What Is Ethereum & How Does It Work?

Key Takeaways

• Ethereum was conceived in 2013. It is a decentralized blockchain platform that supports Ether (ETH) and can execute smart contracts.
• A hard fork in 2016 created two separate Ethereum networks: Ethereum (the current version) and Ethereum Classic.
• In 2022, it transitioned from a proof-of-work (PoW) to a proof-of-stake (PoS) consensus mechanism to address energy consumption concerns and improve scalability.
• Ethereum blockchain offers versatility and cost efficiency through its support for smart contracts, enabling innovation and reducing transaction costs.
• Ethereum’s celebrations coincide with the approval of Ethereum exchange-traded funds.

Around the globe, from San Francisco to Tokyo, industry experts and enthusiasts are eager to celebrate Ethereum’s 9th birthday. As a blockchain of significant size, it does not have a specific date of commencement but a series of critical milestones from its conception in 2013 to the present, culminating with its latest development and the final spot approval of Ethereum exchange-traded funds (ETFs).

From Bitcoin To Ethereum’s Conception

In 2009, Satoshi Nakamoto introduced a groundbreaking alternative to fiat currency, using cryptography to form a sound medium of exchange called Bitcoin (BTC). Bitcoin became the first cryptocurrency that offered a decentralized alternative to centralized, traditional currencies.

Bitcoin’s creation opened a new era of financial freedom and innovation. Numerous individuals swiftly realized, explored, and admired the potential of blockchain technology. As a result, developers and cryptography enthusiasts began to contemplate whether blockchain had more untapped potential.

When he was nineteen, Vitalik Buterin, one of the founders of the Ethereum blockchain, embarked on an audacious new venture to push the boundaries of Bitcoin’s capabilities.

Due to its limited design, Bitcoin lacked the versatility to support various functionalities, prompting Vitalik to conceive Ethereum. The latter aimed to establish a platform where developers could build decentralized applications (dApps) using smart contracts.

To realize this vision, a team of individuals, including Gavin Wood (creator of Polkadot and Kusama), Charles Hoskinson (creator of the Cardano blockchain), and Joseph Lubin (founder of ConsenSys), worked assiduously to bring Ethereum to fruition.

What Is The Ethereum Blockchain?

As of July 2024, the Ethereum blockchain, with a total market value of $407.27B, is second on CoinMarketCap after Bitcoin.

The blockchain offers leading technology with a vision to change the world in various exciting and debatable ways.

Ethereum is an attempt at a decentralized blockchain platform that offers unique features centered around providing smart contracts, decentralized finance (DeFi), and dApps.

A smart contract can be likened to a digital vending machine. When you insert the precise amount of coins into the machine and select your desired beverage, you enter into a smart contract with the vending machine.

This is because the vending machine acknowledges your payment, identifies the specific drink you’ve chosen, and fulfills its end of the deal by dispensing the beverage. Fundamentally, a smart contract functions on the same principle as a vending machine: it is straightforward and reliable.

Smart contracts serve as the foundation of Ethereum’s vision, enabling the development of DeFi and dApps on its platform. These self-executing contracts have the terms of the agreement directly written into code and are immutable once deployed on the Ethereum network. This means that once the contract is entered, it cannot be changed.

Ether (ETH), Ethereum’s native cryptocurrency, powers these smart contracts and fuels transactions and computational services on the network.

How Does Ethereum Blockchain Work?

Ethereum is more than just a cryptocurrency because of the many features it provides to its network users. At its origin, Ethereum’s PoW consensus mechanism relied on miners to secure the network and validate transactions, giving it a highly decentralized image.

As mentioned, Ethereum has migrated away from PoW to PoS. The reasoning behind this shift includes addressing issues related to high energy consumption and centralization, as stated by the media. 

Additionally, this migration has helped the Ethereum community scale, which would not have been possible on a PoW system like Bitcoin when operating smart contracts.

Ethereum’s PoS Consensus Mechanism

Here’s an overview of Ethereum’s PoS consensus mechanism in six steps:

1. Validators: PoS uses validators instead of miners. Validators are users who hold a certain amount of Ether and choose to stake it in the network. Recently, Ethereum’s “Shanghai hard fork” was completed. This update allows users to secure and validate blockchain transactions on the blockchain to withdraw their funds.
2. Block proposals: Validators take turns proposing and validating blocks on the Ethereum blockchain. When a validator proposes a block, it creates a block with transactions and broadcasts it to the network.
3. Block validation: Other validators then validate the proposed block, checking to ensure the transactions are valid and that the proposed block adheres to the network’s rules. Validators can either vote to accept or reject the proposed block. They essentially check whether the Block proposal follows the rules of the Ethereum network.
4. Rewards: Validators who participate in block proposals and validation are rewarded with ETH. However, validators who behave maliciously, such as by proposing invalid blocks or trying to double-spend, are penalized by having their staked ETH slashed.
5. Network security: Ethereum’s PoS system uses a randomized process to select validators who propose and validate blocks. The likelihood of being chosen is proportional to the amount of ETH staked. While larger stakers have a higher chance, this mechanism is designed to incentivize network security rather than concentrate power.
6. Finality: Once a block is accepted by the network and added to the blockchain, it is considered final. This means that transactions on the block cannot be reversed, which is an essential property for decentralized applications.

Although Ethereum and its smart contracts are designed to be immutable, there are situations where contracts may need to be reversed due to errors or mistakes, including human error during the programming phase or incorrect data inputs. This has raised concerns about the immutability of smart contracts and sparked debates in the community.

History Of The Ethereum Blockchain

2013

• The White Paper: Vitalik Buterin conceives Ethereum as a new platform for dApps beyond cryptocurrency and publishes Ethereum’s white paper, aimed at broader audiences, including developers, investors, and the general public.

2014

• The Yellow Paper: Gavin Wood releases Ethereum’s yellow paper, which specifies technical aspects and details about Ethereum’s protocol, such as the Ethereum Virtual Machine (EVM), consensus mechanism, and transaction processing.
• Ethereum’s Initial Coin Offering (ICO): Ethereum raises $18 million in crowd sales, funding its development. This event is often considered one of the earliest and most significant ICOs, as it set the stage for future token sales on the platform.

2015

• Frontier launch: Ethereum launched its initial version, called “Frontier.” This release introduced the first blockchain platform that could be programmed to run smart contracts and dApps), beyond just facilitating cryptocurrency transactions like Bitcoin.
• Genesis block: Ethereum’s first block is mined, and the Ethereum blockchain is officially started.
• First Ethereum Improvement Proposal (EIP-20): Standardizes the ERC-20 token interface.

2016

• Homestead: Transition from a beta testing phase, “Frontier,” to a more stable and secure version suitable for production use, “Homestead,” included several protocol improvements and optimizations.
• The DAO: Members of the Ethereum community created the decentralized autonomous organization (DAO), which raised $150 million.
• DAO Hack: The DAO was hacked. It resulted in a loss of $50 million.
• Hard Fork: Ethereum undergoes a controversial hard fork to recover the stolen funds, creating Ethereum (ETH) and Ethereum Classic (ETC), which continues to operate using proof-of-work (PoW) and caters to users who prefer that consensus mechanism.

2017

• ICO boom: Ethereum becomes the platform of choice for ICOs, raising billions of dollars for crypto projects.
• Metropolis upgrade: The Byzantinum upgrade improves security and performance.
• Enterprise Ethereum Alliance: It connected Fortune 500 companies and Ethereum experts.
• Scalability crisis: The CryptoKitties (an NFT game) craze causes network congestion, highlighting scalability issues.

2018

• Challenges in place: This year was marked by several issues related to scalability, security, and vulnerabilities, which delayed planned upgrades. Despite these challenges, the Ethereum community continued to work on solutions to address them, setting the stage for future improvements that would drive the blockchain’s popularity.

2019

• Metropolis upgrade “Constantinople” and “St Petersburg”: Constantinople upgrade enhanced Ethereum by speeding up operations and reducing resource use. It also improved smart contract interactions to allow more flexibility. St Petersburg upgrade was focused on safety to ensure that everything continued to run smoothly without introducing potential vulnerabilities.

2020

• Decentralized Finance (DeFi) boom: Ethereum has exploded in popularity, allowing users to recreate traditional financial systems, such as lending, borrowing, and trading, using blockchain technology without intermediaries.
• Total Value Locked (TVL) surge: The total value locked in DeFi protocols soared, reaching billions of dollars leading to a massive influx of funds into the ecosystem.
• Ethereum consensus layer upgrade: Like its predecessor, Bitcoin, Ethereum was initially built on a PoW consensus mechanism. However, the network was designed to be more than just a cryptocurrency exchange platform. The energy-intensive PoW consensus mechanism began to be replaced with “proof-of-stake” (PoS). It started with the launch of the Beacon Chain in December 2020. The upgrade aims to enhance performance, reduce transaction costs, and significantly improve sustainability by lowering energy usage.

2021

• Non-fungible tokens (NFTs) boom: Ethereum has become the leading blockchain for the booming NFT market. Games, celebrity brand engagement, digital art collectibles, and marketplaces such as Rarible and OpenSea were critical drivers for the NFT boom. 
• London Hard Fork: This was a significant upgrade that introduced EIP-1559, a fee structure and fee-burning mechanism to stabilize transaction costs, implemented as part of the London Hard Fork. Some of the benefits of this fork included improved fee predictability, reduced volatility in transaction costs, a deflationary mechanism for ETH, and a better user experience.

2022

• The Merge: Ethereum successfully transitioned from PoW to PoS, reducing energy consumption and improving security and scalability. This process began with the launch of the Beacon Chain in December 2020, which ran parallel to the Ethereum Mainnet and handled PoS consensus independently. The Merge involved integrating the Beacon Chain with the Ethereum Mainnet and replacing PoW with PoS for consensus across the entire network.

2023

• Shanghai Upgrade: The 2023 Shanghai Upgrade was a significant update for Ethereum that allowed validators to withdraw their staked ETH. This meant that people who had locked up their ETH to help secure the network could access their funds and any rewards they had earned. 

2024

• Ethereum’s Dencun upgrade: EIP-4844, via proto-dank sharding, brings a new transaction type to Ethereum that allows “blobs” of data to be temporarily stored in the beacon node.
• First Ethereum ETFs: On May 23, 2024, the U.S. Securities and Exchange Commission (SEC) approved the listing and trading of eight Ethereum ETFs on SEC-regulated exchanges.
  

  EIP	YEAR	ACTION
  EIP-155	2016	Protected Ethereum from hackers trying to protect transactions.
  EIP-1153	2018	Made it cheaper to use Ethereum by storing some data temporarily.
  EIP-20	2015	Created a standard way to make new coins on Ethereum (like ERC-20 tokens).
  EIP- 721	2017	Create a way to make unique items on Ethereum (like NFTs).
  EIP-1559	2021	Made fees on Ethereum more predictable and fairer.
  EIP-3672	2022	Helped make Ethereum more secure by improving how it verifies information.
  EIP-4844	2023	Made Ethereum faster by storing some data in a different place.
  EIP-4788	2023	Improved how Ethereum keeps track of its data.
  EIP-5656	2023	Made it faster to copy data on Ethereum.
  EIP-7609	2024	Aims to lower storage costs.

The DAO, The Hack, And The Hard Fork, 

Ethereum, like Bitcoin, has a rich history and has faced many challenges, such as its infamous DAO attack in 2016. The DAO was a blockchain-based venture capital fund that utilized smart contracts to allow investors to earn investment returns on their investments. 

However, the smart contract code contained a flaw that enabled the attacker to drain a significant amount of ETH from the DAO’s funds into a child DAO.

The DAO hack ultimately led to a hard fork of the Ethereum network, which involved rolling back the blockchain to a previous state to undo the damage. This fork resulted in the creation of two separate Ethereum networks: the current Ethereum blockchain (the resulting forked blockchain) and Ethereum Classic (the original version of the Ethereum blockchain).

It is important to note that Ethereum Classic still uses the PoW consensus method, whereas Ethereum moved to a PoS consensus mechanism, commonly known as the Merge upgrade. Environmental concerns drove the decision to switch to a PoS method.

Prior to the planned Merge, a hard fork of the Ethereum network known as ETHW was created, still employing the PoW consensus mechanism. This resulted in a victory for ETH miners. Chandler Guo, a Chinese miner who opposed the PoS consensus method, launched the PoW-based Ethereum blockchain.

Token Standards On The Ethereum Blockchain

Ethereum holds different ERC tokens akin to various digital items or assets created on the Ethereum platform. These token standards dictate how new tokens should be made on the Ethereum blockchain. Here’s a brief overview of these token standards:

• ERC-20 tokens: These tokens are fungible and can be exchanged with one another, signifying that each token inherently possesses the same value as the others.
• ERC-721 tokens: Acting as NFTs, these unique digital assets are ideally suited for representing digital art, collectibles, and in-game items, effectively showcasing their irreplaceable nature. One of the earliest and most famous examples of an NFT is CryptoKitties, a blockchain-based game where users can buy, sell, and breed virtual cats with unique traits and characteristics.
• ERC-1155 tokens: Often viewed as a hybrid of the ERC-20 and ERC-721 token standards, ERC-1155 allows the creation of fungible and non-fungible tokens. This standard is useful for developers creating unique and interchangeable items.

Additional ERC Token Standards

• ERC-223: An ERC-20 improvement aimed at preventing accidental token transfers to non-supporting contracts.
• ERC-777: Advanced token standard providing more features for interacting with tokens, including hooks for handling tokens.
• ERC-827: Extends ERC-20 by allowing token holders to approve third-party spending, transfer, and call on behalf of the token holder.
• ERC-884: Standard for representing shares in a Delaware corporation on the Ethereum blockchain.
• ERC-998: Composable non-fungible token standard, allowing NFTs to own other NFTs and ERC-20 tokens.
• ERC-1400: Standard for security tokens, integrating compliance features directly into the tokens.

These standards provide various functionalities and use cases, from simple, fungible tokens to complex, composable NFTs and security tokens.

https://twitter.com/KittiesNice/status/1814224946257694871

By offering a comprehensive suite of solutions, Ethereum strives to decentralize the internet, creating a network of computers that combine into a powerful decentralized supercomputer, enabling transparent and secure transactions without intermediaries such as banks. 

This involves a neutral third party who holds funds, assets, or documents until all pre-established terms in a contract are fulfilled, ensuring the agreement between the involved parties is honored.

Bitcoin Vs Ethereum: Key differences

Bitcoin and Ethereum are the most well-known cryptocurrencies, yet they hold notable differences in their underlying objectives and architectural design. The following points highlight some of these key differences:

Ethereum Wallets

Ethereum is a decentralized network of computers that work together to execute code or smart contracts. To interact with these contracts, users need Ethereum wallets , which are software or hardware tools that hold private keys and provide public addresses for sending and receiving Ether, the native cryptocurrency used on the Ethereum network.

There are two types of Ethereum wallets: full nodes and light nodes. Each serves different user needs based on their requirements for security and convenience.  

Ethereum wallets are essential tools for interacting with the Ethereum blockchain. They enable users to manage ETH and other tokens, execute smart contracts, and participate in the decentralized ecosystem. 

These wallets come in various forms categorized into two types that offer different advantages:

• Full nodes: These are also known as “full client” wallets and hold the entire blockchain history and verify transactions.
• Light nodes: These rely on third-party full nodes to get information when needed. They are often referred to as “lightweight” or “thin client” wallets and are typically faster to sync and use less storage space.

Hardware wallets are physical devices that store a user’s private keys offline. They are the most secure way to store Ether; however, unlike smart contract-powered wallets, they can only send and receive Ether and ERC-20 tokens. Some examples include Ledger Nano and Trezor.

Software wallets are digital wallets that run on a computer (e.g., desktop wallets like Exodus and web wallets like MetaMask ) or mobile device (e.g., MyEtherWallet ) and store the private keys for accessing cryptocurrencies online.

Paper wallets offer a basic level of security by storing your private and public keys offline on a physical piece of paper. However, they are less convenient for frequent transactions and require extra care to prevent loss or theft, making them a less secure option overall.

Popular Ethereum dApps

Decentralized applications are software programs that run on the Ethereum blockchain. They are designed to be decentralized, which means they operate on a distributed network of computers rather than being controlled by a central authority.

dApps can be used for various purposes, including creating marketplaces, managing digital assets, and executing complex financial transactions through the integration of smart contracts.

Uniswap

Uniswap is a decentralized exchange (DEX) built on the Ethereum blockchain that allows users to trade cryptocurrencies without the need for intermediaries. It uses an automated market-making (AMM) system and enables users to trade any ERC-20 token pair, earn rewards, and provide liquidity to the platform.

AMMs use a mathematical algorithm to determine the price of assets based on the ratio of the available tokens in a liquidity pool. Instead of relying on order books like centralized exchanges, AMMs automatically adjust the price based on the amount of assets being traded, providing liquidity to the platform and enabling decentralized trading without the need for intermediaries.

Aave Protocol

The Aave protocol enables users to borrow and lend from a selection of over 30 Ethereum-based assets. Users can choose between stable and variable interest rates based on their preferences and market conditions. Users can also obtain flash loans. In addition to traditional assets, Aave also offers pools for real-world assets such as real estate. The platform’s governance token, AAVE, allows users to participate in voting on Aave Improvement Proposals (AIPs).

OpenSea

OpenSea is a peer-to-peer (P2P) marketplace for buying, selling, and discovering non-fungible tokens, including digital art, gaming items, collectibles, and other unique digital assets, using cryptocurrency.

Benefits Of Ethereum

Ethereum is a blockchain-based decentralized platform with several benefits compared to traditional centralized systems. These include:

• Versatility: Ethereum supports various functions, such as smart contracts, DApps, and DAOs, enabling innovation and collaboration across industries.
• Cost and time efficiency: Smart contracts automate complex transactions, eliminating intermediaries and reducing expenses for businesses and individuals.
• Enhanced performance: PoS system increases scalability, security, and energy efficiency, elevating the platform’s potential.
• Continuous improvement: Developers actively work on updating Ethereum’s functionality and security, ensuring its competitiveness in the blockchain landscape.

Disadvantages Of Ethereum

Ethereum, like any other technology, has its share of disadvantages, including:

• Rising transaction costs: As Ethereum’s popularity grows, transaction fees increase, potentially limiting access for small businesses and individual users.
• Ether volatility: Ether’s unpredictable price can challenge day traders and long-term investors.
• Scalability concerns: Ethereum must continuously adapt to accommodate the increasing demand for decentralized applications and smart contracts.
• Ongoing development: Ethereum developers face the challenge of finding practical solutions to improve network performance and accessibility.

The Future Of Ethereum

Since Ethereum’s inception in 2015, questions have been asked about the future evolution of the protocol, particularly in addressing significant challenges such as scaling. Phase one, known as The Merge, took place on September 19, 2022, and was an essential part of the development of Ethereum as it transitioned away from PoW to PoS consensus. By making this leap, the Ethereum Foundation is actively envisioning the state of Ethereum a decade from now.

Ethereum’s development is undergoing a complex and lengthy transition to become a more robust, secure, and powerful version of its former self, ultimately enhancing its capabilities and potential impact to deliver scalability. Ethereum’s development roadmap, outlined by Vitalik Buterin, consists of five key phases that begin with the Merge.

• The Merge: Transitions from PoW to PoS consensus mechanism
• The Surge: Implements sharding to improve the network’s scalability.
• The Verge: Introduces “verkle trees” to optimize store data.
• The Purge: Reduces the historical data helping to maintain efficient operations. 
• The Splurge: Fine-tunes the network to ensure the robustness of previous upgrades. 

Ethereum continues to evolve its strategies for handling transactions more efficiently and cost-effectively through a series of upgrades. Initially, traditional sharding was proposed to divide the network into smaller segments, facilitating parallel transaction processing. However, this concept has been refined and replaced by approaches like “proto-danksharding” and “danksharding,” which aim to optimize data handling and expand throughput more effectively. 

Alongside these developments, Ethereum also heavily leverages “Layer 2” solutions such as Optimism and zkRollups. These technologies process transactions off the main network, significantly enhancing speed and reducing costs by alleviating the burden on the Ethereum blockchain.

The Purge phase involves cleaning up Ethereum’s chain state to improve efficiency and reduce storage requirements, making it more accessible for individuals to run nodes. The final phase, the Splurge, focuses on improving the user experience for developers, attracting more innovative applications and solutions to the Ethereum platform.

As Ethereum’s story continues to unfold, it will likely remain a dominant force in the blockchain and cryptocurrency space over the next decade. Its community eagerly awaits the many innovations and developments that lie ahead. 

With ongoing upgrades, focusing on scalability, security, and sustainability and its commitment to innovation and enhancement of its infrastructure through advanced protocols, Ethereum is setting the stage for a future where it could be a more integral part of various sectors, including the legal industry, art, property, healthcare, and DeFi. 

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