What Is Ethereum And How It Works?

 Ethereum is an open-source software platform that focuses on dynamic and decentralized computing. The own cryptocurrency that this system uses is called Ether (ETH).

What is Ethereum

Ethereum is based on a so-called blockchain and thus on the same technical foundation as Bitcoin. However, Ethereum is not a pure cryptocurrency but serves extended functions such as smart contracts as a decentralized ecosystem for blockchain projects of all kinds. Therefore, Ethereum can also be described as an open protocol or kit for decentralized applications. More details and backgrounds in the further course of the article.

Ethereum is the alternative to the classic client-server concept, which is widespread on the Internet, in which data is stored centrally on servers of large Internet companies or in the cloud and requested and accessed by various devices as required. As is usual for blockchain technology, the data with Ethereum is distributed decentrally on devices around the world, is publicly visible and traceable. This ensures data integrity and makes Ethereum and the data practically forgery-proof.

Ethereum has its own cryptocurrency: Ether (ETH). This is a digital currency that works similarly to the most prominent example Bitcoin and is suitable for payments within the network or as an investment. The Ethereum blockchain now provides the basis for countless other cryptocurrencies that have emerged from so-called "Initial Coin Offerings" (ICOs) and are implemented as "ERC-20 tokens" on the Ethereum blockchain.

    Ethereum at a glance

    • Cryptocurrency: Ether (ETH)
    • Market capitalization: € 425,197,577,728.68
    • Founders: Vitalik Buterin, Gavin Wood
    • Developer:  Ethereum Foundation
    • Published: July 30, 2015
    • Consensus algorithm: Proof of Work, soon to be Proof of Stake
    • Use case: infrastructure, smart contracts, DApps
    • Programming language: Go, Rust, C #, C ++, Java, Python
    • Blockchain size: 235 GB (May 2021)
    • Website: Ethereum

    What are the advantages of Ethereum?

    The big advantage of Ethereum is the programmability with which the project stands out from Bitcoin, Litecoin, and many simple representatives. Ethereum is therefore also known as "cryptocurrency 2.0", whereby Ethereum is much more than a pure cryptocurrency. The ability to organize Initial Coin Offerings (ICOs) for crowdfunding of projects, to program a wide variety of decentralized applications (dApps), and to build smart contracts (intelligent contracts) based on Ethereum is what makes the technology so special.

    Application examples for Ethereum

    Thanks to its programmability, Ethereum offers a particularly wide range of uses and applications. With the help of ICOs, dApps, Smart Contracts, and Defi, the options range from raising capital to simple everyday applications and games to projects aimed at revolutionizing the financial industry and using blockchain technology to bring an entire industry into the digital age.

    ICOs - Initial Coin Offerings

    Especially in the early days after its publication in mid-2015, Ethereum was used for Initial Coin Offerings (ICOs) and there was a real gold rush mood among investors and technology-loving users. But what actually is an initial coin offering? It is a kind of crowdfunding, with which companies or projects raise capital from many individuals in order to finance their company or their project. An ICO is very reminiscent of an Initial Public Offering (IPO) or a classic IPO. In return, there are no shares for the investment in an initial coin offering, but coins or tokens - which is why an ICO is often referred to as a "token sale".

    A key difference between ICO and IPO: While an IPO on the stock exchange is subject to strict regulations, ICOs are largely unregulated. This offers advantages, but also creates a certain degree of uncertainty for investors. There was certainly fraud and, as a result, total losses among investors.

    Ethereum itself emerged from an ICO. In 2014 the project raised money for the development - a total of around 18 million US dollars - and in return gave investors the first generated units of their own internal cryptocurrency Ether. Their value has increased massively in the years since the first issue and made the ICO a success for many investors.

    In the meantime, the Ethereum ecosystem is often the foundation of new ideas and projects in the blockchain area. A wide variety of projects collect ethers as funding and, on the basis of smart contracts, issue their own tokens implemented on the Ethereum blockchain in return. Prominent and successful examples of such ICOs are the Chinese blockchain platform and cryptocurrency NEO, the Basic Attention Token (BAT) belonging to the open-source web browser "Brave" and the Binance Coin (BNB) from the well-known Chinese crypto exchange Binance.

    dApps - Decentralized Applications

    Decentralized Applications, or dApps for short, are also part of Ethereum. As the name suggests, dApps are programs that are not executed on a central server, but distributed across the entire network - and that is what makes Ethereum what it is. Due to the decentralized architecture, these programs are censorship-resistant and therefore cannot be switched off.

    The possible uses of dApps are huge and since Ethereum and other crypto projects are comparatively young technologies, the possibilities are currently hardly imaginable. In the first few years after the development of Ethereum as a programmable platform for decentralized apps, a lot of dApps have been created, including simple games and serious applications from the areas of health, social affairs, and finance.

    DeFi - Decentralized Finance

    Many projects based on Ethereum deal with the topic of Decentralized Finance (DeFi) and are thus aimed at revolutionizing the financial industry. DeFi stands for services in the financial sector that are completely decentralized and run without a middleman. Borrowing can be made possible for everyone, for example. Decentralized finance projects are:
    • digital
    • decentralized
    • Open-source
    • based on a blockchain
    The goal of many DeFi developers is the digitization and democratization of various financial products using the Ethereum blockchain. The projects ranged from simple stable coins to gold investment solutions and issuing and investment platforms to crypto payment services that enable fast and inexpensive payment with cryptocurrencies.

    Compared to traditional financial services, decentralized finance solutions offer many advantages. All processes are digital and automated using smart contracts. In contrast to normal banks, weekends and opening times are irrelevant - DeFi applications are available around the clock. Middlemen and their fees are largely eliminated, which lowers the costs of transactions and, thanks to the decentralized, predominantly unregulated structure, there are no access restrictions for people in developing countries or people who are rejected by normal banks. With regard to decentralized finance and thus the banking of the future, Ethereum and similar platforms offer enormous potential.

    Insurance, sports betting, and more

    The special properties with regard to ICOs, dApps, and Smart Contrats and the high flexibility of the programmable crypto platform make Ethereum universally applicable. There are hardly any limits to the imagination of developers, which is why Ethereum is conceivable for a wide variety of industries and projects.

    The digitization and automation of the insurance industry are conceivable, for example. With the help of simple if-then functions, numerous insurance benefits can be realized. When reaching retirement age, a private pension or life insurance could be paid out automatically - without any manual intervention or middleman.

    The use of dApps and smart contracts for sports betting is also conceivable and in some cases already implemented. As soon as the correct result applies, the tokens are paid out automatically and the tipper is rewarded.

    The Internet of Things is another huge topic that Ethereum has solutions for. Parking meters or locks that automatically register incoming payments and then release parking spaces or access points are conceivable.

    Potential areas of application of Ethereum and Smart Contracts:

    • Financial transactions & capital market
    • Real estate: land register entries, notarial services, crowd investing, etc.
    • Political elections and voting
    • Energy industry
    • Logistics & supply chains
    • Insurance
    • Health care (health history)
    • Personal details / identity
    • Cybersecurity
    • Internet of Things
    • and much more

    How does Ethereum work?

    Ethereum is the name and umbrella term for the decentralized and programmable crypto platform that has been developed since 2013. But how does Ethereum actually work in detail?

    Similar to classic cryptocurrencies, the basis is a decentralized network or a system distributed all over the world without a central server structure. The Ethereum blockchain forms the common database with which all network participants - nodes and clients - work.

    A copy of the blockchain with all transactions and data is stored in parts (light nodes) or in full (full nodes) on all participating clients and is continuously updated. Mining nodes take over the "mining", thus confirming transactions and thus also generating new units of the internal cryptocurrency ether.

    Smart contracts

    Smart contracts are a very important and indispensable part of Ethereum. These are digital contracts that are implemented in the Ethereum network and are automatically executed as soon as the agreed amount of Ether (ETH) has been received or another condition is met.

    In practice, it works like this: An interested party transfers the required amount of ETH from their Ethereum wallet to the specified ETH address. The smart contract automatically registers the incoming payment with the correct amount, enters it in the public and decentralized blockchain, and releases the corresponding consideration in the form of tokens, features, services, or other goods.

    The big advantage: You no longer need a middleman. Everything works transparently, comprehensibly, and automatically according to the if-then principle. The blockchain, with its many copies distributed to clients around the globe, in which every transaction is practically forgery-proof, ensures the security of both sides with regard to manipulation.

    Ethereum Virtual Machine (EVM) and gas

    Smart contracts are programmed in the Solidity programming language, translated into bytecode, and executed on the Ethereum Virtual Machine (EVM).

    The virtual machine is a very important part of Ethereum and forms the basis for executing smart contracts. The Ethereum Virtual Machine (EVM) is the runtime environment for dApps and other components of Ethereum that works separately from the blockchain. The EVM forms an additional intermediate level that takes on important security functions. The EVM protects the network against DDoS attacks, prevents access to third-party smart contracts, and is also a secure test environment for Ethereum developers.

    For the execution of the programmed code in the Ethereum Virtual Machine (EVM) runtime environment, so-called "gas" is due as payment. Each command to be executed in the EVM costs a certain amount of gas. So gas is the fuel with which Ethereum works and in principle is very similar to the transaction fees for Bitcoin and other cryptocurrencies.

    The price of gas is set in "Gwei". Gwei is the smallest unit of Ether - 1,000,000,000 Gwei equals 1 ETH. At least 4 Gwei are due, but it is advisable to pay a higher price. Similar to the Bitcoin transaction fees, the gas paid decides the speed with which the transaction is processed, confirmed, and fully executed by the miners. The better a transaction is paid for, the higher the reward and thus the interest of the miner in realizing the execution quickly. If the amount of gas is too low, a transaction may get stuck and be significantly delayed.

    Ethereum wallets usually have functions that automatically calculate the gas price and, in addition to the minimum price, also offer the option of paying the optimal gas price for a quick transaction with one click.

    Ethereum mining

    One thing that Ethereum has in common with many simple cryptocurrencies is the creation of new units or coins through mining - that is, the "prospecting" of ETH.

    In Ethereum mining, similar to Bitcoin, transactions are validated by miners. This is currently mainly done through pure computing power based on the proof-of-work principle.

    Similar to Bitcoin, the transactions are summarized in blocks, added to the existing blockchain, and validated using the calculation of cryptographic tasks and the creation of a hash. For solving the tasks, i.e. for validating the transactions stored in the block and thus the secure continuation of the blockchain, the miners receive a reward in the form of newly generated ethers.

    In order to increase their chances of success, miners form so-called "mining pools" and share the reward. In the beginning, Ethereum mining was attractive to everyone and even possible with gaming graphics cards. In the meantime, however, professional mining rigs with several interconnected graphics cards and, above all, a very low electricity price are necessary in order to be able to operate Ethereum mining profitably.

    That could change in the future, however, as Ethereum is to switch from the proof-of-work algorithm (PoW) to the proof-of-stake algorithm, or PoS for short. The proof-of-stake process does away with the immense computing power required for PoW mining. Instead, the generation of new blocks and thus also the distribution of the reward is determined in an energy-saving and environmentally friendly manner on the basis of the respective share in the network.

    Further development of Ethereum

    Ethereum is a living project and development does not standstill. Ethereum started in July 2015 as a beta in the "Frontier" phase. Frontier should form the basis and the framework for Ethereum and the associated main functions - in other words, lay the foundation for the entire project. Among other things, the proof-of-work algorithm was implemented and the foundation for important components such as dApps and smart contracts were created.

    The second phase of Ethereum development followed in March 2016: "Homestead". With Homestead, the developers mainly took on troubleshooting in order to eliminate problems, optimize processes and increase security for everyone involved.

    The third phase, "Metropolis" aims to make Ethereum fit for everyday life and for the masses. With Metropolis, applications for end consumers and everyday use are to be created and Metropolis also brings light clients with it. Light clients save users from having to download and save the entire blockchain, which is several hundreds of gigabytes in size. With so-called "zk-SNARKs", Metropolis also has an innovation in its luggage that enables anonymous transactions.

    The fourth and final development phase of Ethereum is called "Serenity" and is intended to implement the change from the PoW to the PoS algorithm and be the basis on the way to "Ethereum 2.0".
    Ethereum 2.0 Roadmap
    Ethereum 2.0 Roadmap, source: consensys.net

    The future: From Ethereum to Ethereum 2.0

    The development of Ethereum continues all the time. The Ethereum developers are currently working intensively on "Ethereum 2.0" - an improved and future-proof form with which some existing problems should be a thing of the past.

    Ethereum 2.0 not only includes the change to the proof-of-stake algorithm and thus the introduction of energy-saving and resource-saving staking, but also the introduction of a new virtual machine or runtime environment called eWASM.

    Ethereum founder Vitalik Buterin shared a roadmap and thus enabled a look at his vision of Ethereum for the next few years. The implementation of Ethereum 2.0 is expected to take five to ten years and is divided into six phases.

    The starting point is phase 0, in which Ethereum changes to the proof-of-stake algorithm and in the course of this also starts the new beacon chain required for this. In connection with this, there is also a new token as a reward for stakers: ETH2. In later phases, so-called shard chains for optimal scalability of Ethereum and also the introduction of the new virtual machine, which should provide even more options for developers and their projects, will follow.

    Risks and challenges with Ethereum

    Due to its programmability and the associated application scenarios, Ethereum is certainly one of the most complex and complicated crypto projects - and that brings with it problems. In the worst case, Ethereum becomes a platform for specialists and “nerds” and, due to its complexity, does not make the leap into people's everyday lives, which is necessary for sustainable success.

    Many critics also doubt that simple things such as sports betting and sales contracts and even more complex projects relating to insurance, decentralized finance and e-government can be easily implemented as smart contracts on the basis of Ethereum. What is important is the trust of people who want to rely on their contracts being programmed securely and accordingly executed reliably. The "scams" that still occur frequently in the crypto scene keep making headlines and are therefore a problem for almost all crypto platforms and crypto currencies.

    What Ethereum is still missing is a real "killer app" - an application scenario for everyone that convinces with the advantages of the blockchain, the special functions of Ethereum and the necessary security.

    Ethereum: future and forecast

    Regardless of critics and the challenges that undoubtedly exist, Ethereum is certainly one of the most interesting crypto projects and Ether accordingly a crypto currency with great potential - this became clear not least at the beginning of 2018, when an ETH was worth more than 1000 euros.

    The great advantages of Ethereum include its great popularity in the crypto scene, numerous active developers who use Ethereum as the basis for their own projects and tokens and, last but not least, active further development. Vitalik Buterin and other makers did not stop their work after the start of Ethereum in mid-2015, but continue to push their project forward with new developments.

    With Ethereum 2.0, the platform should finally be made fit for the future and for even more applications in the coming years. The true potential of Ethereum and Ether will only become clear over time. Perhaps the “killer app” with which Ethereum makes it into the life of the masses is already in development and will help ETH's course into new spheres in the future.

    Ethereum explained in 20 seconds