How does Ethereum work?

Ethereum (ETH) is the second-largest cryptocurrency by market cap, a position it has occupied for years. Most people consider it the second-most important crypto project ever created. While Bitcoin (BTC) holds the top position for starting the cryptocurrency industry, Ethereum turned it into what it is today.

This guide will explore Ethereum, its history, products, and purpose. It will also explain how Ethereum works and its advantages and disadvantages. By the end, you will know precisely why Ethereum is such an important project for the crypto industry.

What is Ethereum?

Ethereum is a decentralized blockchain platform that allows users to transfer digital money. However, this is only scratching the surface of the project's capabilities. Ethereum revolutionized the cryptocurrency industry by allowing users to deploy code. This allowed for the creation of smart contracts, and countless decentralized applications (DApps) that were built on top of its network. Its flexibility allowed the creation of sophisticated programs, all of which run on a distributed network.

However, smart contracts and DApps were only the first step. The evolution of Ethereum's blockchain and its products continued, leading to many others, as we will discuss soon.

Ethereum’s history

A team of developers created Ethereum, the most prominent among them being Vitalik Buterin. Buterin wrote Ethereum's whitepaper in 2013, outlining the key concepts and technical details. Eventually, the project launched in 2015 as a result of a collaborative effort involving multiple individuals. Apart from Buterin, other participants were Gavin Wood and Joseph Lubin. Wood also played a major role in designing the Ethereum Virtual Machine (EVM). Meanwhile, Lubin later established a blockchain software technology company ConsenSys.

Ethereum's consensus algorithm was initially Proof of Work (PoW). This meant that users could engage in Ethereum mining. Mining was necessary to process Ethereum transactions. However, due to the algorithm's limitations, Ethereum realized it had to adopt a new one. These limitations made its network unable to scale, and once Ethereum transactions grew in number, so did the gas fees.

Ethereum gas fees are fees everyone must pay whenever they make a transaction. However, to make their transaction more attractive to miners, they started paying more and more. The miners would pick transactions with greater payments first, so the more you pay, the shorter you wait.

In time, Ethereum gas fees were often higher than the amount transacted. This was one of the main issues of the Ethereum network. It is also what led to the launch of several similar projects. Each of them sought to replace Ethereum and become "Ethereum killer." However, Ethereum's contribution and innovative nature was never forgotten. This is why it remained at the top while its developers kept working on replacing the consensus algorithm.

This finally happened in late 2022 when Ethereum successfully switched to a Proof of Stake (PoS) consensus mechanism. This is the current Ethereum consensus algorithm, while Proof of Work was finally retired from the Ethereum network.

What does Ethereum do?

Simply put, Ethereum is a blockchain-based development platform. As such, it allows users to create various blockchain products, including smart contracts. Smart contracts were the first step in creating all other products. You can create an app by setting up several smart contracts and having them all work together.

All the work is done by smart contracts, which self-execute when their terms are met. Apart from smart contracts, Ethereum has made the following products possible:

• Decentralized applications (DApps) — DApps are decentralized applications that can serve any purpose that traditional applications can. Their biggest difference and advantage is that they are decentralized. There is no central authority to them, and they are more privacy-oriented.
• Decentralized Finance (DeFi) — DeFi is a collective name for a crypto-project offering decentralized banking services. It provides numerous ways for users to establish passive income. This includes decentralized lending, staking, yield farming, liquidity mining, and more.
• Non-Fungible Tokens (NFTs) — Non-Fungible Tokens are unique and interchangeable. While you can replace one Ethereum with another with no difference in their value, this is not the case with NFTs. Each is tied to a unique digital or physical item that holds some value. NFTs have found their way into gaming, collections, real estate, artwork, etc. By owning an NFT, you also own the underlying asset.
• Decentralized Exchanges (DEXs) — Decentralized exchanges emerged as an alternative to centralized platforms. They have several advantages, such as not requiring you to deposit your asset onto their platform. That way, you remain in control of your funds at all times. They are typically cheaper to use, and they can complete your swaps instantly.
• Ethereum tokens — Ethereum tokens are not ETH — the project's native coin. Instead, this term refers to cryptocurrencies launched on Ethereum's network. Other projects use Ethereum's platform as their underlying technology. This is what makes them tokens instead of coins. Coins are the cryptocurrencies that power the entire platform. A token is a separate cryptocurrency that runs on that platform.
• The metaverse — The metaverse is a digital world that runs on blockchain technology. It is a virtual reality that uses NFTs and cryptocurrencies as payment methods. It offers virtual space that users can purchase, own, and use in many ways. Some examples include software and game development, running businesses, organizing virtual events, and more.

How does Ethereum work?

Users who run the network are called Ethereum nodes. They replace centralized servers. To breach the network, one would have to hack 51% of the computer systems that protect the network.

This is also what makes the network decentralized and immune to attacks. It is also only possible to crash the network if you hack thousands of separate computers at once.

The network is a decentralized system that runs a computer known as the Ethereum Virtual Machine. Each node around the world has a copy of this computer. For any change or interaction to become true, it must first be verified. After that, the algorithm automatically updates each copy. However, this only happens after the change has been verified. Unverified changes get dismissed.

Network interactions are called Ethereum transactions. They are all processed and stored within blocks of the Ethereum blockchain. Transactions are public, and anyone can view them using block explorers like Etherscan. Since the idea was to use ETH as a utility token rather than a token of value, it doesn't have a capped supply.

To interact with Ethereum, users must first obtain some of its coins. These coins can be stored in Ethereum-compatible wallets. It is also worth noting that any interaction on the Ethereum network comes with gas fees. These fees must be paid to process your transaction, regardless of size.

Ethereum pros and cons

Like every crypto project, Ethereum has its advantages and disadvantages. A lot of its flaws have been eliminated by switching to PoS, such as scalability issues and high fees. However, even with that being the case, some issues remain. Fortunately, there are more advantages to compensate for the flaws.

Pros:

• Decentralization
• Resistance to censorship
• Great network security
• Automatization of tasks and actions through smart contracts
• Access to dApps, DeFi protocols, NFTs
• Supported by multiple Ethereum wallets
• Incentivizes users to run Ethereum nodes
• Earning rewards from staking
• Extremely low risk of failure

Cons:

• Ethereum is expensive to develop on
• Smart contract vulnerabilities
• Regulatory uncertainty
• Upgrade challenges

The importance of Ethereum

Ethereum is one of the cryptocurrency industry's most significant projects. Ethereum is responsible for the crypto industry's utilities that we know today. As such, Ethereum is also responsible for the tremendous growth and development of crypto over the years.

This is why learning how Ethereum works and what it can do is essential. With its upgrade to PoS, Ethereum 2.0 has finally arrived. Now, it is free to continue its evolution, and possibly invent even more products.

FAQs

How do you explain Ethereum to a beginner?

Ethereum is a blockchain-based development platform. It can record code, which allows for the creation of sophisticated applications and software. It is powered by its native cryptocurrency, Ether (ETH).

What consensus mechanism does Ethereum use?

Following its upgrade to Ethereum 2.0, Ethereum has switched to Proof of Stake. Before that, it was using Proof of Work, like Bitcoin, Dogecoin, Litecoin, and many other cryptos.

How Ethereum works vs. Bitcoin?

Bitcoin uses a consensus algorithm called Proof of Work, which requires users to contribute computing power. Provided resources are then used for solving complex mathematical equations to process transactions and mine new BTC. Ethereum requires users to stake their tokens and become validators who monitor transaction processing.

Who controls Ethereum?

Ethereum is decentralized, meaning that there is no central authority. It has its developers who create new upgrades, but its community runs it. All decisions are made through voting in a true democracy.