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What is Ethereum

What is Ethereum

What you'll learn:

  1. The origins of Ethereum
  2. Ethereum's unique characteristics & ecosystem
  3. Ethereum's limitations
  4. The proposed transition to Proof of Stake [Updated September 2022]

Ethereum is a blockchain-based system where anyone can build and securely deploy any digital service without going through a formal, centralised approval process - such as getting an App added to Apple's App Store. 

It is the brainchild of Vitalik Buterin, a Russian born computer programmer, who was an early Bitcoin advocate, but thought it lacked a scripting language to enable connected applications. 

Ethereum has been dubbed the ‘world computer’ as it enables permissionless access to a Turing Complete system that can process any request expressed in its bespoke programming language.

It uses a set of standards for creating tokens that allow value to be transferred within, and between, applications built on Ethereum, creating a vast interoperable ecosystem.

As of 15 September 2022, Ethereum completed its much-anticipated transition to Proof-of-Stake (PoS) in an event otherwise known as "The Merge".

We can summary Ethereum's objective as providing a platform that allows developers to build digital applications that are 

  1. Decentralised - there is no central third party control. 
  2. Reliably secure - fraud and third party interference are very difficult if not impossible
  3. Universally accessible - anyone can build, deploy and use Ethereum applications without the need for permission.

Ethereum's Unique Characteristics & Ecosystem

So how does Ethereum achieve these objectives? Ethereum was designed as a blockchain with a built-in ‘Turing complete’ programming language - called Solidity - that can be used to create smart contracts. 

All that ‘Turing complete’ means is that Solidity is a programming language capable of programming for any hypothetical computation. Thus, in theory, any computer application can be programmed in Solidity and run on the Ethereum platform. This language, therefore, is what Ethereum’s ‘smart contracts’ are written in. 

Just like Bitcoin uses blockchain technology to store its transactional data in a secure and decentralised way, Ethereum uses blockchain technology to store transactional data and contractual data.

By providing a blockchain complete with a programming language, Ethereum can achieve its objective of being a platform for decentralised, reliably secure and universally accessible apps to be built on. 

From this, we can start to understand the ecosystem that Ethereum enables and why there is so much interest in the platform. 

Before Ethereum, the blockchain world was limited to one main application (cryptocurrency through Bitcoin) and other speculative projects such as Namecoin that used blockchain to sell decentralised domain names. Ethereum provides the platform for any decentralised application to be built on top of. 

But how will these DApps work? Well, a key component of their functionality is Ethereum’s native currency Ether used as sound money for transactions on the Ethereum platform. As with Bitcoin, the Ethereum platform rewards users that verify transactions by charging fees. Ethereum’s transaction fees are known as Gas (more on this later).

Unlike Bitcoin, however, Ethereum also allows for other currencies to be used on the platform. Anyone can create assets and use Ethereum to trade them. These are known as tokens. 

Some famous applications of tokens include:

  1. Stablecoins: tokens tied to a traditional currency’s value, solving much of the volatility problem with current cryptocurrencies. 
  2. Governance tokens - these can represent voting power for a decentralised app. 
  3. Collectables tokens - these tokens can represent collectable items such as digital art or collectable game items. These are commonly known as NFTs (non-fungible tokens).

Ethereum Ecosystem & Innovations

Since 2013, many decentralised applications have been built on Ethereum. The surrounding Ethereum ecosystem has grown to a market cap of over $140 billion. Famous decentralised applications include digital art marketplace Foundation and browsers such as Brave that let you earn cryptocurrency from browsing the internet. 

More recently, Ethereum has powered the explosion of the decentralised finance industry, otherwise known as DeFi.

Innovations include decentralised exchanges and lending platforms amongst many others. The industry is young, moves fast and is continually growing and is an excellent example of the power of Ethereum. 

Another interesting example of the power and perhaps the dangers of the Ethereum platform is the DAO. The DAO was a digital Decentralised Autonomous Organisation and a form of investor-directed venture capital fund. 

The DAO aimed to be a new venture capital fund that allowed investors to vote via tokens granted based on the amount invested. It is estimated that the fund reached an Ether value of over $150 million. 

It lasted around 6 months in 2016 before an attack that saw nearly $50 million worth of Ether stolen. This Ether was eventually returned to its original owners via a ‘hard-fork’. This fork means the original Ethereum blockchain is no longer the main Ethereum chain (known as mainchain) and is now called Ethereum classic. 

The DAO highlighted specific vulnerabilities with creating DApps at scale. Namely that the complex codebases needed to develop large DApps such as the DAO can be exploited.

To get the whole story of Ethereum and understand where the platform is heading next, we need to look at these vulnerabilities in more detail and evaluate the platform in light of its limitations.

Ethereum's Limitations 

The most significant limitation of Ethereum - like with Bitcoin - is its scalability, which, as with Bitcoin, is hard to achieve without sacrificing  decentralisation or security, 

Fiat currency achieves security and scalability but sacrifices decentralisation to do so. In contrast, Bitcoin achieves decentralisation and security but sacrifices scalability to do so. At the moment it’s a similar story with Ethereum, while its critics also point to its founder as a point of failure, along with a lack of clarity over its total supply. 

When Ethereum launched, it was seen as an upgraded version of Bitcoin not just because it made DApps possible, but also because it upgraded the number of transactions that could be processed per second. 

This lent more scalability to the platform, but it’s still constrained. Bitcoin can handle around 5 transactions per second, whereas Ethereum can handle about 30. Compare this with a platform like VISA that can run 50,000 per second, and we can see the current limitations of cryptocurrencies. 

This limitation of Ethereum, coupled with its ability to empower developers to produce DApps, led to the rise of the ICO ecosystem. An ICO - initial coin offering - initially funded Ethereum; inspiring many developers to raise funds similarly. 

Many promised things that they couldn’t deliver on the current Ethereum platform. Thus, the resulting ICO frenzy where teams raised lots of money but often failed to deliver on their promises. 

How then, can Ethereum be claiming to be a ‘world computer’? If it can’t scale, surely it can’t compete? 

ETH 2.0 - Proof of Stake

In its current form, Ethereum cannot compete with Fiat systems such as VISA. Here we come to the advent of ETH 2.0 or Ethereum 2.0. 

Eth2 refers to a series of upgrades to the Ethereum platform that are currently being worked on. The three main objectives of these upgrades are increased scalability, security and sustainability. These objectives are being achieved in two main ways, the introduction of sharding and the migration to a new consensus mechanism known as proof-of-stake. 

Sharding is a computer science technique used to distribute the load on a particular network. In Ethereum’s case, the idea is to spread the transactional and contractional data processing load across 64 different chains. It is hoped that this technique will improve Ethereum’s capacity to process transactions to up to 100,000 per second. 

Proof-of-stake is an alternative way for blockchains to achieve consensus. These are known as consensus mechanisms. Up until now, Bitcoin and Ethereum have used a mechanism known as proof-of-work.  

Proof-of-work is very costly in terms of computer processing power which translates to high energy costs. It also risks the network being corrupted if mining centres grouped together and took control of more than 50% of the network. 

Proof-of-stake aims to address these two problems by randomising the consensus burden rather than having it as a competition. Switching to proof of stake will see a transition from miners to validators. There will still be a reward for confirming transactions; however, it will be more of a random selection than proof-of-work. 

As we saw earlier Ethereum’s transaction fees are known as Gas and naturally, these fees fluctuate with demand and are limited by Ethereum’s transaction processing limitations. Increased demand and a limited supply are a recipe for high fees.

It is hoped that the Eth 2.0 upgrades will dramatically increase Ethereum’s capacity to process transactions and therefore Gas fees (transaction fees) will become much lower. 

Through these two main upgrades and a promise of a more easily upgradeable infrastructure, Ethereum 2.0 aims to be the platform that Vitalik initially envisioned for Ethereum. The community launched the first phase of Eth2 in December 2020, and the full rollout is planned to take place over the next two years. 

It remains to be seen if Ethereum can fulfil its promise of being the ‘world’s computer’, but you certainly can’t fault them for their ambition.

Update of September 2022

After more than six years of playing second fiddle to Bitcoin -- but remaining by far the largest and most successful smart contract blockchain in existence, Ethereum finally completed its much-anticipated transition from Proof-of-Work to Proof-of-Stake on 15 September 2022.

Initially billed as Ethereum 2.0 in the years coming up to this event, it had been referred to as the “Ethereum Merge” for months, including by famed co-founder Vitalik Buterin himself.

In the week preceding the event, Ethereum markets performed strongly, bettering Bitcoin's own rally in the period. However, almost immediately after the Merge was successfully confirmed, Ether (ETH) price dropped from as high as $1,700 to below $1,300. While this signaled some possible loss of confidence from investors who did not back the transition to a less energy-intensive form of crypto mining, there were other macro factors at play. Not least of these was the US Federal Reserve meeting the following week, which many expected to announce another interest rate hike -- expectations were met.

Industry experts are generally positive over the Merge, since there are proven benefits of faster processing speeds and better stability, which should reflect as significant reductions in gas fees used to pay for Ethereum transactions. However, security benefits will take time to demonstrate.

At the same time, the majority of altcoins that are built atop Ethereum, or as second layer networks on top of Ethereum (such as Polygon and Arbitrum) could also enjoy greater success in adoption and utility after this latest Ethereum upgrade. Rivals like Polkadot and Solana, however, could face increased pressure; there are likely to be competitors who will fall by the wayside.