What is Ethereum?

What is Ethereum?

Ethereum is a blockchain that uses a native currency called Ether (ETH) which can be transferred or traded just like Bitcoin (BTC). But the true genius of Ethereum is that it is not simply another Bitcoin clone.

Instead, Ethereum is a computing platform upon which many thousands of decentralised applications can be built. These applications range from non-fungible tokens (NFTs), to decentralised finance (DeFi) markets, to cross-border bank loans and digital government bonds.

Ethereum uses smart contracts to power DeFi and NFT markets and automatically carry out actions.

The key analogy for Ethereum here is that of the TCP/IP tech stack that underpinned the creation of the internet, along with all the various protocols that were built on top of it.

The initial infrastructure of TCP/IP, created in 1983, allowed for computers to be networked and linked together, and to send data back and forth between computers spread all over the world.

Later internet protocols like IMAP (created in 1986) and HTTP (created in 1991) were built to sit on top of this base layer, allowing for world-changing applications like email and interlinked website pages.

In the same way, Ethereum's blockchain is the foundation layer upon which innovative global financial applications are created. And it is responsible for all of today's fastest-growth niche cryptoasset markets.

What is proof of stake?

Proof of Stake (PoS) is one of the key ways to secure blockchains and confirm that the transactions and data stored on them are valid.

PoS blockchains require users to stake their tokens to have a chance of being selected to validate blocks of transactions, and be rewarded for doing so with block rewards and transaction fees.

To be eligible, computer users (called validators) need to deposit their crypto tokens into a special contract which acts as collateral in case anything goes wrong.

On PoW blockchains, miners compete against one another for rewards through the use of energy-intensive computer hardware. By contrast, PoS networks are defined by the ownership and allocation of crypto tokens. The more tokens a user locks into special contracts, the more likely they are to be chosen as validators again by the PoS algorithm.

This also means that the barrier of entry for individuals seeking to secure PoS networks is lower than that of PoW networks. Anyone willing to deposit their crypto tokens can be a validator by using their computers, tablets, or smartphones with internet connections to confirm transactions. It is important that validators maintain active internet connections because they can be penalised for any downtime on their end.

One criticism levelled at PoS blockchains as opposed to PoW blockchains is the advantages afforded to large token holders. If there are a large amount of tokens allocated to project founders before a blockchain launches publicly, they may hold outsized sway over how the network operates.

The first PoS cryptocurrency was developed in 2012 and was called Peercoin. Since then, many other crypto projects like Solana, Avalanche, and Tezos have launched as PoS blockchains.

What are smart contracts?

A smart contract is a self-executing piece of computer code that carries out a set of irreversible instructions, and is recorded on a blockchain.

In the physical world, contracts are agreements between two or more parties that are created with the help of middlemen and other counterparties.

Smart contracts streamline this process by connecting Party A and Party B directly with one another, and setting terms in place that cannot be revoked.

The term “smart contract” was coined by English computer scientist Nick Szabo. In 1996, he published a paper describing a smart contract as a “set of promises, specified in digital form, including the protocols within which the parties perform on these promises.”

In general anyone can trigger the execution of a smart contract just by sending a payment in ETH to a contract account that is running on the Ethereum blockchain.

Smart contracts allow developers to build dApps and DeFi protocols that take advantage of a blockchain's security and reliability.

Another way to think about smart contracts is that it is a set of promises laid out in code, which uses the logic statement: ‘If This, Then That'. So If This happens, Then That triggers something else. The innovation with smart contracts is that this happens automatically once a set of conditions are met. Imagine a smart contract between a company and an employee. When an employee has completed a certain project, or a certain number of hours of work, a smart contract can automatically trigger to pay their wages.

Smart contracts open the door to a vast range of new internet-based applications. These include price oracles, which pull in real-time data like stock price information into blockchain applications.

What are gas fees?

Gas fees are transaction fees paid by users to record their transactions to a blockchain. The fees are used as rewards to validators - geographically-distributed computer users - for verifying transactions and keeping the blockchain network running properly.

Gas fees also offer an extra layer of security to blockchains by making it costly for bad actors to interact with the network and attempt to disrupt it.

Gas fees tend to be small fractions of cryptocurrencies native to a blockchain and are often not set in stone but depend on how much a particular blockchain is being used at any one time.

Users can pay higher gas fees if they want a transaction confirmed more quickly, as these higher rewards incentivise validators to process their transactions first. Likewise, users that pay lower gas fees may see their transactions stuck in a queue because validators are less motivated to confirm them in a timely manner.

Why are Ethereum gas fees so expensive?

Gas fees tend to be more expensive on Ethereum than other blockchains because of the sheer amount of users it attracts, which makes the network congested.

Every application and user on Ethereum is competing for a limited amount of space.

The very large volume of transactions that pass through the thousands of decentralised apps, DeFi protocols, and NFT platforms built on the Ethereum blockchain lead to spikes in gas prices.

Because gas fees are priced in ETH, they also naturally go up – or down – depending on the market value of Ethereum. Because gas fees are a small fraction of ETH, transactions on the Ethereum network are denominated in “gwei”. 1 gwei equals 0.000000001 ETH.

During periods of elevated blockchain activity, for example when a new DeFi protocol launches, or a popular set of NFTs are created for sale, the average price for gas fees can climb to very high levels indeed.

Why is Ethereum turning off Proof of Work?

Proof of Work is a type of consensus algorithm: a way for lots of computers on a network to prove that blockchain transactions are valid, by proving that they have expended energy and solving puzzles. Proof of Work is considered to be highly secure, but the downside is that as networks grow, it becomes extremely energy intensive for computers to carry out this work.

This is because expensive and specialised computers called ASICs must be used to to run billions of complex calculations, with each competing with one another to be the first and fastest to solve difficult mathematical puzzles and solve blocks.

These computers must be online and operating 24/7, and the larger the network, the more electricity is required. This is the process called ‘mining'. Mining is not meant in a literal sense, but instead as an analogy for the way that commodities such as gold and silver are produced in the non-crypto world. The computer that is the first and faster to solve the puzzle and confirm a block of transactions gets an automatic reward in the native currency of the blockchain, for example Bitcoin.

Proof of Stake, by contrast, is a newer type of consensus algorithm. Those computers that process blocks of transactions are not required to compete with one another to solve complex puzzles. Instead, they must deposit some of the blockchain's native currency in a smart contract to be in with a chance of processing blocks, and therefore gaining the associated reward. This deposit is called a ‘stake'. This method of securing blockchains uses far less energy than Proof of Work.

What is the Ethereum merge?

The Ethereum Merge is a long-awaited software upgrade to the Ethereum blockchain.

The Merge will fundamentally alter the way that Ethereum functions. Instead of being a Proof of Work network, like Bitcoin, it will switch over to be a Proof of Stake network.

The idea of changing Ethereum from a Proof of Work network to a Proof of Stake network came as early as 2015. The blockchain's co-creator, Vitalik Buterin, said back then that he expected the change to happen by 2016. So with a confirmed date of September 2022, the Ethereum Merge is around six years overdue.

The Ethereum Merge upgrade is expected to improve the amount of energy it takes to power Ethereum by more than 99%.

What other Ethereum upgrades are coming?

The Merge is one of a suite of upgrades planned for Etherum over the next decade.

Over the coming years, more improvements will be added to Ethereum to make transaction fees cheaper, improve congestion, and make the overall experience much faster and easier to use.