Bitcoin, the first cryptocurrency ever created, is still the biggest and most well-known name in the space. But there are other valuable cryptocurrencies out there with different features and values, such as Ethereum. And that’s where things get confusing.
Ethereum is the second-largest cryptocurrency after Bitcoin, but it’s also far more than just a digital currency. This blockchain can be used to create smart contracts and applications, including ones that allow for decentralized file storage or even advanced voting systems.
If you’re new to the world of cryptocurrency, learning about Ethereum can be daunting — but it doesn’t have to be! Here’s a quick look at what Ethereum is and how it works.
What is Ethereum?
In short, Ethereum is an open-source, public, decentralized platform that runs smart contracts using a cryptocurrency called Ether. Ether can be used to trade with other users and pay transaction fees and services within the Ethereum ecosystem. The platform was proposed by Vitalik Buterin in 2013 and launched in 2015 after a crowdsale in 2014 (during which it raised $18 million). It went live on July 30, 2015, with 11.9 million ETH sold.
Bitcoin and Ethereum are both decentralized peer-to-peer networks that enable people to transact with each other without the oversight of third parties. However, they have different long-term visions and limitations.
Bitcoin was created to send money around the world quickly and cheaply, free from the control of any central authority or institution. It was designed to provide an alternative to fiat currency, such as the U.S. dollar, and to circumvent high bank fees and slow cross-border transfers. Because of this singular focus on being an efficient payment system, it has trouble scaling up to meet the demands of other applications: transactions can be expensive, slow, and unreliable.
Ethereum also functions as a currency based on blockchain technology, but it aims to be more than just a digital way to move money from point A to point B. Ethereum’s creators imagined it could be used for so much more — to run smart contracts between trusted parties regardless of geographic location without intermediaries and create decentralized organizations that don’t need administrative overhead.
How does Ethereum work?
The Ethereum blockchain is a database designed to add information. Once information is added, the data can’t be changed or deleted. Ethereum contains millions of transactions grouped into blocks and smart contracts. Blocks form a sequence — a complete record of the history of Ethereum.
Ethereum captures everything that happens on the network in real time. A copy of each transaction is distributed throughout the network. Each node on the Ethereum network keeps a copy of this history. The database is synchronized through a decentralized network. This makes Ethereum available to anyone who can use the internet.
Ethereum works with the native currency Ether (ETH). Every transaction on the network requires some amount of ETH to be paid to execute it successfully. The amount varies based on how much computational power was used during the execution of the contract. This means that users can choose whether they want lower fees by using less computing power or higher fees by using more computing power when executing their contracts. Thus, the network participants can affect the speed of transaction confirmation.
The Ethereum network uses smart contracts to create an economy — free of states and banks. Let’s take a closer look at what a smart contract is.
What is a smart contract?
Ethereum’s blockchain has been used for smart contracts, which are self-executing agreements and do not need any third-party involvement. The advantage of these contracts is that they can be executed automatically, with no need for human intervention or oversight. In fact, a smart contract is just a piece of software code embedded in a blockchain. The code contains the terms of the contract. When they are completed, a transaction automatically occurs.
Smart contracts ensure the functioning of decentralized projects (DeFi, DApps, etc.) without the support of regulatory authorities. In this case, smart contracts ensure that the stipulated agreements are followed in the correct algorithmic sequence.
The algorithm itself is written inside the blockchain; therefore, the rules for transactions and other manipulations cannot be changed and are binding on all participants.
Let’s take an example: the process of buying and selling cryptocurrency between users. Unlike traditional transactions, this one has performed anonymously and is not regulated by intermediary bodies. Thanks to smart contracts, no third party is needed for a transaction between two parties because the terms of the deal are encoded in the program. This removes the possibility of fraud and ensures that the transaction is conducted in a specific algorithm of sequential actions.
How do smart contracts work?
Smart contracts are part of the blockchain software code and work directly within the network. They perform a service essentially the same as paper contracts, except in the digital sphere. The conditions are written not with a pen on paper, but with mathematical algorithms and programming languages.
A smart contract is a conditional algorithm or a set of instructions for completing an action if certain conditions are met. As in a paper contract, the conditions are subject to mandatory implementation. The transaction will be implemented when the conditions are met, and users will receive the stipulated result. After completing the algorithm and the correct execution of the operation, smart contracts become part of the registry, getting into the blockchain itself.
The Ethereum and Bitcoin blockchains have a few other fundamental differences. First is the Solidity programming language. Secondly, the different status of the definition of the transaction. The ETH blockchain identifies a transaction as a whole part of the network ecosystem, while the BTC blockchain defines a transaction as a separate element. Thirdly, Ethereum allows you to develop smart contracts that will further carry out the process of generating new tokens according to the ERC-20 standard.
In many ways, the innovations of the Ethereum blockchain have made it possible to significantly simplify the interaction between various platforms, services, and crypto wallets.
Ether and gas
The main purpose of Ethereum is the transactions of digital assets and the support of the Ethereum blockchain. Whenever transactions are made and closed on the Ethereum blockchain, the user is charged a commission in the Ethereum cryptocurrency.
There are two concepts within the Ethereum system: Ether and gas. And this sometimes confuses:
- Ether is what you see on your balance when you buy this altcoin. Transactions are carried out in ethers.
- Gas is a unit of measurement of calculations, that is, how much power is spent on a transaction. For each, there is a certain “price,” indicated by gas.
Gas is necessary for transactions and the operation of smart contracts. The average cost of gas is constantly changing. To a greater extent, it depends on the miners. When the network is overloaded, the cost of gas rises, and when there is little activity, it falls. The more complex the contracts are, the more gas they ask for. In Ethereum, gas serves as a measure of computing power. Gas is designated as gwei. One ETH is equal to one billion Gwei.
What is the ERC-20 token?
On the Ethereum blockchain, users can create their own tokens. These tokens use a specific smart contract that tracks the transactions of that token. ERC-20 stands for Ethereum Request For Comments; the number 20 is a unique identifier that distinguishes the standard from others.
ERC-20 is a standard, or in other words, a set of rules, designed to simplify and improve the creation process for new Ethereum-based tokens.
ERC-20 tokens do function like regular cryptocurrencies, but their concepts are different. In fact, the terms “cryptocurrency” and “tokens” have different meanings, and they should not be confused; they are not equivalent.
First of all, cryptocurrency is a form of digital asset encrypted with cryptography. This means that these cryptosystems run on their own separate blockchains, and the ledgers are distributed across decentralized blockchains.
In turn, tokens are a utility that exists on top of the blockchain. Ethereum ERC-20 tokens and other alternatives like ERC-223 and ERC-721 are among the most popular.
What makes ERC-20 tokens different from standard cryptocurrencies is that they run entirely on the Ethereum blockchain and not on their unique blockchain. Therefore, a gas fee in ETH is charged for the transaction, and the miner uses this fee to complete transactions on the network.
How are Ethereum and Bitcoin different?
Let’s start by looking at how the Bitcoin blockchain works. It was created by a person or group of people under the pseudonym Satoshi Nakamoto in 2009. The only type of transaction in this blockchain is the transfer of bitcoins from one address to another.
Bitcoin operating conditions are written in the Bitcoin Script language. It is not a universal or flexible language. The code is executed once and does not affect the fate of the blockchain in the future.
Everything works differently on Ethereum. The Ethereum Virtual Machine (EVM) is responsible for its programmability. It is a Turing complete machine, which means that all problems can be solved using only a Turing Computing Machine (or its equivalent). Turing completeness is a fundamental concept in computer science, which can be used to measure, for example, the universality of a programming language.
The Turing complete machine means that, theoretically, it can perform arbitrarily complex calculations, and contracts can be executed multiple times. There is no such possibility in the Bitcoin blockchain.
The EVM is completely sandboxed, meaning it does not have access to the resources of the computers it is running on. The machine only has access to the last block of Ethereum. Therefore, the payment for a transaction in the network is proportional to the computing resources used in its execution.
Using Ethereum in DeFi
The Ethereum blockchain has acquired a special role in decentralized finance (DeFi). It is considered the main blockchain for applications in this area. Most applications (dApps) also mainly use the Ethereum blockchain, and until 2020, all GameFi projects were only on this platform. Ethereum blockchain allows everyone to create their own smart contracts and applications that will work in certain areas (finance, business, healthcare, etc.)
However, projects are constantly emerging that want to carve out their niche in DeFi. This is caused by several reasons, including issues with scalability, low speed, and high transaction costs.
Future of Ethereum
At the moment, Ethereum uses the Proof-of-work (PoW) consensus type. New blocks appear as a result of mining, and solving complex cryptographic problems with the help of equipment. Ethereum, Bitcoin (BTC), Bitcoin Cash (BCH), and Litecoin work according to this consensus mechanism. However, PoW has a scalability issue, as it requires more and more computing power.
There is an update coming to the entire Ethereum network — Ethereum 2.0. The main difference between Ethereum 2.0 is the use of the Proof of Stake (PoS) consensus mechanism. The second version of Ethereum should provide greater efficiency and scalability of the network.
Proof-of-stake will solve the problems associated with high energy costs. Instead of mining, there will be staking; that is, validators will confirm new blocks depending on the share of cryptocurrency ownership. The PoS method is used in cryptocurrencies such as Cardano, Stellar, Ripple, EOS, and NEO.
What is Ethereum 2.0
Ethereum 2.0 is the second iteration of the Ethereum blockchain and a full transition to Proof-of-Stake. Verification of transactions in the blockchain will no longer depend on computing power but on staking. The transition’s support is confident that this will help make the network secure, including minimizing MEV (Miner Extractable Value) risks.
In addition, Ethereum 2.0 is expected to increase network bandwidth and, as a result, increase the speed of transactions and reduce costs and gas fees. The transition will also help Ethereum maintain its leading position in DApps.
It is worth noting that the transition to PoS is a complex technological process that can’t be completed in one day. Developers carry out hard forks to mitigate possible risks within the network during the transition.
Ethereum hard forks
As conceived by the developers, a full transition should go through a series of updates and hardforks. It was named Metropolis.
- The first stage — Byzantium — took place in October 2017. Thanks to this update, the processing speed of transactions has been increased, the reward for miners has been reduced from 5 to 3 ETH, and the overall privacy of the system has also been improved.
- Most importantly, the activation date of the “difficulty bomb” has been pushed back a year and a half. Initially, it was thought that Ethereum would immediately work on PoS, but in 2015, when it was launched, this technology was still “raw.” After the network was launched on PoW, a “difficulty bomb” was placed in it — a programmed mechanism for exponential mining complication, which encourages network participants to switch from the PoW algorithm to PoS as soon as possible.
- The second stage of Metropolis was the Constantinople hard fork. It was planned for 2018, but after the test network launch, the Ethereum team decided to postpone it. It was launched on February 28, 2019, along with the St.Petersburg update, which removed some bugs in the network. The hard fork increased the efficiency of the network and reduced the reward for miners from 3 ETH to 2 ETH. Some operations have been simplified; it has become easier to develop smart contracts.
- The third major update is Istanbul, which should bring Ethereum closer to version 2.0. It made it possible to increase the network’s resistance to DDoS attacks, change the price of gas for various operations, and increase the scalability of the cryptocurrency.
- Berlin became the second phase of Istanbul. It was followed by the London hard fork, which was activated in August 2021. The latest update burned some of the miners’ commissions and expanded the gas limits in the block. After the update, the base commission for each block replaced the gas bidding auction.
- On October 27, 2021, the Altair update was activated. It introduced penalties for inaction and misbehavior of validators.
The next step in the Ethereum upgrade process is to merge the mainnet with Ethereum 2.0’s Beacon Chain, enabling full staking. Once this is complete, Ethereum shard chains will launch in 2023, increasing the blockchain capacity, as transactions can be split across 64 new chains. These implementations are currently live on the testnet, with over 11 million ETH already staked by users.
Ethereum’s goal is to make it easier for developers to create new applications that use blockchain technology. Smart contracts can eliminate the need for an intermediary, enabling the creation of decentralized applications (dApps), decentralized autonomous organizations (DAOs), and much more. The full-fledged launch of Ethereum 2.0 can seriously impact the entire crypto industry, facilitating the widespread adoption of blockchain technology in the daily lives of more people around the world.
