What Is Ethereum and How Does It Work?

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A common mistake occurs when Ethereum and Ether are used interchangeably to describe cryptocurrency. But that is not entirely accurate.

Ethereum is a blockchain-based platform used primarily as decentralized support for collaborative applications, and Ether is the native token used to run the operations on its platform.

Ethereum’s platform is mainly used to store digital information and data without intermediaries. The data shared on it (through a network of computers called nodes) cannot be manipulated or changed. For example, housing contracts can be drawn up without housing agents, and money transfers can be made without banks. Ether (ETH), the network’s token, is used to facilitate payment in transactions globally.

The Ethereum blockchain was first proposed in 2013 and, subsequently, introduced in 2015 by developer Vitalik Buterin. Although Ethereum has similarities to Bitcoin, using the same proof-of-work consensus and a decentralized public ledger, it’s supposed to be more scalable (i.e., facilitate more transactions per second, or TPS). For example, the recent Ethereum London hard fork is a stepping stone for their 2.0 upgrade to counter some of Ethereum’s existing issues — such as network congestion.

Today, the Ethereum ecosystem is thriving, with almost 3,000 decentralized applications powered by the Ethereum community. At the same time, Ether remains the top altcoin with a market cap of over $350 billion on Aug. 17, 2021.

How Does Ethereum Work?

Ethereum is an open software platform built on blockchain technology, enabling developers to build and deploy decentralized applications (DApps) and smart contracts. A user who wants to tap into these applications needs to pay gas fees since computing resources are limited on Ethereum.

The Ethereum blockchain is sometimes dubbed the “world’s computer.” Not only is it viewed as a way to give users better control over their digital information and personal data, but  Ethereum’s smart contracts also allow developers to automate the terms on DApps, which is a big plus for Ethereum’s success. And of course, Ether (ETH) is the cryptocurrency that fuels those DApps.

For example, a smart contract that runs on the Ethereum blockchain helps define the rules and the agreement to enforce the contract when those conditions are met. This is achieved through the predetermined terms and codes (functions and states) that reside on a particular address on the blockchain. The gas fees are used as a mode of payment to compensate for the computing power used to validate the transaction on the Ethereum blockchain. Usually, when a transaction is more complex, a user must pay higher transaction fees, or gas fees, in order to process a smart contract.

The Purpose of Ethereum Smart Contracts 

Smart contracts are self-executing contracts with the terms for the agreement written into the digital code on the blockchain. Functions for these smart contracts can include insurance, supply chains, real estate and gaming.

Handling transactions and keeping track of the balances of the tokens also come under the responsibility of a smart contract. ETH must be sent to the smart contract in order to receive tokens in return. In contrast, ERC20 refers to the standard of rules for creating and issuing tokens on the Ethereum blockchain that all tokens must follow. 

These tokens can take the form of utility tokens and security tokens. Utility tokens are explicitly designed for use on DApps, or to promote a product. A security token, on the other hand, is an investment, for example, shares or even company funds. Security tokens are subject to strict regulatory frameworks, but this isn’t the case for utility tokens. 

DApps: Understanding Decentralized Applications

DApps are written with a unique code, Solidity, that was created especially for Ethereum. Some of the top DApps range from gambling, raising capital (ICOs) and DeFi to gaming, social networking and exchanges. They are not owned by a single entity, thus cutting out the middleman.

With many of the DApps on the Ethereum blockchain, users can gain incentives, such as tokens.

Here are some of the most well-known DApps in existence:

  • CryptoKitties: Launched in 2017, CryptoKitties is one of the first blockchain-based games. It uses smart contracts, enabling participants to collect and breed digital images of cats. They can be sold on the game’s marketplace. Most cats sell for under $100, but the most expensive cat ever sold brought an astounding price of more than $300,000. 
  • Brave: With more than 9 million active users, Brave aims to provide users an alternative to conventional digital advertising and service platforms while rewarding users with Basic Attention Tokens (BAT) whenever they participate in the ecosystem.
  • Uniswap: Uniswap allows users to swap ERC20 tokens through the use of a smart contract. Users can do this by connecting their MetaMask wallets. 
  • MakerDAO: MakerDAO allows users to borrow a stablecoin, DAI, with ETH used as collateral. The borrower pays interest on the loan, but if the value of ETH falls too much, the collateral will be sold to pay for the loan. 

Ethereum blockchain logoImage CC: Unsplash

What Is Ether?

Ether (symbol: ETH) is the native cryptocurrency that acts as the “fuel” for Ethereum transactions within the network. For example, a program that’s associated with the Ethereum network requires computing power to execute the request. When a user pays a node the Ethereum gas fee, the node will execute the transaction.

However, ETH transaction fees usually vary, depending on the demand and the complexity of the service required. For instance, the recent demand in decentralized finance (DeFi) has increased the number of transactions, such as sending tokens via decentralized exchanges (DEXs), causing the entire network to be congested. Because of this, ETH gas fees skyrocketed.

There are a few ways Ethereum derives its value. These include receiving gas fees, and borrowing and lending Ether via autonomous smart contracts using networks like AAVE, Compound and Yearn Finance to earn interest. At the same time, the booming interest in DeFi and NFT (non-fungible tokens)has increased the value of Ether.

Ether still remains the world’s second-largest cryptocurrency by market cap. Ether reached its all-time high of $4,362 in May 2021 but has since dipped, following the bear market. ETH is trading at slightly over $3,100 on Aug. 20.

History of the Ethereum Blockchain

Bitcoin’s primary purpose was always intended to be that of facilitating digital currency, but over time people started to realize that blockchain could also be used for other functions. 

Computer programmer Vitalik Buterin was one of these people. Being an early investor in Bitcoin himself, he envisaged more possibilities for nascent technology. He initially tried to build DApps on the Bitcoin blockchain but realized its capabilities at the time were insufficient. 

He then started to work on his own blockchain and, in 2013, published the Ethereum white paper. The Ethereum network, in its first incarnation known as Frontier, was launched in July 2015. 

In 2016, there was a major security incident when $50 million worth of ETH was stolen. This resulted in the blockchain being split in two. Its original version was carried on as Ethereum Classic, while a new chain was created, known as Ethereum. On this chain, the theft of the funds was reversed. 

Since then, the network has gone from strength to strength. There are now over 200,000 tokens and almost 3,000 DApps on the Ethereum network. Recently, the DeFi boom has been at the center of the network’s expansion. Despite the ongoing success story of the network, there have long been calls to expand its capabilities. That’s where Ethereum 2.0 comes in. 

Ethereum 2.0 Prospects

The creation of Ethereum 2.0, a major update for the Ethereum network, originated in calls to improve upon its scalability. These issues are primarily due to Ethereum’s proof of work (PoW) consensus mechanism. Although very secure, the mining process involved in PoW takes up vast amounts of electricity, meaning only around 15 transactions per second can be processed. With the increasing amounts of DApps using the network, this has long been considered far too slow. 

This is why Ethereum’s developers are moving from the existing platform to Ethereum 2.0, also known as Serenity. Their new algorithm will be based on a proof of stake (PoS) consensus. It’s hoped that this move from mining to staking will significantly increase Ethereum’s TPS and security, relieving the network’s congestion and reliance on computing power. Blockchain technology company ConsenSys puts it this way: 

“Each shard chain is like adding another lane to upgrade Ethereum from a single-lane road to a multiple-lane highway. More lanes and parallel processing lead to much higher throughput.”

Initially scheduled for release in 2019, Ethereum’s Serenity upgrade is expected to reach completion within the next two years. 

Bitcoin vs. Ethereum: Similarities and Differences

Despite their fundamental differences, Bitcoin and Ethereum do have certain similarities. One key difference is the fact that Bitcoin is used as a simple digital ledger for record-keeping. Ethereum, on the other hand, allows a contributor to automate transactions by building code into them.

Similarities:

  • Both are digital currencies that can be used as methods of payment, traded on exchanges and stored in hot or cold wallets
  • As both are digital currencies, they can also be considered stores of value.
  • Both are decentralized in nature and utilize blockchain technology.
  • Both are controlled and issued by multiple entities. 

Differences:

  • Although ETH functions much like any other cryptocurrency, this is not its primary purpose. ETH is used to facilitate the operations of smart contracts and DApps on the Ethereum network, and on the ecosystem as a whole. 
  • Despite the move toward Ethereum 2.0 to increase TPS on the network, block transactions for ETH are still verified significantly faster (15 seconds, rather than 10 minutes) than similar transactions for BTC. 
  • As smart contracts take place on the Ethereum network, transactions may contain executable code. However, any data stored on network transactions for Bitcoin will generally just be stored by nodes in an encrypted address on the blockchain. 
  • Although ETH has been created using the same consensus mechanism as Bitcoin (PoW), this is set to change to proof of stake with Ethereum 2.0. Instead of miners competing against each other in terms of computing power to validate transactions (and receiving ETH as a reward for doing so), they will instead stake their crypto funds as collateral to verify transactions. 

Pros and Cons of Using Ethereum

Just like any other blockchain technology, Ethereum has its advantages and drawbacks. Here are some of the prominent ones.:

Ethereum Benefits

  • It’s stable and supports an extensive network. The platform supports over $1.5 billion in trading volume, and Ethereum staking has just topped $21 billion after the London hard fork. Over 1,900 DApps are built on its blockchain. The entire network is secured and maintained by over 250,000 developers — more than any other blockchain community.
  • Good data coordination. The network’s participants are less reliant on third-party intermediaries to write and interpret contracts and validate transactions because Ethereum is built on decentralized architecture. That means all information is transparent. Moreover, the written smart contracts are immutable, providing smoother and reliable execution.
  • Better scalability and interoperability. Ethereum is one of the more scalable networks, processing around 7-15 transactions per second. More than 14,0000 active nodes help process each transaction, which is challenging during congested transaction periods. Thus, sharding is a necessary step in order for Ethereum 2.0 to resolve its scalability issues.

Ethereum Disadvantages

  • The rising popularity causes high transaction costs. The gas fees on Ethereum surged to a high of $23 per transaction in February 2021 due to the soaring number of DeFi protocols. When the gas fee is high, it follows that your net profit will run thin if you’re a user on the blockchain. 
  • Unpredictable outcome of Ethereum 2.0. The project has been delayed multiple times, even though it promises to solve the scalability problem. Still, the proposed increase in efficiency is questionable, since the migration of centralized to decentralized transactions is a painstaking process for DApps developers to adapt.
  • Prone to crypto inflation. Unlike Bitcoin supply, which is capped at 21 million, ETH does not have a fixed total supply. That puts ETH inflation under scrutiny. The store of value might not be as impressive as BTC when assessed through the lens of supply and demand.

Is Ether a Good Investment?

As with any investment, the phrase “do your own research” is sound advice. However, what can’t be denied is the very handsome return you’d have if you’d invested in ETH at its inception. Any investment in ETH in January 2016 would have yielded around 30,000% growth in May 2021. However, hindsight is 20/20, and crypto as a whole is subject to volatility.

Despite being priced way under its highs, ETH reached a high of over $340 during the infamous crypto bull run of 2017. Its price has recovered impressively since the recent market crash, which affected many cryptocurrencies as the COVID-19 pandemic struck in March 2020. The launch of Ethereum 2.0 also stands investment prospects for ETH in good stead. Although predictions vary, the consensus seems to be bullish for the years ahead. For example, FXStreet predicts Ether will go bull again, after the London hard fork on the mainnet with the implementation of the EIP-1559 update. Forbes believes that Ether may hit $20,000 in the long term, following Ethereum’s major updates.

Where to Buy Ether 

You can buy Ether in significant cryptocurrency exchanges through your local fiat currency, or simply trade Ether from Bitcoin or USDT. However, Ether is most commonly traded on crypto exchanges with stablecoins like USDT or USDC. For example, you can buy ETH on Bybit via a variety of payment methods, including Visa and Mastercard or a bank transfer. Once your transaction is completed, check the balance in your Bybit wallet, or simply transfer the ETH to a cold wallet, such as MetaMask.

The Bottom Line

So far, the Ethereum network has been a fantastic success story. With the dawn of Ethereum 2.0, this looks set to continue. Although Ethereum shares some similarities with Bitcoin, comparing the two is ultimately like comparing apples to oranges because the two networks have fundamentally different goals. As with much in the world of crypto, what lies around the corner may be unpredictable — but that’s what makes the ride such a thrill.

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Disclaimer

This article is intended for and only to be used for reference purposes only. No such information provided through Bybit constitutes advice or a recommendation that any investment or trading strategy is suitable for any specific person. These forecasts are based on industry trends, circumstances involving clients, and other factors, and they involve risks, variables, and uncertainties. There is no guarantee presented or implied as to the accuracy of specific forecasts, projections, or predictive statements contained herein. Users of this article agree that Bybit does not take responsibility for any of your investment decisions. Please seek professional advice before trading.

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