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What is Ethereum and How Does it Work?

Beginner
7 min
What is Ethereum and How Does it Work?

Ethereum is the world’s second-largest cryptocurrency after Bitcoin. However, unlike Bitcoin, Ethereum exists to be more than just a store of value or medium of exchange. Ethereum is a decentralized computing platform built on its own blockchain. This piece will cover everything you need to know about Ethereum and how it works.

What is Ethereum? 

Ethereum is a platform that is credited with bringing the execution of decentralized smart contracts to the blockchain world. This allows it to facilitate an ecosystem of applications, other crypto tokens and even other Web3 protocols. Ethereum was founded by eight co-founders, with Vitalik Buterin the best known of the group. Ethereum’s goal is to become a global network for decentralized application, allowing people from all corners of the planet to run fraud-resistant software and take complete control over their finances.

What is blockchain technology?

A blockchain is essentially a public ledger that duplicates and distributes information across multiple computer networks (officially known as ‘nodes’). Blockchains get their names from creating new blocks when the previous one is verified and added to a chain. These nodes work together to independently verify that the data on the blockchain is running smoothly. This is different to traditional data systems, like a bank, which tend to rely on a central entity (e.g., the business) to verify information.

How is Ethereum different from Bitcoin? 

In several ways, Ethereum and Bitcoin are similar. They are both digital currencies that are exchanged online and held in different forms of cryptocurrency wallets. Both are autonomous, which means they aren’t distributed or supervised by a central bank or other governing body. And both make use of blockchain, a modern, digital distributed ledger system.

But there are a number of key differences between Ethereum and Bitcoin as well. The Ethereum network’s transactions may include executable code, while the data attached to Bitcoin network transactions is mostly only used for note keeping (although Ordinals is slowly changing this).

Ethereum is significantly faster than Bitcoin (an Ether transaction is validated in seconds, while a Bitcoin transaction takes minutes) and the algorithms used to encrypto data is quite different. (Ethereum uses Ethash while Bitcoin uses SHA-256). 

In terms of their general goals, the Bitcoin and Ethereum networks are distinct. Bitcoin was developed as a substitute for national currencies and hence aspires to be a medium of exchange and a store of value. Ethereum was designed as a forum for irreversible, programmatic contracts and applications using its own currency.

Initially, both protocols utilised a Proof-of-Work consensus mechanism – more colloquially known as mining. While Bitcoin still employs this method of validating transactions, Ethereum ‘Merged’ to a less power-hungry Proof-of-Stake system in the 2020s.

Key Takeaway

Ethereum is a decentralized platform for smart contracts and decentralized applications, whereas Bitcoin is primarily a store of value and medium of exchange.

How does Ethereum work?

Smart contracts

Smart contracts are similar to regular contracts, however the conditions and rules in the contract are automatically enforced via code. A smart contract is different from a conventional contract because it is intended to run on its own instead of depending on a third party. Smart contracts are generally written in the Ethereum programming language called Solidity.

Figure 1 – How smart contracts work

Decentralized apps (dApps)

Decentralized applications (dApps) are similar to the apps on your phone, except they are decentralized, rather than running through a central server. Actions performed via these applications are settled by the blockchain – ranging from simple token swaps to running a fully-immersive game, complete with its own economy. The majority of dApps on Ethereum revolve around decentralized finance (DeFi), and taking financial control away from major institutions like banks. However, as the dApp ecosystem has evolved, so too has their scope.

Ultimately, some in the community believe that dApps will eventually mirror the functions of most popular smartphone apps that rely on a sensitive data source (for example, anything including transactions).

ERC-20 tokens

The Ethereum network functions as a foundation layer for other cryptocurrencies to build on top of. These cryptocurrencies that are built on top of the Ethereum protocol are known as ERC-20 tokens. Some of the most popular ETH-based projects include The Sandbox, Chainlink and Uniswap.

Gas fees

Each transaction or smart contract execution requires a fee in order for it to be processed. On the Ethereum network, this cost is known as a gas fee.

Examples of dApps running on the Ethereum network

Art and collectibles

Rarible: an online platform to buy and sell physical and digital artwork or NFTs.

Gaming

Decentraland: a virtual world you can explore and can hold online events. Connect with your peers and collect and trade land.

Decentralised Finance (DeFi)

Uniswap: Easily exchange tokens or provide tokens for interest.

Decentralised Technology

Brave Browser: Earn tokens for browsing and supporting creators with earned tokens.

Did You Know?

In order for a dApp to run on the Ethereum network, there must be gas or fuel to pay for the nodes – this gas is paid with the Ethereum network’s native token, Ether.

What is Ether?

Ether (ETH) is the digital currency that nodes on the Ethereum network are paid as a reward for verifying transactions, executing smart contracts, and running dApps. It also incentivises developers to create dApps that are as efficient and simple as possible. ETH is the second-largest cryptocurrency behind Bitcoin, by market cap.

How to buy Ether (ETH)

You can buy Ethereum (ETH) from most big cryptocurrency exchanges. Swyftx is a popular crypto exchange in Australia and New Zealand where users can buy Ether with low fees and store it in their personal crypto wallet.

What’s next for Ethereum?

Ethereum has a team of skilled developers who are working behind the technology to constantly make it run more efficiently. With more dApps and smart contracts running on the network, more upgrades need to be made for it to handle the capacity. Ethereum has undergone several upgrades over the past decade, including the Shanghai Upgrade, Pectra Upgrade and the Merge.

Ethereum is constantly exploring ways to improve its network to ensure it can continue to act as the foundation for decentralised finance.

  • Scalability: Ethereum will introduce shard chains to spread the network’s load across 64 new chains. This makes it easier to run a node while keeping the hardware requirements low. Additionally, several projects have built atop the Ether network to process transactions independently on a separate chain, while finalising data back on Ethereum’s main chain. These protocols, known as Layer 2s, have drastically improved the speed, costs and accessibility of Ethereum.

  • Security: Moving to the new sharding system and using proof-of-stake will require new security measures to avoid coordinated attacks. Ethereum 2.0 will solve this

Did You Know?

Moving from a Proof of Work consensus mechanism to Proof of Stake reduced the Ethereum network’s energy usage by a whopping 99.95%!

Summary

Ethereum is a versatile and powerful platform for executing smart contracts and running decentralized applications. It distinguishes itself from Bitcoin, which is primarily a medium of exchange and store of value. If you’d like to learn more about Ethereum, smart contracts, and dApps, there are heaps of great resources on Swyftx Learn!

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