What is Ethereum? (2021) A Simple Explanation

Ethereum is an open-source, decentralized platform that allows developers to create smart contracts and decentralized applications. While Bitcoin utilizes blockchain technology to facilitate digital currency transfers, Ethereum expands on the idea by using blockchain technology to build a technical foundation, which smart contracts and decentralized applications can build upon for a near-infinite amount of uses.

InvestorRoyale Summary: Ethereum
• Ethereum is an open-source software powered by a network of computers spread worldwide, meaning it is decentralized. 
• Ethereum has a native cryptocurrency, Ether, which can be traded and used for transactions for a small fee.
• Smart contracts are a central feature of Ethereum, and they are effectively agreements executed via programming code rather than through human or third-party intervention.
• The use cases for Ethereum are still being discovered, but applications are already attempting to disrupt traditional finance and art markets.
• The biggest problem facing Ethereum is scalability, which the network is aiming to solve through the Ethereum 2.0 upgrades.  

The Ethereum blockchain hosts a native cryptocurrency, Ether, which is currently the second-largest crypto by market cap. Through the Ethereum network, holders of Ether can send coins to anyone worldwide for a small fee.

Ethereum is an open-source project, meaning that many people played a role in its creation; however, Vitalik Buterin, raised in Canada, is most often cited as having played the most significant role in the creation of the Ethereum blockchain. Vitalik published Ethereum’s whitepaper in 2013 before launching the project in 2015.

Below, we lay out a comprehensive overview of the Ethereum blockchain, including primers on smart contracts and decentralized applications, an easy-to-understand explanation of how the network functions, and more. 

Why Was Ethereum Created?

Ethereum’s 2013 Whitepaper states that the purpose of Ethereum is to allow for the building of decentralized applications. Ethereum was intended to be, and is, a base layer for applications to build upon. 

Below, we summarize the philosophies behind Ethereum’s design from the original whitepaper for you to get a sense of the considerations that went into creating the Ethereum network:

  • Simplicity: The protocol should be simple to implement, and complexities should be avoided unless they provide a significant benefit. 
  • Universality: Ethereum should be designed to apply to any use.
  • Modularity: The Ethereum protocol should be designed in a modular fashion to ensure a change in a protocol in one area does not compromise the entire system’s functionality.
  • Agility: The network is open to changes within the protocol, given they are for the betterment of the system.
  • Non-discrimination and non-censorship: The Ethereum network does not attempt to stop certain actors from using the network for “undesirable” usage. Regulatory functions on the system should be built to control the harm rather than restrict specific applications.

How Does Ethereum Work?

The Ethereum network comprises thousands of computers spread worldwide using their processing power to support a single virtual world computer. The people who use their computers to power the network are called miners and are the Ethereum blockchain’s lifeblood. 

Anytime an action is executed on the Ethereum network, miners compete to be the ones to process said action and add it onto the existing blockchain. In exchange for processing work on behalf of the Ethereum network, miners are rewarded with a small amount of Ether, called a gas fee

Gas fees incentivize miners, and this incentivization method means that every transaction executed on the blockchain requires a gas fee. The size of the gas fee associated with a transaction is directionally proportional to how much “work” is required to complete the transaction.

While anyone can technically sign-up and become a miner for the Ethereum blockchain, Ether’s increasing price has made mining an incredibly lucrative industry, creating intense competition. Individual miners are unlikely to break even unless they have a massive processing advantage. Even mining in a group with other miners, also known as pool mining, isn’t guaranteed to yield a profit.

Pro Tip: Why is Mining for the Ethereum Network Difficult?
Since miners compete against one another to process transactions on the Ethereum network, miners are incentivized to improve their computing power. This arms race to create superior computing power carries high electricity, cooling, and storage costs. Today, if you want to mine on the Ethereum network, you likely won’t achieve profitability unless you have the adequate computing power and the sizable capital necessary to scale and absorb some of the other costs mentioned above.

Smart Contracts Explained

A key feature of Ethereum are smart contracts, which are similar to real-world agreements, except they are programmed to automatically execute when contract terms are met. No single entity or person has the power to alter the actions of a smart contract once it has been introduced into the blockchain. The result is that smart contracts can improve speed, safety, and trust in many interactions.

Example

Smart Contract in Action

Let’s imagine a smart contract is created to facilitate refunds between a software company and its customers. The company states on its website that users are allowed a 100% refund should they use the software for less than 100 hours in the first week. 

Without a smart contract in place, you would have to trust the software company and take them at their word that refunds will be issued should certain conditions occur (i.e., using the software for less than 100 hours in the first week). 

Smart contracts eliminate the need for trust since they can be programmed to occur given certain conditions. In this instance, a smart contract would automatically issue you a refund if you used it for less than 100 hours in the first week. The software company would have no power to stop the transaction. 

Smart contracts operate on the Ethereum network as a program with their own balance of Ether. They have the ability to send transactions on the network; however, they are only allowed to operate within the confines of their original programming. Users of the Ethereum network wishing to use a smart contract can send transactions to the smart contract, triggering a certain act from the program. 

Organizations or people can use smart contracts for various things, given their primary function is to facilitate agreements. Below, we list just a few ways organizations or people might utilize smart contracts:

  • Facilitate transfers of assets
  • Pay insurance claims
  • Compensate employees for their work
  • Confer educational degrees via non-fungible tokens

Decentralized Applications Explained

Another key feature of Ethereum are decentralized applications, more commonly known as “dapps,” which function similarly to the applications you’re used to using on your phone or computer. Since Dapps utilize the Ethereum blockchain, they can integrate smart contracts and store information on the Ethereum blockchain. 

It might help to think of Dapps as the user interface behind smart contracts. Adding onto our previous example, if a smart contract facilitated a refund mechanism, a Dapp might be a portal you can access to view and manage your refunds. 

Perhaps the most significant advantage of dapps over traditional applications is that they have no owner. The implication of this is that anyone can take a dapp and build upon it or integrate it into a different use, allowing for speedy development and launch. A grossly oversimplified yet valid interpretation would be to say that Ethereum (through dapps) enables developers to build with legos of code rather than starting from scratch for every project. 

In our example, one software company could create a “portal” dapp for customers to manage their refunds, and a competitor could also utilize the same dapp for their customers. One of the significant downsides of dapps is that fixing issues, like bugs, require coordination amongst the people who support the network, in this case, miners. 

Ether vs. Ethereum: Are They The Same?

Ethereum is an open-source software used to facilitate smart contracts and decentralized applications, while Ether (ETH) is the cryptocurrency that incentivizes miners to support the network’s operations. The two terms are often used interchangeably, but they do not mean the same thing. When someone says they’re buying Ethereum, for example, they more than likely mean they are buying Ether, the crypto asset. 

Example

Ethereum vs Ether: Clarification

To better understand the difference between Ether and Ethereum and how they function in tandem: let’s consider a scenario in which a developer created an application on the Ethereum network that allows for two parties to communicate privately via short messages similar to texting.
 
How would the Ethereum Network entice miners to use their computing power to facilitate the transactions or messages in this instance?

Ether (ETH) is the answer to the Ethereum network’s incentivization problem referenced above. Every transaction on the Ethereum network requires a gas fee, which is simply a small amount of Ether. The larger and more complex a transaction is, the larger the associated gas fee. Gas fees are paid out to miners to incentivize them to use their computing power to support the Ethereum network by processing transactions.

Ether (ETH) serves the function of powering the Ethereum network and is the reason why you might have seen Ether (ETH) referred to as “digital oil.”

What is Ethereum 2.0?

Ethereum 2.0 is an upgrade to the existing protocol of the Ethereum network. Much in the same way Apple creates and pushes out iOS updates, Ethereum is constantly being improved with updates and patches. Ethereum 2.0, also referred to as Eth2, aims to make the Ethereum network more scalable, secure, and sustainable.

What Is the Main Problem with Ethereum 1.0?

The main issue plaguing the Ethereum network is scalability. More specifically, every miner supporting the Ethereum blockchain must verify and process transactions individually. As more transactions are added to the network, this creates congestion and a slower overall blockchain.

One of the major criticisms of the Ethereum network in its current state is the amount of energy it requires to operate and the effects on the environment. Ethereum 1.0 requires miners, who support the network, to use computing power to process transactions. The result of thousands of computers supporting the network across the globe is that Ethereum requires 26.5 terawatt-hours of electricity per year, according to TIME.  

It might help to think of the Ethereum blockchain as a highway, transactions as cars on that highway, and miners as toll booth operators; wherein Ethereum’s current state, a single-vehicle must pass through every toll booth to stay on the highway.

Below, we cover some of the most critical changes and their implications for the network.

Shard Chains

Sharding or Shard Chains refers to splitting up a database to ease the burden of processing said database. In Ethereum 2.0, sharding will be used so that miners will not have to verify and process every transaction, rather just the transactions assigned to them. 

Continuing with our highway example, sharding would be the act of creating additional lanes for vehicles, where toll booth operators are only responsible for processing cars in their respective lanes. In theory, this should create a more efficient network, resulting in faster transaction times.

Other more technical additions to the Ethereum blockchain include the beacon chain and the docking, which are necessary components that will allow the Ethereum network to move away from a proof-of-work consensus mechanism.

Ethereum: Proof-of-Work Versus Proof-of-Stake

Proof-of-work and proof-of-stake are fundamentally different ways to support transactions and ensure security on the Ethereum network. Below, we distill the key differences between the two protocols:

Proof-of-Work (PoW)Proof-of-Stake (PoS)
Who Supports the Network?MinersValidators
How Do They Support the Network?Miners compete to solve mathematical problems with computational power. The more computing power you have, the higher your chance of receiving a reward.An algorithm selects a validator to process a transaction, wherein validators with more currency staked on the network have a higher chance of being selected.
How Are They Rewarded?The first miner to solve the mathematical problem receives a payout. Validators are awarded a fee for every transaction they are selected to process. 
How could the network be compromised?You’d have to control over 51% of the computing power that makes up the network.You’d have to own 51% of the crypto on the Ethereum network.

In summary, the Ethereum network is currently supported by miners competing against one another to earn rewards using their computational power to process transactions. In the future, the hope is for the network to be supported by validators, who stake their cryptocurrency on the network. These validators are then eligible to be selected to process transactions for the network.

Validators are disincentivized from attacking the Ethereum network since doing so comes at the cost of losing their staked Ether. As it stands today, if you wanted to launch an attack on the Ethereum network, you could do so by controlling 51% of the computing power which makes up the network. However, once Ethereum moves over to PoS, you’d have to hold 51% of the Ether on the network to launch an attack, which is generally perceived as a much more difficult undertaking. 

Moving from a PoW to a PoS consensus mechanism would have the added benefit of reducing the electricity needed to support the Ethereum network since staking would effectively eliminate the need for miners. Therefore, PoS is seen as a way for the Ethereum network to become more environmentally friendly.   

Pro Tip: What is Staking in Ethereum?
Staking allows people who hold Ether to become a validator on the Ethereum network by depositing 32 ETH. ETH holders who stake are eligible to earn rewards for processing transactions on the network or validating others’ processing work. By staking your crypto, you’re unable to sell, trade, or send the asset.

ETH holders with less than 32 ETH available for staking may seek alternate methods to stake, such as Staking in a pool with others. Staking is becoming more popular with each passing day, and even popular exchanges like Coinbase have now added staking waitlists.

Be aware that Staking carries significant risks since it’s possible to lose your staked ETH. Some actions that might result in a loss of crypto include hostile network actions, failing to validate, and going offline.   

What Can Ethereum Be Used For?

Since Ethereum is a platform upon which applications can be built – its use cases extend as far as its developers and users are willing to use the network for. Today, there are three popular categories of uses, which we outline below. 

Decentralized Finance (DeFi)

DeFi refers to a growing movement to replace the work of traditional financial intermediaries, such as banks, exchanges, and even insurance companies, through smart contracts on the Ethereum blockchain. While DeFi apps may be built on any blockchain technology, Ethereum has quickly become the most popular due to its robust ecosystem.

DeFi is still in its infancy, but it has large potential implications for the traditional financial world. One major aim of the DeFi movement is to make traditional finance more open and accessible, by catering to any user regardless of race, identity or income level. Another aim of DeFi is to give people more control of their capital through more transparency.   

Examples of DeFi:

  • Aave: Allows you to lend or borrow crypto assets to others; lending earns you interest income while borrowing means you have to pay interest. 
  • Uniswap: Convert an ERC-20 token into a separate ERC-20 token without the need for an intermediary. 
  • Polymarket: Bet on certain events’ outcomes without the need to pay a fee to a facilitating party.

Non-fungible tokens (NFTs)

NFTs are tokens that represent non-divisible ownership in a digital or physical item, altering the traditional method through which artists and creators receive compensation for their work. In simpler terms, an NFT is a crypto asset, representing ownership in a piece of intellectual property it’s associated with. 

Learn more about NFTs by reading our in-depth explanation of NFTs and their potential value propositions.

Decentralized autonomous organizations (DAOs)

DAOs are similar to any formal group of people or entity, such as a government, a charity, or a public company, with the only difference being that DAOs operate without human intervention. DAOs might help facilitate decision-making, given specific guidelines set by the creators of the DAO. For example, a developer might create a DAO to manage funds for a charity or a grant, wherein money management decisions are automatically made through a pre-set programmable code.

Where Can You Buy Ethereum?

As a reminder, Ethereum refers to blockchain technology, and Ether is the crypto supporting the Ethereum network. Interested investors can purchase Ether through three primary methods: centralized exchanges, decentralized exchanges, and wallets. 

Centralized Exchanges: Centralized Exchanges allow you to purchase Ether using traditional fiat money and cryptocurrencies. The Ether you purchase is held in the exchange’s custody until you transfer it to a private wallet. A few examples of popular centralized exchanges are Coinbase, Gemini, and Binance. 

For most people, this will be the easiest and most straightforward way to purchase Ether. 

Pro Tip: Not Your Keys, Not Your Crypto
The well-known saying “not your keys, not your crypto” in the crypto community serves as a constant reminder to holders that centralized exchanges may be subject to attacks, hacks, and other events that may jeopardize your crypto assets. Crypto enthusiasts recommend keeping your crypto off centralized exchanges after purchasing by storing your assets in a private wallet.   

Decentralized Exchanges: Decentralized Exchanges allow you to purchase and sell Ether and other cryptocurrencies by trading with other market participants. Rather than relying on third parties to serve as intermediaries, decentralized exchanges rely on smart contracts to process transactions. 

Decentralized exchanges are less user-friendly when compared to centralized exchanges and require a bit more know-how. 

Wallets: Wallets allow you to interact with the Ethereum blockchain. The relationship is similar to how you need an internet browser to interact with the worldwide web. By having the ability to interact with the blockchain, wallets allow you to store your crypto, including Ether. Some more specialized wallets even give you the ability to purchase Ether with a debit card. 

The Ethereum Foundation offers a great tool to find a wallet that is suitable for your needs. 

Ethereum FAQs

Below, we address some of the most common questions surrounding the Ethereum blockchain.