What is Ethereum? How does Ethereum work? ETH Explored:

Chances are you’ve heard of Bitcoin, the first cryptocurrency created in 2009 by a mysterious (some would even say shadowy) developer—or group of developers—using the pseudonym Satoshi Nakamoto. You may even be a little familiar with the blockchain, the virtual ledger of transactions that makes Bitcoin possible, and know that blockchain technology is expected to have a revolutionary impact on … well, everything. However, have you heard about Ethereum?

You may have heard of Ethereum and know that it’s a cryptocurrency similar to Bitcoin. It’s actually the second-largest cryptocurrency based on market capitalization, which (at the time of this writing) is over $18 billion USD; But Ethereum isn’t just a cryptocurrency—it’s a separate blockchain platform, with distinct differences to the one that underpins Bitcoin. The name Ethereum refers to the Ethereum blockchain—the proper name of the cryptocurrency is Ether (though it is often referred to as Ethereum or ETH).

Ethereum was launched on July 30th, 2015, by a group of eight developers. It was initially proposed in late 2013 by a Russian-Canadian programmer named Vitalik Buterin, who was joined on the project by Mihai Alisie, Amir Chetrit, Charles Hoskinson, and Anthony di Iorio. The initial five developers were joined by Joseph Lubin, Jeffrey Wilke, and Gavin Wood in early 2014.

At the time of its initial launch, a single Ether token (or “coin”) was worth about $0.30 USD. At the time of this writing, a single Ether token is worth $170.77. In other words, $30 of Ether in 2015 would be worth a lot more today than it was at its inception.

How Does Ethereum Work?

The Ethereum blockchain is an open-source platform used to create and run decentralized digital applications—commonly called “dapps”—that enable its users to conduct transactions directly with one another to buy, sell, or trade goods and services without a centralized authority serving as a “middle man.” Users of the Ethereum blockchain can transfer money without needing to first go through a bank, can draw up binding sales contracts without calling on the services of a lawyer, and can even raise funds for projects like app development through a system that relies on “crowd sales,” which operate in a way that’s similar to traditional crowdfunding systems, but (like everything on the Ethereum blockchain) is decentralized.

Ethereum runs on a global network of computers that work together as a sort of supercomputer, assembling and running “smart contracts,” or applications that operate independently of any third party. This means these smart contract apps are highly resistant to tampering—hacking, interference, or even censorship—as the Ethereum blockchain is (due to its distributed nature) theoretically impossible to hack.

While the blockchain that powers Bitcoin transactions was created almost solely for that purpose, the Ethereum project has always had larger goals in mind. In fact, Ethereum’s own website puts it in plain language, stating “Ethereum is a global, open-source platform for decentralized applications. On Ethereum, you can write code that controls digital value, runs exactly as programmed, and is accessible anywhere in the world.”

That code—the smart contracts—runs on what’s called the “Ethereum Virtual Machine,” which is another name for that decentralized, distributed computing network made up of all the devices running Ethereum nodes. Anyone can set up and run an Ethereum node, which provides computing power to the larger virtual machine. Anyone else can then run a smart contract—essentially, an application written to run on the Ethereum Virtual Machine.

Blockchain Differences: Ethereum vs. Bitcoin

The Bitcoin blockchain exists, first and foremost, to keep track of Bitcoin. Though other uses have presented themselves, that first blockchain was devoted to making ownership and transfer of the world’s first cryptocurrency possible. The Ethereum blockchain also tracks its own cryptocurrency—Ether (ETH)—but its main focus is far different. While the Bitcoin blockchain is (more or less) a ledger of transactions, Ethereum’s blockchain was built with a focus on running the decentralized applications written specifically for it.

The Three Layers of Ethereum

In order to focus primarily on running decentralized, distributed applications, Ethereum was constructed with three layers. The first layer is basically the blockchain—the large network of computers that process transactions and keeps a ledger of them, much in the same way that the Bitcoin blockchain works. The second layer is the software layer—the programming language (called Solidity) that the smart contracts are written in and run on. The second layer relies on the first for its operation. The third layer is made up of all the different applications that run on Solidity, with different features and offering different services to users of the Ethereum network.

Proof of Work

Then there’s Proof of Work vs. Proof of Stake. This gets a little technical, so bear with us. Proof of work is essentially a method of protecting against tampering or interference, like a distributed denial-of-service (or DDoS) attack. DDoS attacks work by tying up all of the resources of a targeted computing system by sending an avalanche of bogus requests—imagine someone tying up your phone by calling so quickly and so often that it was impossible to receive other calls or make any outbound calls yourself.

Proof of work—which was the central revolutionary idea behind the Bitcoin blockchain—allows for what are called trustless and distributed consensus systems. Basically, that translates into a system that relies on a public ledger of every Bitcoin transaction—ever—to keep track of the flow of the cryptocurrency. That ledger relies on “blocks” of transactions—and those blocks are “chained” together, each one relying on the one before it for proof of validity.

But these blocks have to be verified by nodes on the network before they’re accepted onto the chain. Think of it this way: each new block is like a puzzle with a set number of pieces. Those pieces are sent out—digitally—to every node on the blockchain network that’s set up to accept them. The only purpose of these nodes is to verify these new blocks. Now imagine each puzzle piece has a random number on it. The puzzles pieces will only fit together correctly one way—say to form a square—but the numbers have nothing to do with how the pieces fit together. That’s where the puzzle-solving comes in.

So, these puzzle-solving nodes scramble to assemble the puzzle correctly, trying to combine the pieces in different ways until they find the right order that makes the desired shape. The first one to get the square announces it to the rest of the network—essentially shouting “Bingo!”—and then transmits the instructions for how to put the puzzle together. The instructions are the order in which those random numbers must be assembled, row by row, to make the square. It takes some time to solve the puzzle, but once it’s solved, it can easily be verified by other nodes on the network (by following the pattern of random numbers, allowing them to form squares with their own puzzle pieces, thereby validating the work of that first lucky puzzle solver).

That’s the proof of work: the list of random numbers in the correct order to solve the puzzle. The way proof of work guards against tampering or DDoS attacks is pretty straightforward: an attacker can’t target every puzzle solving node at once, so even if they manage to shut down one or two, there are a bunch of other nodes working on the puzzle—which will still get solved.

That’s a very simplified example, but it’s more or less accurate. In Bitcoin, the puzzle solvers are called “miners,” and they’re rewarded for solving the puzzle by being allowed to create a new Bitcoin, which is their payoff for the amount of work they put in—work that was done to verify the new block on the blockchain, and solving these puzzles isn’t trivial. In some estimates, all the computers running the Bitcoin blockchain at any given moment are consuming about the same amount of energy as the entire country of Ireland. That’s significant.

Proof of Stake

Then there’s Proof of stake. This system operates much differently. Proof of stake works sort of like a lottery. You “buy-in” for the chance to validate a new block before it gets added to the chain—to check it over, run computations on it, and make sure it’s accurate. In fact, these block creators are called “validators” in the proof of stake system.

The validator is chosen more or less at random—like in a lottery—but the amount of cryptocurrency they’ve put up—their “stake” in the process—does have a direct effect on their likelihood of being chosen. Think of it like buying lottery tickets: the more you buy, the higher your chance of winning, though there is still the chance that someone who has bought fewer tickets (put up less stake) will get the prize. You don’t lose the stake you put up—in fact, if you’ve chosen to validate the new block, you receive a new unit of cryptocurrency as a reward.

The way this system guards against malicious action is simple—if you’re caught trying to alter a new block or do something shady with it, you do lose the stake you put in. It’s like a guarantee—in a proof of stake system, you’re essentially saying “I promise this much cryptocurrency that I won’t do dishonest things if chosen to validate the next block.” See the logic? The more you put up, the higher your chances of being chosen as a validator—and the greater your loss if the rest of the network calls shenanigans on you.

The single most significant advantage that proof of stake has over proof of work is that it’s much more economical. Once a validator is selected, they have the exclusive right to validate the next block in the chain. That means one computer doing computations—instead of hundreds of thousands all racing with copies of the same puzzle, trying to be the one to solve it first. The other validators aren’t wasting energy, which dramatically reduces energy consumption compared to proof of work, and this is (of course) much better for the environment.

Ethereum hasn’t yet converted to a proof of stake validation system, but it’s something that’s been widely discussed, and the current consensus is that (sooner or later), the Ethereum blockchain will run on proof of stake.

Other Benefits of Ethereum

Ethereum is, as we’ve seen, significantly different in terms of operation than the traditional Bitcoin blockchain. There are other improvements over the older technology—transactions are faster on Ethereum, at about 15 per second, while Bitcoin has less than half of the transmission speed, at about seven per second.

It’s also cheaper to send transactions on Ethereum than on Bitcoin. This gets complex very fast, but when you’re sending cryptocurrency, there’s always a transaction fee—the amount you’re paying to have that transaction transmitted through all of the various computers that make up the network. That fee has been growing on Bitcoin—transaction fees range significantly depending on how fast you want your transaction to go through.

However, Ethereum uses a different method of calculating transaction fees, and though it is comparing apples to oranges, it is still much, much lower. In Ethereum, you don’t pay per transaction—which is how Bitcoin does it—but rather per computational step, which is more befitting a network built and intended on which to run applications. Ethereum uses a system they refer to as “gas,” and each computational step requires a specific amount of gas. The price of gas is determined dynamically by the users of the network—higher network usage drives the price up, for instance—and the total fee is calculated as the amount of gas required times the current gas price. It may seem a little confusing, but it’s cheaper—current transaction fees on the Ethereum network are about $0.16.

Ethereum’s Amazing Flexibility

Perhaps the most fantastic thing about Ethereum’s blockchain system is how flexible it is. You can, for instance, easily create your own cryptocurrency. The Solidity program language and the Ethereum system has built-in, everything you need to write code that would allow you to create a new form of cryptocurrency, set a value to it, and allow for interested parties to buy and sell it. This is done by creating a “token,” or an object that has a certain value assigned to it by the creator. The value of the new cryptocurrency can change over time, and you could theoretically create a competitor to the Ether cryptocurrency while using the network that Ether is native to.

Not only that, but you can create games on the Ethereum network. The smart contracts allow for the creation of games of chance—like dice, or roulette—and there are, in fact, already Ethereum “casinos” which are increasing in popularity all the time.

To learn more about cryptocurrency, blockchain, and ethereum, please be sure to check out our blog post Here on the Top 25 Bitcoin, Blockchain and Cryptocurrency books!

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