Ethereum is a major player in the crypto market, with a huge first-mover advantage in processing complex crypto transactions. If you’re investing in crypto or thinking about buying in, it’s probably already on your radar. And if it’s not, well, it should be. Here’s my guide to what Ethereum is and how it works.
Ethereum’s origin story
Vitalik Buterin wrote the Ethereum white paper in 2013. He was just 19 years old at the time, but the Russian-born Canadian was onto something big.
At the 2014 North American Bitcoin Conference in Miami, Buterin compared Ethereum to Bitcoin with an analogy. Bitcoin is like “simple mail transfer protocol” (SMTP), which lets you send and receive email. Ethereum is like the programming language of the internet (Javascript), which developers use to build a range of internet applications (e.g. Facebook, Gmail, and crypto wallets). In other words, Ethereum is a platform for crypto innovation.
Why Ethereum is such a breakthrough technology
Ethereum was the first crypto protocol to use smart contracts. These are programmable rules that developers can upload to the Ethereum blockchain. Like regular Ethereum users, smart contracts have their own wallet addresses. That’s important to understand: you can send tokens directly to other users or send them to smart contract addresses, which have conditional payment rules attached to them.
Smart contracts open up a range of crypto possibilities. Back in 2017, new blockchain projects raised billions from initial coin offerings (ICOs) through Ethereum smart contracts. If you wanted to buy token X, you’d simply send ETH to a smart contact address before the ICO launch. Then on the project’s launch day, the smart contract would send token X back to your Ethereum wallet – based on the rules programmed into the smart contract.
The market collapsed in 2018, but ICOs proved an important point: smart contacts could execute complex transactions on the Ethereum blockchain without going through a financial middleman. As time went on, Ethereum’s capabilities grew…
How Ethereum’s decentralized applications (dapps) work
Online banking, social media, gaming, and investing apps all function seamlessly on your smartphone. If Ethereum was your phone, you could think of its apps as decentralized applications (dapps).
You see, Ethereum is a “layer 1” crypto protocol, meaning developers can build all sorts of dapps to run on its network. What’s more, these dapps can have their own native “ERC-20” tokens – which you can securely send, receive, and store on Ethereum’s blockchain. Here are some examples of dapps running on Ethereum:
- Compound: a decentralized finance (DeFi) protocol where you can earn interest on your crypto by locking it in Ethereum smart contracts.
- Uniswap: a DeFi exchange where you can trade crypto, and deposit crypto collateral in smart contracts to provide liquidity for other traders – banking some of their trading fees in the process.
- MetaMask: a crypto wallet that connects your PC or mobile device to the Ethereum network, allowing you to securely send, receive, and store all kinds of tokens on the blockchain.
How it works with NFTs
You can mint and trade “ERC-721” tokens on Ethereum – more commonly known as non-fungible tokens (NFTs). These have value because they’re unique, and can’t be copied or cloned. CryptoPunks, Bored Apes, and Meebits are popular examples here.
Rare jpegs have caught the eyes of collectors, but there’s a lot more that you can do with NFTs on Ethereum.
You can play NFT games on dapps, such as Alien Worlds, Sorare Fantasy Football, or Axie Infinity. Each game has different rules, but the general aim is to play, have fun, and collect in-game NFTs – with your ownership record of those updated on Ethereum.
You can also buy plots of digital NFT land on Ethereum-based projects like The Sandbox and Decentraland. In these “metaverse” worlds, you can interact with other people through your digital avatar. And if you own NFT land, you can build on it (just like with regular land) to further monetize your investment.
And of course, there’s ether
With so many interesting things being built on the Ethereum blockchain, you may wonder what that might mean for the long-term value of ether – the native coin of Ethereum.
Let’s go back to the smartphone analogy: your phone’s more useful (and more valuable to you) when it's running more applications. Ethereum is a base-layer blockchain, and its network value grows as more dapps and NFTs are built on top of it. Since ether is the “fuel” of the Ethereum network (users need some to pay fees to miners for Ethereum transactions), demand for ether goes up as the network grows.
Ethereum 1.0, proof-of-work and ether mining
Like Bitcoin, Ethereum currently uses a proof-of-work (PoW) system to validate and secure its blockchain. Here, miners compete to solve complex cryptographic puzzles to attach each block of transactions to the blockchain. As a reward for solving the puzzle, the victorious miner wins freshly minted ethers, which are then added to the total coin supply. On top of that, miners also earn ether transaction fees for their hard work.
Around 13,000 new ethers are mined every day. Since each Ethereum block takes about 13 seconds to mine, victorious miners receive about two ethers per block.
Ethereum’s PoW is extremely secure, but it also makes the network slow and expensive. It can process only around 30 transactions per second – that’s a lot less than competitor smart contract blockchain Solana, which can handle up to 65,000 per second. In terms of ether fees, each transaction will set you back about $15 on average – depending on the dollar price of ether. That’s even more than bitcoin transactions, which usually cost between about $1 and $5.
As with Bitcoin, Ethereum’s fees rise with network traffic. That’s because too many transactions can cause network congestion, so users bid up their fees to get miners to process their transactions ahead of others. In times of high network demand, Ethereum’s fees have been north of $50 – making it really expensive for smaller transactions.
But that’s set to change: Buterin and the Ethereum developers are upgrading the blockchain, which promises to be faster, cheaper, more secure, and more energy efficient.
Ethereum 2.0 and the end of ether mining
Ethereum is changing from a PoW to a proof-of-stake (PoS) blockchain, which means there’ll be no more energy-sucking, competitive ether mining. With PoS, “validators” confirm transaction blocks according to how much ether they “stake” – that is, how much they put up as collateral.
Validators will earn transaction fees in return. This works a bit like a wheel of fortune, where a random calculation selects the winner. Validators with more ether staked have a higher chance of winning on average.
Ethereum’s merge to full PoS is expected sometime in 2022, but it’s been under way since December 2020. Back then, ether holders started staking a minimum of 32 ethers on the “Beacon Chain” – a separate PoS blockchain that runs in parallel to the current PoW chain. Once the Beacon Chain merges with the PoW chain, the need for ether miners will go away – with only validators keeping the network in check.
PoS will mean Ethereum consumes far less electricity. And validators, unlike miners, won’t have to fork out on expensive mining equipment and cover sky-high electricity bills. They’ll just need to put up ether collateral. As a result, they won’t need such high ether rewards to incentivize them to validate and secure the blockchain. In other words, PoS is going to slow the creation of new ether, which will make ether a more scarce commodity – and likely a more valuable one in the coming years.
The PoS merge could also make Ethereum even more secure. Think about it: you’d need more than half the total ether staked to outbid the validator network – and that’s just to hijack a single transaction. You’d have to be insanely rich for that, and even then, the juice wouldn’t be worth the squeeze. A hack attempt wouldn’t likely bear fruit either. Validators would stand to lose their entire stake if they break the rules, and that threat should make Ethereum’s validator network impenetrable.
After the merge, Ethereum will be onto the next 2.0 upgrade: sharding. That will essentially split the chain into 64 pieces to reduce network congestion. Think of this like a highway with more lanes to ease the traffic. That should make Ethereum transactions a lot faster, and lower their fees.
Why ether is like “digital oil”
If bitcoin is digital gold, ether is digital oil – transaction fuel for the Ethereum machine. Etheruem transactions can be simple (i.e. sending ether to another person) or complex (e.g. minting an NFT or lending ERC-20 tokens to earn crypto interest).
As the first smart contract blockchain, Ethereum has a commanding market lead over younger competitors like Solana, Avalanche, and Fantom. Much like Facebook or Google, Ethereum’s benefited from a growing network effect – the more people use it, the more people use it. Combine that with the promises of Ethereum 2.0, and you’ve got good reason to consider holding ether in your long-term crypto portfolio.
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