Ethereum Explained: What It Is, How It Works and Why It Matters

Most of the biggest ideas in crypto like lending without a bank, owning digital art, and building financial apps wouldn’t exist without Ethereum. While Bitcoin introduced a decentralized digital money network, Ethereum explored the possibility of running programs on blockchain.

It allows developers to write and deploy code on the blockchain that runs automatically, without anyone in the middle controlling it. That changed the crypto market a lot by allowing developers to build financial apps, digital assets, games, DAOs, NFTs and other on-chain services.

Read on to understand what Ethereum is, how ETH works, what smart contracts do, how Ethereum differs from Bitcoin, and what risks you should know before using it.

What is Ethereum?

Ethereum is a decentralized blockchain network or a software platform, not a currency like Bitcoin. It allows people to send value, create tokens, run programs, and use on-chain applications.

It’s more like a shared global computer or operating system. No single person or company owns it. Instead, thousands of participants around the world run the software that keeps it going. They store the data, validate the transactions, and maintain the system.

But the most notable feature of Ethereum is that it’s programmable. Developers can write applications that run directly on the Ethereum blockchain. These applications inherit the same properties as the network itself including being decentralized, transparent, and resistant to tampering.

Ethereum vs ETH: What Is the Difference?

Ethereum is the blockchain platform or the ‘world computer’ that holds the applications. ETH, or ether, is the native digital currency of that system. ETH is what you actually hold in your wallet, send to others, or use to pay fees when using Ethereum-based applications. Some of the uses of ETH include:

• Paying gas fees
• Staking and validator rewards
• Sending value
• Buying or interacting with Ethereum-based assets
• Acting as collateral in some DeFi protocols
• Participating in Ethereum-based markets

Who Created Ethereum?

The idea of Ethereum started with a 19-year-old programmer named Vitalik Buterin. After months of studying and writing about Bitcoin, he published a whitepaper proposing a programmable blockchain. He was convinced Bitcoin use was too narrow and there was potential for a blockchain that could do any computation that a normal computer can run, given enough resources.

The Ethereum project attracted a group of talented co-founders, including Gavin Wood, Joseph Lubin, Charles Hoskinson, and others. In 2014, the project ran a public crowdsale to raise funds and the network officially launched in July 2015.

But in 2016, a vulnerability in The DAO smart contract allowed a hacker to drain $60 million in ETH. A majority of the Ethereum community implemented a hard fork to recover the funds. That created a new version of the blockchain and it’s what we use today as Ethereum (ETH). Those who rejected the hard fork remained on the original, unaltered chain, now called Ethereum Classic (ETC).

How Ethereum Works

Ethereum works by combining a global network of computers, validators, smart contracts, and fees into one shared system. Each part plays a role in processing transactions, running applications, and keeping the blockchain secure without a central authority.

1. Nodes maintain the network

Some crypto users around the world dedicate their computers to run specialized software, and are referred to as Ethereum node operators. Each full node (computer) stores the entire Ethereum blockchain.

2. Transactions are submitted

A transaction on the Ethereum network can be anything like someone sending ETH, using a dApp that operates on the blockchain, or utilizing a smart contract. Whenever that happens, the transaction is broadcast to all nodes.

3. Validators secure the network

Once a transaction is sent to nodes, they independently verify whether it’s valid according to Ethereum’s rules and add a block for it. The computers that validate the transactions are called validators, and the owners stake ETH as collateral to do it.

4. Smart contracts execute instructions

If the transaction is verified and added to a block, the work shifts to the relevant smart contract. These are automated programs that run ‘if/when…then’ rules to execute transactions without middlemen.

5. The Ethereum Virtual Machine processes activity

In every node around the world, smart contracts are executed in a software platform called Ethereum Virtual Machine, or EVM. All nodes operate the same EVM, so the results are identical every time.

6. Gas fees pay for computation

Just like transactions in traditional finance, those on Ethereum have costs as well called gas fees. The fees pay validators for processing transactions. They also restrain people from spamming the Ethereum network with unnecessary activity as each engagement comes with a price tag.

What Are Smart Contracts?

A smart contract refers to an automated program on blockchain. They run ‘if/when…then’ rules to execute transactions without human intervention. Developers craft the conditions based on the financial service they want the smart contract to perform.

One of the simplest examples is: ‘If payment is received, then transfer the assets.’ The same principle applies to other applications of smart contracts like issuing crypto loans, minting NFTs, or releasing collateral when a debt is repaid.

What is Ethereum Used For?

Here is a look at the most common applications of Ethereum:

• Decentralized Finance (DeFi): Many DeFi apps work on Ethereum. These are financial applications that run on blockchain technology without traditional intermediaries. In DeFi, the rules for each service like borrowing or lending are implemented by smart contracts rather than companies or individuals.
• Stablecoins: Most stablecoin transfers or issuing are done on Ethereum and Ethereum-compatible networks.
• NFTs: Ethereum, thanks to its smart contracts, helped make the concept of non-fungible tokens popular.
• DAOs: Decentralized Autonomous Organizations, or DAOs, are organizations in the crypto space controlled by token holders rather than traditional corporate structures. Members vote on proposals, and the results are executed on-chain thanks to Ethereum smart contracts.
• Token Creation: Developers can create their own fungible tokens or non-fungible tokens on Ethereum.
• Gaming and Digital Ownership: Ethereum allows in-game assets like characters, items, and land to be represented as NFTs. Players can own, transfer, or sell the assets outside the blockchain game.
• Tokenized Real-World Assets: Crypto users can use Ethereum to build digital representations of real-world assets such as treasury bonds, real estate, and private equity.

Ethereum, DeFi and the ETH Economy

Most DeFi applications are built on Ethereum. Besides, DeFi also utilizes ETH in various ways including paying gas fees, serving as collateral in lending apps, and staking. It’s also commonly traded in pairs across decentralized exchanges. This makes the relationship between DeFi and Ethereum both technical and economic.

On the economic side of the relationship, DeFi activity impacts ETH demand. If more people use DeFi applications, there’s more block space used up and additional ETH spent on fees. It could also mean more ETH is locked into staking and liquidity positions. So, higher DeFi activity stretches ETH supply while increasing network participation.

However, the same activity that can strengthen ETH’s economics also concentrates risk. Smart contract exploits, over-leveraged positions, and protocol failures have all caused losses on Ethereum-based platforms.

Ethereum Upgrades: From the Merge to Scaling

Ethereum has undergone several upgrades since its official launch in 2015. The biggest one happened in September 2022 and is known as The Merge. Its purpose was to replace energy-intensive mining with Proof of Stake validation. That alone cut Ethereum’s energy consumption by roughly 99%.

Before that, in August 2021, another improvement referred to as EIP-1559 changed how fees work. All fees were going to validators before it. But afterwards, a portion of the gas fees is now burned permanently. The higher the activity on the network, the more is burned. That reduces the token’s overall supply and affects ETH market outlook.

More recent upgrades like Dencun center on scalability to make transactions faster and cheaper for Layer 2 networks. These are express lanes that process transactions off-chain, bundle them, and submit final data to the main chain.

What Gives ETH Value?

One of the major sources of ETH’s value is network demand. High activity on Ethereum-based platforms boosts transaction fees and burns more ETH. In turn, this reduces the amount of the token in supply and increases ETH’s value.

Proof of Stake, which Ethereum uses instead of mining like Bitcoin, also tends to support long-term price appreciation of ETH. The system requires validators to stake a minimum of 32 ETH. This locks up a massive supply and reduces token issuance. A similar thing happens when the token is used as collateral in DeFi.

Since the EIP-1559 upgrade, the supply dynamics of the token impact its value as well. The improvement requires some amount of the ETH used as gas fees to be burned permanently, removing it from circulation. Whenever the network is busy, more of the token is burned while more ETH is issued during periods of low activity.

Market perception also plays a role in the value of ETH. Most people including investors, institutions, and developers have an optimistic view of the network, especially due to its capabilities of facilitating dApps, stablecoins, and tokenized real-world assets (RWAs).

How to Buy and Store ETH

The easiest way to buy ETH is through a crypto exchange or broker app. With these platforms, you can deposit fiat currency like dollars or euros and purchase ETH directly. But ensure the exchange you select is regulated in your jurisdiction, has a solid security track record, and charges reasonable fees. Also check whether they offer 24/7 customer support and make it easy to withdraw your assets to a personal wallet if you choose to.

You can leave your ETH on the exchange where you bought it. But if the exchange is hacked or goes under, your ETH could vanish quickly. A safer option is to transfer your tokens to a software wallet. This refers to an application on your phone or computer that holds your access or private keys and puts you in control of your assets.

Better yet, you can use a hardware wallet that makes your access keys almost immune to remote hacks. It’s usually recommended especially for a large amount of ETH. For both software and hardware wallets, double-check transactions as sending ETH on the wrong network or to the wrong address can result in permanent loss.

Risks and Limitations of Ethereum

Like everything else, Ethereum has risks and limitations. Here are the major ones.

• Gas fees: Transaction costs tend to rise sharply when block space demand increases.
• Scalability: Ethereum is quite scalable and Layer 2 extends its capacity hugely. But it’s not yet at the scale that can serve billions of users simultaneously at low cost.
• Smart contract risk: Smart contracts are as good as the code they’re written in. A bug or fault in the contract can result in errors and financial losses. Sticking to well-audited protocols from established teams reduces risk but does not eliminate it.
• Scams and phishing: People still get scammed through fake token contracts, malicious wallet approval requests, impersonator websites, and social engineering attacks.
• Bridge risk: A cross-chain bridge is a dApp that makes it possible to move crypto assets between blockchains, for instance Ethereum and Layer 2 networks or other chains. However, tokens being transferred via a bridge are more susceptible to cyberattacks.
• Regulatory uncertainty: Regulations around crypto activities including staking rewards and DeFi yields are evolving constantly.
• Complexity: Between gas settings, wallet approvals, and network selection, there are many places where a beginner can make a costly mistake through no fault other than not knowing what they did not know.

Ethereum and Crypto Market Activity

As the second largest crypto by market capitalization, ETH turns out to be one of the most widely traded digital assets. All kinds of people from retail investors to advanced traders and traditional investors have their ways of getting exposure to the token.

For retail investors, ETH spot markets allow them to buy and sell the asset instantly at the current market price. Advanced traders don’t buy and own the token itself like retail traders. They use complex financial instruments called contracts (futures, options, and perpetual swaps) that require speculating on the price of ETH and taking risks with the potential for bigger returns. ETH derivatives are traded on both centralized exchanges and decentralized finance (DeFi) platforms.

Traditional investors typically trade Ethereum via spot ETH exchange-traded funds. The ETFs are a more familiar investment vehicle to them and are accessible on regulated exchanges or brokerage accounts. Just like with any other ETFs, investors do not directly buy or own Ethereum.

Key Ethereum Terms Beginners Should Know

• ETH / Ether: The native cryptocurrency of the Ethereum blockchain and the second largest cryptocurrency by market cap.
• Gas: The transaction costs on the Ethereum network, typically paid in ETH.
• Smart Contract: A self-executing program stored on the blockchain for facilitating automatic transactions or financial services when its conditions are met.
• dApp: A decentralized application built on a blockchain to offer financial services that mirror traditional finance like lending or borrowing.
• EVM (Ethereum Virtual Machine): The software platform where all Ethereum smart contract executions occur.
• Validator: A node or computer that confirms transactions and adds blocks to the Ethereum chain. Besides hardware and software requirements, a node operator must stake ETH to qualify.
• Staking: Locking up ETH to help secure the network in exchange for rewards, similar to earning interest on savings.
• Layer 2: Off-chain or side-chain networks built on top of Ethereum to make transactions cheaper and faster. They process transactions, batch them, and submit summarized data to the main chain (Layer 1).
• ERC-20: The universal set of rules or standard for creating and implementing fungible tokens on the Ethereum blockchain.
• NFT (Non-Fungible Token): A unique and non-interchangeable digital asset on the blockchain that certifies ownership of digital or real-world assets.

Ethereum’s Role in the Future of On-Chain Finance

Ethereum was the first crypto innovation that helped people understand and experience the full potential of blockchain. Before it, blockchain was just a simple payment ledger, but Ethereum transformed it into a programmable computer. It paved the way for the existence of DeFi, stablecoins, NFTs, and tokenized assets.

ETH’s value is tied to how much the world uses Ethereum. Other factors that contribute to ETH’s value include staking, public perception, and DeFi activity.

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