What is Ethereum?
by Alyona Shepilova
Jun 16, 2023
Ethereum was conceived in 2013 by a young programmer Vitalik Buterin. The word 'ether' refers to a mythological invisible medium that allows light to travel. Buterin argued that Bitcoin and blockchain technology could benefit from other applications besides money. His aspiration was to create a medium that would allow applications to run on top of. Ethereum finally launched in 2015.
Ethereum, Ether and ETH
First things first, what is the difference between Ethereum and Ether? Very simple, Ethereum is the name of the protocol, but not the name of the currency. The coins are called Ether (or ETH for short). Now that we have this out of the way let's begin.
What is Ethereum?
We know that Bitcoin is all about freedom of payments – two people can transact with each other without the need for an intermediary. And it doesn't actually matter if they sit in one room or reside on different continents: the Bitcoin protocol makes payments fast and efficient. The same goes for Ethereum; only the funds' transfer was never its sole purpose.
You see, Ethereum is so much more than just digital money. Instead, you can think of it as a decentralised computing platform which runs on thousands of devices around the globe. What does it offer? It allows developers to write and run code for just about anything on a secure and open Ethereum protocol burying the possibility of censorship for good.
One of the unique things Ethereum can offer is smart contracts.
A smart contract is not a legal contract – it's a code that runs on a blockchain and executes itself when certain conditions are met. Codes are impartial, so there's no need for a trusted intermediary to supervise the process.
The idea is best explained by its creator, a computer scientist Nick Szabo, who coined the term' smart contract' long before Ethereum was conceived. He compared smart contracts to a 'humble vending machine'. A vending machine is a contract, and anyone who agrees to the price can participate in an exchange with the vendor – insert coins and receive a product (and change). There's also a security mechanism that protects the goods and funds from potential attackers.
That was back in the nineties. The Ethereum smart contracts run on the Ethereum Virtual Machine (EVM) – an integral part of the Ethereum blockchain, which converts smart contracts into instructions a computer can understand. For example, return 'Thank you!' every time someone sends 1 ETH to the contract.
EVM can also handle bets and employment contracts, act as escrow and even support a decentralised gambling facility. These are just a few examples of what this machine could do for legal, financial and social contracts, but the prospects are exciting. However, there are drawbacks.
EVM is still very young and lacks processing power. According to its developers, right now, it's about as powerful as a late 20th-century mobile phone. But if we compare that hypothetical phone with what we have right now – we'll see that this is not a life sentence for EVM. Technological progress takes gigantic steps with every passing year, so, probably, we'll soon be able to enjoy sophisticated smart contacts in real-time. Bonus points if they become cheaper to execute.
How does Ethereum work?
Surprisingly similar to the Bitcoin blockchain. For example, here, we also have nodes. What they do is store the snapshot of the network and how it looks at any given time (all the account balances and smart contracts). When the status quo changes (a transaction is made, a smart contract is triggered), nodes update their snapshot following the new state of the network.
Transactions on Ethereum are also packed into the already familiar blocks, which are linked to each other like a chain. To create new blocks, Ethereum uses mining (and Proof-of-Work), though this is about to change. See, What's Proof-of-Stake? below.
How many ethers are there?
The initial supply was 72 million ETH, more than 50 million of which were distributed in a public sale (you could buy ETH with BTC or fiat currencies).
With all the mining and rewards happening through the years, there is currently just under 120 million ETH in circulation. However, the currency doesn't have a hard cap (limit on the maximum supply possible). Unlike Bitcoin, Ethereum is trying to become a foundation for the new financial system. You can't be entirely sure how much money you'd need for that. The current emission schedule gives us five new ETH every 10 seconds, but that is generally quite chaotic and changes frequently.
What is Ethereum gas?
Fees on the Ethereum blockchain vary depending on how much computational power a transaction requires. Simple transactions are the cheapest, and heavier smart contracts are more expensive (doubly so if they are required to be run for a long time).
The unit of measure of computational power is called gas. Not a coincidence: you need to take your transaction from point A to point B, and the gas fee is basically the cost of the 'gasoline' that will get you there. Gas fees are paid in gwei, which is a unit of ETH. This is done for convenience; it's easier to say that your transaction costs you 1 gwei rather than 0.000000001 ETH (what a mouthful).
(Gwei itself can be further divided into wei: 1 gwei = 1,000,000,000 wei. Ether is a highly divisible cryptocurrency).
Previously, gas fees were calculated like this:
Gas fee = Gas units * Gas price per unit
Gas limit = 21,000 units of gas (this is standard for a standard transfer)
Gas price = 200 gwei -> 21,000*200 = 4,200,000 gwei or 0.0042 ETH
This is how much I pay to send you 1 ETH. You get 1 ETH, a miner receives 0.0042 ETH, and I'm charged 1,0042 ETH.
If you're wondering how we knew we had to pay precisely 200 gwei as a gas price per unit, that was, uh, a guess. In the olden days, users basically took a stab in the dark and picked a number that felt right (that would, in their opinion, guarantee the inclusion of their transaction in the next block). This could, of course, have been an educated guess – you could base it on a historical chart of gas prices – but still.
But now gas fees are calculated like this:
Gas fee = Gas units * (Base fee + Tip)
The base fee is the minimum price per gas unit to include a transaction in a block. It's calculated by the network and is based on demand (no uneducated stabs in the dark anymore). You would think that the base fee will end up as a monetary reward for miners, but no. This amount is actually burned (deleted from existence). The miners are rewarded with tips, but tips are optional. They can give your transaction preferential treatment, but it's up to you whether you want to tip (though many wallets will decide that you do automatically).
Let's say you want to return the favour and send me 1 ETH. A simple transaction, so the gas limit is 21,000 units. Also, it's a slow day, so the base fee is 100 gwei. You're very generous and include a tip of 10 gwei.
Gas fee = 21,000 * (100+10) = 2,310,000 gwei or 0.00231 ETH.
You are charged 1,00231 ETH. I receive 1 ETH. Some miner receives a tip of 21,000 * 10 gwei (= 210,000 gwei or 0,00021 ETH). And base fee of 21,000 * 100 gwei (= 2,100,000 gwei or 0,0021 ETH) is burned forever.
One important thing to add to this – gas is also responsible for block size. It would be nice to stretch the block to satisfy the demand at any given time, but it doesn't function like this. Where Bitcoin accommodates around 2,000 transactions in one block, Ethereum's block has a target size of 15 million gas. It can stretch up to 30 million gas, but that's it. So, sometimes it doesn't even matter how much you tip – if there's a traffic jam of large tippers, then there's a traffic jam.
What are Ethereum tokens?
One of the great things about Ethereum is that it allows developers to create tokens. Tokens are digital assets built on another's cryptocurrency blockchain. They are similar to other cryptocurrencies (have value and can be traded); they just outsource their blockchain.
Developers decide on the characteristics of their token (how many to issue, how often, whether the token will be divisible etc.) and record it in the smart contract. You might have heard the expression' ERC-20 token'. ERC-20 is a technical standard used for token implementation; it also sets rules tokens must follow. There are other standards like ERC-721, which is used to create unique tokens, but ERC-20 is a bog standard for regular mutually-interchangeable ones.
Some of the most prominent examples of ERC-20 tokens are USDT, USDC, DAI, LINK, UNI, AAVE, BAT etc.
DeFi, dapps, dexes, stablecloins – who are you when you're at home?
No tale about Ethereum and smart contracts is complete without DeFi. Today, we will only touch on the topic and save a full-blown discussion for later.
So, DeFi. Decentralised finance. What is it? DeFi is a global financial system of products and services accessible to anyone who uses Ethereum (ETH and smart contracts). As such, it's an alternative to the world of traditional finances.
Gives you control over your money (you store it, you see what's happening to it)
Gives you access to global markets and other alternatives to your local currency and banking options
Always-open markets that allow you to trade 24/7
No centralised authorities who can deny access/services and block payments – it is primarily owned and maintained by its users
Transparency – anyone can inspect the code
Automatic, faster, safer services since they are operated by the code and not humans.
DeFi is an umbrella term. It can mean a plethora of financial instruments powered by smart contracts and the Ethereum blockchain. You can borrow and lend money, grow a portfolio of digital assets, trade like a professional and even solve the volatility problem of cryptocurrencies.
And dapps? Dapps or decentralised apps are the apps that offer you the services mentioned above. They're just like any other app but built on a smart contract of the Ethereum blockchain.
DEXes? DEX is short for a decentralised exchange (for tokens). Dexes connects buyers and sellers directly without the need for a trusted intermediary (instead, they use the code of smart contracts).
Finally, stablecoins are cryptocurrencies that are meant to solve the volatility issue. While being Ethereum tokens, their value is pegged to a real-life currency (usually, the U.S. dollar), so you can enjoy the freedom of transfers along with the relative stability of the asset's price.
So, we know that an Ethereum block can accommodate 30 million of gas worth of transactions maximum. We also know that Ethereum is the home to a myriad of dapps, whose crypto lenders and borrowers transact incessantly. The question is, can Ethereum handle them all? Will it take well the ever-growing demand?
The ability of a blockchain to accommodate more and more users without compromising user experience (longer confirmation times, higher processing fees etc.) is called scalability. So, the obvious answer would be to increase the size of the block, right? Well, unfortunately, it is a little bit more complicated than that.
Here we come to the Blockchain Trilemma. A blockchain must be scalable, secure and decentralised. It's a precarious equilibrium. If we give more attention to one, one of the remaining two will inevitably suffer.
Consider this, Ethereum and Bitcoin are both secure and decentralised. They have many invested nodes to ensure their respective blockchains contain only valid transactions. But they lack scalability. Okay, we can stretch a block until it fits all unconfirmed transactions. But nodes constantly update the data they keep on the blockchain – and bigger, fuller blocks won't be kind on their hardware. Nodes are not getting paid, so we'll start losing nodes, which will lead us to a decrease in decentralisation.
What to do?
Ethereum seems to have an answer, and the answer is Ethereum 2.0. Ethereum 2.0 is a major set of upgrades to the Ethereum protocol. Once implemented, they will improve the network's ability to process transactions rapidly and securely. This will allow Ethereum to finally become a foundation for the new financial system it's striving to be.
Switching to Ethereum 2.0 is a long and arduous process that consists of multiple steps. For example, remember when we talked about gas, we said that gas fees are now calculated differently? This changed with the implementation of the Ethereum Improvement Protocol 1559, also known as 'London Hard Fork'. What it did on a grander scale is basically reduced the supply of Ether in circulation. In the long term, it might make ETH more valuable. It also made the gas fees more predictable, which is good when you're planning to scale up.
The process is supposed to culminate (but not end) somewhere in 2022 with the event known as 'The Merge' when Ethereum will become Proof-of-Stake.
Proof-of-Stake is a mechanism for confirming transactions on a blockchain. As such, it's an alternative to Proof-of-Work. Where PoW relies on miners' effort and their expensive equipment to add blocks of new transactions to the blockchain, PoS is supported by validators, who are chosen by the Ethereum protocol. To become a validator, a user needs to stake 32 ETH (think of it as locking your funds for a while). This may seem like a lot, but the good news is – no specialised, costly equipment is required, and an ordinary laptop will suffice. Because of this, PoS is a much 'greener' and more sustainable solution. For their work, validators will be rewarded with ETH.
Although always known as Ethereum 2.0, the politically correct term for the Ethereum protocol upgrade is now the 'Consensus layer'. Why? Developers argue that this will help avoid ambiguity, especially for new users. Fair enough. Consensus is when users agree on the validity of transactions. What makes them come to an agreement – or a consensus – is consensus mechanisms (already familiar to you Proof-of-Work, Proof-of-Stake etc.). And since Ethereum 2.0 (sorry, we meant Consensus layer) is all about the Proof-of-Stake consensus mechanism, the new name (even though less bombastic) describes it to a tee.
To sum it up
Ethereum strives to become a foundation for the new financial system of digital assets that runs on an open blockchain. This will be a safer and faster alternative to the world of traditional finances as well as more inclusive and transparent. Ethereum is home to many tokens (digital assets created on another cryptocurrency's blockchain). It also made possible the creation of stablecoins (cryptocurrencies whose exchange rate is attached to a fiat currency).
While currently Proof-of-Work, Ethereum is in the process of switching to a more energy-efficient consensus mechanism – Proof-of-Stake.
Ether itself is the second-largest coin by market capitalisation and bitcoin's most significant competitor.
Blockchain trilemma – a concept coined by Vitalik Buterin. Blockchains should offer decentralisation, scalability and security, but the best they can offer is 2 out of 3. When you're trying to improve one, something else will inevitably suffer.
Consensus layer – previously known as Ethereum 2.0. A major set of updates to the Ethereum protocol that should make it more scalable, i.e. allow it to process more transactions faster. This includes switching to Proof-of-Stake.
Consensus mechanism – a method for validating new transactions and keeping the blockchain secure. For example, PoW or PoS.
Dapp – stands for 'decentralised app'. Apps that run on a blockchain and offer a scope of financial services.
DeFi – an umbrella term for financial instruments powered by smart contracts. You can borrow and lend money, earn, trade and much more – all on a blockchain.
DEX – short for 'decentralised exchange'. Trade your tokens directly without the need for an intermediary because smart contracts supervise the process.
Ether – Ether or ETH is the name of the currency. Second only to bitcoin, ETH is the number two digital currency by market capitalisation (of many thousands).
Ethereum – the name of the protocol. A future foundation for the new financial system of digital assets that runs on an open blockchain (see DeFi).
Gas – a unit of measure of computational power (e.g. a simple ETH transfer requires 21,000 units of gas). Just like most cars need gasoline to take you from point A to point B, Ethereum needs gas to process transactions.
Gas fee – how much gwei you need to pay for processing a transaction / executing a smart contract. Calculated as follows: Gas units * (Base fee + Tip), where the base fee is the minimum price per gas unit to include a transaction in a block (calculated automatically by the Ethereum protocol).
Gwei – a smaller unit of Ether, which is equal to 0.000000001 ETH. Gas fees are calculated in gwei for convenience.
Proof-of-stake – a consensus mechanism that allows validators to add a new block of transactions to the blockchain. This doesn't require much computational effort, but you have to be chosen by the protocol to validate a new block. Your chances often depend on how much crypto you have staked and how long it's been staked. Also, there's an element of randomness.
Scalability – a blockchain's ability to accommodate the demand and process as many transactions as required without resulting in longer processing times and higher fees.
Smart contract – a piece of code that runs on a blockchain and executes itself when certain conditions are met.
Stablecoin – an Ethereum token whose value is pegged to a real-life currency (usually, a U.S. dollar).
Staking – when a person who owns an amount of cryptocurrency instead of using it for trading puts it away so it can serve as their right to confirm blocks on a blockchain.
Token – a digital asset built on another's cryptocurrency blockchain. Tokens are similar to other cryptocurrencies (they have value and can be traded); they just outsource their blockchain.
Validator – a person responsible for adding new blocks (containing newly-made transactions) to a PoS blockchain.
Wei – the smallest unit of Ether, which is equal to 0,000000001 gwei or 0,000000000000000001 ETH.