin does offer a form of smart contract functionality, Ethereum's is more flexible and generalized, allowing for an array of applications, from games to DeFi platforms, to be built atop its platform.

3. Tokenomics

Bitcoin has a capped supply, with a maximum of 21 million coins ever to be mined into existence. This scarcity principle is one of its core value propositions. Ethereum, in contrast, doesn't have a hard-capped supply. However, following its transition to Proof of Stake (PoS) in 2022, Ethereum has shown more deflationary characteristics in its supply dynamics.

In summary, while both Bitcoin and Ethereum leverage blockchain technology, they cater to different domains of the digital economy. Bitcoin aims to disrupt the way we perceive and use money, while Ethereum seeks to revolutionize how applications and agreements function in a decentralized setting.

How Does Ethereum Work?

Ethereum’s functionalities extend beyond mere cryptocurrency transfer, and therefore has some unique designs in its working mechanisms.

1. Smart Contracts

Smart contracts are self-executing contracts with the terms of the agreement directly written into code. Once deployed on the Ethereum blockchain, they autonomously execute predefined functions when certain conditions are met. For instance, a smart contract might automatically transfer funds from one party to another on a specified date.

2. Decentralized Applications (DApps)

Built atop Ethereum's platform, DApps are applications that run on a blockchain. They leverage Ethereum's smart contract capabilities, ensuring that all data and transactions are secure, transparent, and immutable. This has led to the rise of various decentralized platforms, ranging from DeFi, GameFi, to decentralized identities.

3. Ether and gas

At Ethereum's core is its native cryptocurrency, Ether (ETH). While Ether can be used for peer-to-peer transactions like Bitcoin, it's primarily used within Ethereum to facilitate and incentivize operations. Every action on Ethereum, from simple transfers to complex smart contract interactions, requires computational effort. This effort is quantified as "gas", and users pay for this gas using Ether.

4. Ethereum Virtual Machine (EVM)

The EVM serves as the runtime environment for smart contracts in Ethereum. More than being confined to just the Ethereum network, it's mirrored across every node within the Ethereum ecosystem, reinforcing decentralization and consensus-driven operations. This comprehensive replication fosters a high level of security and uniformity across the network.

Furthermore, the EVM's design plays a pivotal role in promoting interoperability. Various blockchain platforms have recognized the potential of the EVM and have integrated EVM-compatible layers or mechanisms into their systems. By doing so, smart contracts designed for Ethereum can be deployed and run on these EVM-compatible blockchains without significant modifications. This adaptability not only reduces development efforts but also bridges different blockchain communities, fostering collaboration and expanding the decentralized application landscape.

5. Consensus Mechanisms

Ethereum originally operated on a Proof of Work (PoW) consensus mechanism, much like Bitcoin. However, the network successfully transitioned to Proof of Stake (PoS) with the Ethereum 2.0 upgrades in 2022. PoS offers increased scalability and energy efficiency. In PoS, validators replace miners in the creation and verification of blocks based on the amount of cryptocurrency they "stake" or lock up as collateral.

In essence, Ethereum works as a multi-faceted platform, not just enabling digital currency transactions but also fostering a space where decentralized, trustless applications and agreements can thrive. Its flexibility and adaptability make it a foundational pillar of the modern crypto ecosystem.

The Merge: Ethereum’s Transition from Proof-of-Work to Proof-of-Stake

Ethereum previously relied on a process known as mining, utilizing the Proof of Work (PoW) consensus algorithm, akin to Bitcoin's method. Yet, with the landmark event of "The Merge" on September 15, 2022, Ethereum pivoted to the Proof-of-Stake (PoS) model for its network state updates. This transition to PoS marked the end of Ethereum's reliance on PoW, culminating in a dramatic decrease in energy consumption by nearly 99.95%.

Proof-of-Stake is a consensus algorithm introduced in 2011 as an alternative to Proof-of-Work. It aims to overcome the scalability limitations of PoW networks. PoS is the second-most-popular consensus algorithm, adopted by chains including BNB Chain, Solana (SOL), and Cardano (ADA).

What Is Ethereum 2.0?

Ethereum 2.0 (aka Eth2 or "Serenity”) is a series of the long-awaited upgrades to the Ethereum network that promises, among other things, to improve the network’s scalability. Through the implementation of several enhancements, speed, efficiency, and scalability should be improved without sacrificing security and decentralization. This version of Ethereum has always been on the horizon, but it’s taken some years to roll out. The primary reason for this is that scaling a blockchain in a secure and decentralized way is a challenging task.

The roll-out of Ethereum 2.0 is a gradual process that was initially planned in three main phases to ensure its success: phase 0, phase 1/1.5 and phase 2. Each phase incorporated distinct features essential to Ethereum's new and effective implementation.

Phase 0 saw the successful introduction of the Beacon Chain, launched on December 1st, 2020. It runs parallel to the mainnet and focuses on accepting validators (or stakers) through a one-way deposit contract. Validators' ETH is locked until the next phase, making it essential to understand that un-staking is only possible once shard chains are fully implemented.

Phase 1/1.5 was intended to be the combination of two phases, the introduction of shard chains and Ethereum's mainnet transition from Proof of Work (PoW) to Proof of Stake (PoS). Phase 1 introduces shard chains which enables validators to create blocks on the blockchain through PoS. Phase 1.5 began rolling out in 2021 and marks the official transition away from PoW.

Phase 2, the final phase, will enable Ethereum 2.0 to support fully formed shards and become the official Ethereum network. Shard chains will also work with smart contracts, allowing seamless integration of dApps and various technologies with Ethereum 2.0.

The Ethereum Ecosystem: DeFi, NFTs, DAOs, and Beyond

Since the inception of Ethereum, countless applications and products have been developed on the platform making it the second most popular cryptocurrency. Here are some of the most exciting and interesting features to come from this ecosystem.

1. Decentralized finance (DeFi)

DeFi represents financial applications developed atop blockchain infrastructures. The unique feature of DeFi is that it functions without central authorities, providing an open and programmable financial system.

By leveraging smart contracts and distributed systems, users can securely create decentralized finance applications. DeFi businesses currently offer services ranging from P2P lending and borrowing, to accruing interest on crypto assets, and decentralized exchanges to trade on. Some notable DeFi platforms include Compound Finance, Aave, and UniSwap.

2. Gaming

Gaming and virtual reality has become a large part of the Ethereum network. Decentraland and Sandbox are two of the biggest platforms that have created virtual worlds. The Ethereum blockchain is used to secure tokenized ownership of land, avatars, wearables and other goods. Non-fungible tokens

3. Non-Fungible Tokens (NFTs)

Non-fungible tokens (NFTs) are tokenized versions of digital or real-world assets that function as verifiable proofs of authenticity and ownership within a blockchain network. They can be used by decentralized applications (DApps) to allow for the creation and ownership of unique digital items and collectibles.

Various frameworks have been created to facilitate the issuance of NFTs. The most prominent of these is ERC-721, which is a standard for the issuance and trading of non-fungible assets on the Ethereum blockchain.This standardization of NFTs allows a higher degree of interoperability, meaning that unique assets can be transferred between applications with relative ease.

It is evident that non-fungible tokens (NFTs) have the potential to be one of the key components of a new blockchain-powered digital economy. They could be used in many different fields, such as video games, digital identity, licensing, certificates, or fine art - and even allow fractional ownership of items. Storing ownership and identification data on the blockchain would increase data integrity and privacy, while easy, trustless transfers and management of these assets could reduce friction in trade and the global economy.

4. DAO development

Decentralized Autonomous Organizations (DAOs) are community-led entities, governed by computer code and without central authority. These organizations use smart contracts or applications to gather information or votes to buy into the majority of the group transparently and without the use of a third party.

Even though the role of the Ethereum cryptocurrency may be vague for DAOs, it is clear that there is some sort of influence or interest from a personal and corporate finance perspective.

Frequently Asked Questions.

1. Is Ethereum a cryptocurrency?

Ethereum is the blockchain technology platform which uses ether (ETH) as its native cryptocurrency. The platform itself supports a large range of DdApps, including other cryptocurrencies powered by the ethereum blockchain. It is important to note that many people will refer to the cryptocurrency as Ethereum.

2. How can I buy Ethereum?

In order to buy ether you can use one of many cryptocurrency exchange platforms. Ethereum is supported by all major centralized and decentralized exchanges. You can simply create your account at an exchange that you trust, deposit fiat or cryptocurrencies to buy or swap ETH.

3. Is Ethereum a good investment?

As with any investment, it really depends on your risk tolerance, financial stability, objectives, and so forth. ETH is certainly a volatile investment, you should conduct your own research to determine if ETH is a good investment for you.

4. How does Ethereum make money?

As a decentralized platform, Ethereum does not make money like a traditional organization. Those who participate in securing and maintaining the network as stakers and validators get rewarded. They earn ether as a reward for validating transactions and creating new blocks.

5. Can you convert Ethereum into cash?

The simple answer is yes! You can use online cryptocurrency exchanges for this process. You can create your exchange account and link your bank account to it. Once this has been done, you can send ETH to an exchange account from an Ethereum compatible wallet. Once the ETH has arrived into your exchange account, you can place an order to sell it. Once this order has been processed, you can transfer the fiat currency to the linked bank account.

6. What happens if I lose my ETH?

Since there aren’t any banks involved, you’re responsible for your own funds. You can store your coins on an exchange, or in your own wallet. It’s important to note that if you use your own wallet, you absolutely must take care of your seed phrase. Keep it safe because you need it to restore your funds in case you lose access to your wallet.

FAQs

What Is Ethereum and How Does It Work? | Binance Academy? ›

Ethereum, like Bitcoin and other cryptocurrencies, allows you to transfer digital money. However, it's capable of a lot more – you can deploy your own code, and interact with applications created by other users. Because it's so flexible, all sorts of sophisticated programs can be launched on Ethereum.