Before defining Ethereum, it is important to understand the basics of Bitcoin and blockchain. Bitcoin is built using blockchain: a decentralized, digital, and public ledger system. Bitcoin was created to allow online transactions to take place between users, without the need for a trusted central authority. This brought about a revolutionary change to the global financial stage.
Enter Ethereum. Ethereum was defined by creator Vitalik Buterin in the 2013 whitepaper as a “next-generation smart contract and decentralized application platform.” Like bitcoin (BTC) on the Bitcoin network, Ether (ETH) is the native token on Ethereum. Ethereum was also built to be a Turing-complete platform, capable of supporting a wide range of applications. This is due to Ethereum’s flexibility as a blockchain, which allows developers to create decentralized apps, or dApps, through the use of smart contracts.
Ethereum is therefore considered a second-generation crypto, or cryptocurrency 2.0 as put by Buterin in an early blog post. The applications it supports provide a range of services including gaming, finance, and even healthcare insurance.
How Does Ethereum Work?
Like other cryptocurrencies, Ethereum is built on a blockchain - a decentralized, transparent, and secure digital ledger. On a public blockchain, data is stored and maintained across a distributed network of users called nodes. Each node has its own copy of the blockchain, allowing it to cross-reference its data against others’ for any errors.
Every time a new block is added to the blockchain, all the new transactions must be verified by the network. This is integral to the security of the Ethereum blockchain. Nodes agree on the accuracy of the data of every new block with consensus algorithms. Ethereum currently uses a Proof-of-Work (PoW) consensus algorithm, like Bitcoin. However, Ethereum has begun transitioning to a Proof-of-Stake (PoS) system in order to provide a faster and more energy efficient service. This upgrade is known as Ethereum 2.0 or Eth2.
In PoW, nodes earn more tokens by doing something called mining. This sort of mining does not involve shovels and canaries - this entails solving a cryptographic puzzle set by the Ethereum network. Simple, right? The first node to solve the puzzle broadcasts its solution to the network, and if approved, can add the new block to the blockchain. The successful miner is rewarded newly minted ETH as well as gas fees.
Gas is used on Ethereum to measure the cost of performing transactions. While also paid in ETH, gas fees are listed in tiny denominations of ETH known as Gwei (1 Gwei = 0.000000001 ETH).
Every node running the Ethereum blockchain uses the Ethereum Virtual Machine (EVM), which is essentially a virtual world that acts like a computer system. Operations on the EVM require a certain amount of computing power, which gas pays for.
You choose the gas you want to pay for each of your transactions on-chain. Miners then select which transactions to validate first - usually based on the amount of gas paid - which encourages users to pay higher gas prices in exchange for priority. Users also set a gas limit - the most they are willing to pay - which is typically 21,000 Gwei for standard ETH transactions.
At times, gas fees can become exorbitantly high, especially when the price of ETH spikes up along with activity on the network. An increase in transactions on the network invariably hikes up the fees. Every transaction is in competition for attention, so add some more incentive for the miners to accept your transaction. While this can be good for miners, it can also congest the network and cause scalability issues.
What Can You Use Ethereum For?
Ethereum supports peer-to-peer transactions just like Bitcoin, but it goes so much further than that. People from all walks of life have begun to realize that Ethereum has an incredible array of use cases across many sectors, such as the financial sector as well as the gaming industry. DeFi, DAOs, NFTs - these were born on the Ethereum platform and have since radically changed the crypto space.
Ethereum supports these through the use of smart contracts - automated and autonomous contracts with terms of agreement written as lines of code. This means they will only execute if and when certain predetermined conditions are met, allowing both parties to engage in a direct and trustless exchange.
Short for Decentralized Finance, DeFi refers to the ecosystem of financial services built on blockchain. This is one of the newer additions to the crypto realm which maybe you (or your younger cousin!) has been staking coins with. While Bitcoin provided a starting point for this new financial sphere, Ethereum supports other key services like peer-to-peer lending/ borrowing, trading, and funding. And unlike traditional financial services, DeFi does not require personal information or identification for access.
DeFi markets also stay open 24h, allowing for unlimited trading hours. Early lending protocols like MakerDAO and Aave were pioneers in the DeFi space, the former promoting the use case for stablecoins. Decentralized exchanges (DEXs) make up another integral DeFi sector, allowing users to directly trade their assets thanks to smart contracts. The best examples include Uniswap and Sushiswap.
Decentralized Autonomous Organizations, or DAOs, are organizations collectively managed by all the individuals holding the DAO tokens. Imagine your favorite company operating under rules which all the shareholders (including yourself!) set for it. For example, Maker (MKR) token holders are the primary stakeholders of the Maker DAO system and are the only individuals eligible to vote on governance decisions. A DAO can be applied to any type of arrangement where a group of people need to make decisions.
The most common application of DAOs is in companies, like Maker, in order to set rules for major issues like APY and how to emit new DAI tokens. Aside from financial institutions, a DAO can be used in governance of fund allocation, for venture capital, in betting and prediction markets, lending, and advanced DeFi protocols. Furthermore, rules made by the DAO are enforced by smart contracts on Ethereum. As of now, the state of Wyoming in the USA is the only major traditional government entity that recognizes DAO as a corporate entity.
NFT stands for Non-Fungible Token - 'non-fungible' meaning that it is unique - which is a specialized type of token on the Ethereum blockchain. Fiat currency or ETH, on the other hand, are fungible because their units can be interchanged. The ERC-721 token standard makes NFTs possible, though other standards, like ERC-1155, support semi-fungible tokens.
Because of their unique properties, NFTs have become a popular form of tokenizing collectible items like art, game avatars, and even real estate. When you own an NFT, whether a CryptoKitty or a unique art piece, you actually hold a proof of ownership in the form of a transaction on the Ethereum blockchain. This has been especially revolutionary for digital art, which previously struggled to maintain value because of its reproducibility. Creators can also earn continuous royalties on their work whenever it is resold to a new holder.
The art is also used on some games these days. The NFTs in this case are the game pieces which you can play with, collect, and trade. Play-to-earn games like Axie Infinity have made their mark on the Ethereum ecosystem.
NFTs can serve as collateral for a loan when borrowing money through DeFi applications. For instance, instead of putting up ETH as collateral for a loan, you could use an NFT. They also support fractional ownership, giving users the ability to act as shareholders of a unique asset.
The Future Of Ethereum
We mentioned earlier that Ethereum is upgrading to its 2.0 version in order to improve on scalability, security, and sustainability. This involves transitioning to a Proof-of-Stake system via the Beacon Chain - a bridge network that brings PoS to Ethereum - which will eventually merge with the Ethereum mainnet. Shard chains will then be included to address Ethereum’s scalability.
Don't worry if you don't understand those things because we will have articles explaining what both the Beacon Chain and shard chains are later on. For now, we think you’re all set with enough knowledge to explore the Ethereum ecosystem!