What is Ethereum?

Last Updated May 29, 2018

You’re likely here because you’re interested in Ethereum as an investment or as a protocol for developing or using applications. These motivations to learn Ethereum are not mutually exclusive, and to understand what Ethereum is you need to understand both the financial motivators for investing, as well as the disrupting changes that this new protocol is bringing to users around the world. Particularly as an investor, it is important to buy Ethereum on logic that goes beyond the price growth, as when the price does eventually correct (50% drops should be expected), it is only those who understand the fundamental value of this technology who will continue to hold and benefit from the long term impact of the blockchain.

This guide will examine Ethereum without the technical jargon. How does the blockchain work, what are initial coin offerings and how does Ethereum stack up against Bitcoin? This guide should help you understand the fundamental value that Ethereum – and blockchain more broadly – brings to the world stage, and why this technology might just be the most important innovation since the Internet.

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High Level Ethereum For Beginners

One of Ethereum’s most well known creators, Vitalik Buterin describes Ethereum as a “world computer”. Ethereum can be accessed by anyone in the world with an internet connection, and users can interact with its computational features without permission. Ethereum can be used for data storage, financial transactions, land ownership and much more – both imagined and yet to be imagined.

Ethereum is decentralized; a record of all Ethereum transactions are stored on thousands of different computers around the world. In traditional systems, data is far more centralized, and it can become enormously expensive to achieve the same level of distribution (and thus security) that is enabled by Ethereum.

Ethereum is trusted; thanks to cryptographic signatures and complex mathematics, Ethereum can be interacted without a 3rd party. Information entered into the network is immutable (will not change) and ownership of said information can be proven by its rightful owner.

Ethereum is pseudonymous; with cryptographic signatures, users who own information on Ethereum do not need to release personally identifiable information to prove their ownership. Transacting value across the Ethereum network can be done pseudonymously, and personal details can be revealed only if the sender chooses to do so.

Ethereum is fast; storing and transferring data on Ethereum can happen in seconds, whilst retaining the trust, privacy and decentralized (secure) fundamentals with which Ethereum provides. Once the protocol fully matures and the Ethereum application layer is established, the system will provide utility that is several orders of magnitudes greater than alternative options today.

Of course, Ethereum is still a very young technology. It launched in June 2015 and is still working through a number of upgrades focused on scaling the protocol. However, in its short existence it has made progress at a phenomenal rate. The network value has risen from thousands of dollars to billions in its short lifetime, and this guide will help you to understand what Ethereum has the potential to achieve in the near future.

Why is Ethereum needed?

Through the lens of the status quo, it is very easy to consider the technology of today to be “good enough”. Often it is difficult to imagine how protocols can upend global socioeconomics; in the same way that when the TCP/IP protocol of the Internet was built, few – if any – could have predicted where things would be just a few decades later. Ethereum is somewhat similar, however with the Internet already established globally, this new technology is capable of spreading and being adopted much faster than anything ever seen before. Ethereum will fundamentally change certain aspects of our lives, and in the years to come, we will – as we are now with the Internet – surprised that we ever lived without it…

Peer to peer

The role of the trusted middleman is a relatively new concept. Careers have been built around functions that require 3rd parties to help settle transactions between multiple groups or individuals. The need for a middleman has been essential, and the role has been responsible for unprecedented economic growth in the 20th century. It has also been responsible for economic catastrophe. Ethereum removes the middleman from a vast array of transactions and contracts. Rather than trusting a 3rd party who may (knowingly or unknowingly) fail in their duty as a middleman, people can trust computer code. So long as an individual has faith in the laws of mathematics, they can have faith in Ethereum’s ability to execute whatever transaction was agreed to by two parties. This removal of the middleman achieves enormous advantages in the form of security, speed and efficiency (low cost). In the current state of Ethereum, such transactions are mostly limited to the world of financial payments, however as the technology grows, this application is expanding to much more complex agreements between parties.

Sovereignty

Most people in developed nations take wealth sovereignty for granted. Legal tender issued by governments and central banks ensures that your hard earned dollars can be spent on goods and services. There are two key hazards to this which Ethereum solves:

Opaque Monetary Supply
How many dollars exist in circulation today? No one has an exact answer to that question. The printing press is hard at work – on the judgement of a few – to devalue existing holdings and to incentivize spending, without providing transparent figures by how much and to what extent. At the time of writing, it is certain that the number of Ethereum tokens in existence today is 96,331,928, and there will be roughly 3 new tokens every 15 seconds moving forward. This is all trackable on Ethereum’s transparent blockchain – which is described in more detail further below.

Ownership Rights
The history of humanity has a poor record of protecting individual ownership. Financial transactions have always been – and still are – at the mercy of a few, and the wealth of an individual can be arbitrarily dissolved overnight. This problem is far more of an issue in developing nations, particularly those which have experienced civil war and corruption. The most recent crisis in Syria highlights this; where middle class and low income families looking to flee the country lose their wealth as they cross the border. Ethereum solves this problem in two ways; first of all, property rights and other forms of ownership can (in the near future) be publicly verifiable on the Ethereum blockchain. In more practical and immediate terms however, wealth stored on the Ethereum blockchain cannot be confiscated. Freedom from confiscation is an essential tenet of cryptocurrencies like Ethereum, and through its use, families can take sovereignty over their own wealth and gain global mobility without the trade-off in standard of living.

What makes Ether valuable?

In simple terms, the price of Ethereum is driven by demand. Investors buy Ethereum in the hope that the technology expands and improves – leading to further increased demand (driven by utility) and a return on investment. Those who want to interact with the Ethereum blockchain or to move money out of the fiat system (for reasons not limited to the above) will also push the price higher. Ethereum is valuable because it provides a better solution to the status quo, currently its two most valuable use cases are fundraising (see section on Initial Coin Offerings) and financial transactions. However there is another type of technology enabled by Ethereum which could upend the existing global tangle of digital infrastructure.

Smart Contracts

Ethereum is described as a “world computer” because transactions can initiate sets of functions which carry out automated and guaranteed tasks. For example, a transaction from Alice to Contract Y could run through a function inside the contract which then sends the transaction from Contract Y to Bob. A simple example of a function inside this smart contract would be an escrow, where the funds are released to Bob once certain conditions are met, and Bob can be certain he will be paid. Smart contracts can be linked together to contract a web of automated value transfers which trigger based on prior agreed terms. This technology has the potential to disrupt global finance on an unprecedented level, but even more importantly, smart contracts will also enable machine-to-machine payments in the AI driven economy of the future. Ethereum is currently the most utilized and valuable smart contract platform in the industry, however other platforms do also exist. Bitcoin has a smart contract layer called “Rootstock” and NEO is a blockchain similar to Ethereum which is gaining traction in China. Other smart contract platforms to be aware of include Cardano and EOS.

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What is Ethereum used for?

This article explains some of the current and future use cases of the Ethereum blockchain, helping investors to understand the long-term potential of this asset.
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The Ethereum Blockchain

Blockchain became a buzzword in 2017, several years after it was first described in Satoshi Nakamoto’s famous Bitcoin whitepaper. On the Bitcoin blockchain, transactions in the network are bundled together and stored in blocks, with each block referencing the previous one, all the way back to the first generated block, known as the “genesis block”.

This chain of connected blocks became known as the blockchain; essentially a ledger of all transactions which have ever taken place. The blockchain is stored across thousands of computers (called “Nodes”) which agree on the history of the Bitcoin network and its consensus rules. By distributing the blockchain in this way, the risk of shutting down the system is mitigated.

The Ethereum blockchain is built in much the same way. Every transaction, whether to another individual’s wallet or smart contract, is recorded on its public blockchain. Each transaction broadcast to the network is also processed (validated) by every node on the network to ensure that it follows consensus rules. This means that a single transaction to perform any arbitrary function would need to be executed once for every node on the network. This type of validation brings enormous security to the network, however it has a considerable trade-off with scalability. Software upgrades to improve the scalability of the network whilst retaining this key feature of security are well underway for Ethereum.

Blockchain Stakeholders

There are a number of stakeholders within the blockchain ecosystem. These are:

Nodes
The role of the node is to enforce consensus rules and validate transactions. This covers multiple facets; as one example, a node would validate the balance of an account – ensuring that a transaction plus its “gas” fee (transaction fee) is not be greater than the balance. A transaction which did not validate would simply be ignored and not included in a block – therefore failing to be recorded in the agreed ledger.

Light Clients
Most Ethereum wallets are “light clients”. Unlike a node, a light client does not store a full or pruned copy of the Ethereum blockchain. Instead, these light clients connect to nodes to receive relevant data about the state of the blockchain, allowing the user to safely transact on the network without the complexities of running a node. The size of the Ethereum blockchain is many gigabytes large; light clients allow users to use the Ethereum blockchain without having to download, store and process a copy of every transaction ever created.

Exchanges
Exchanges are the on and off ramps to and from Ethereum and fiat currency (USD, EUR, GBP etc). Exchanges operate outside of the blockchain, however some decentralized crypto-to-crypto exchanges are being built which operate using smart contracts on the Ethereum blockchain. An exchange is a 3rd party private enterprise, and storing funds in an exchange has its own risks (see the risks section to this guide).

Miners
Miners secure the network by bundling valid transactions together into blocks, connecting each new block with the one previously forming immutable history of Ethereum transactions and balances (known as the “state”). This is the blockchain. Finding a block rewards the successful miner with 3 Ether plus the transaction fees of every transaction inside that block.

To mine a block, the miner must provide a “Proof of Work” to satisfy a condition. The condition is that the hash of the block is below a certain target. The target is set in such a way that to meet the condition, the miner must have spent work solving it – “Proof of Work”. The target is dynamic, making the condition easier or more difficult to reach depending on how much effort is being put in by the miners. Through mathematics, the target ensures that – on average – a new block will be found every 12 seconds. If less effort is being spent mining, the target will adjust to become easier, ensuring that the average block time remains at 12 seconds.

A simple analogy to Ethereum mining can be found in the rolling of dice. Assume the target set is to roll a six, 3 times in a row. Once you are successful, you provide proof that you rolled a six 3 times in a row and the network rewards you with Ether. In the case of Ethereum mining, the difficulty is closer to rolling a six dozens of times in a row, however the miners use powerful graphics cards to compute the “rolls” at many trillions of times per second.

Mining is a complex topic that is not covered here in detail, for more technical information, see this guide to Ethereum mining.

Decentralized Applications

Smart Contracts have paved the way for “decentralized applications” or “dApps”. Unlike traditional applications such as Uber or Facebook, a dApp is not owned by a company, instead its code is deployed to the Ethereum blockchain for anyone to run. By creating a dApp, the user does not need to trust a company to execute the terms of service; instead this is done by the smart contracts with which the dApp is built. Currently there are a few dApps on the market which are operational in some way today:

CryptoKitties
This dApp allows users to “breed” cats on the blockchain. Each cat is referenced by its own unique Ethereum address which makes up its genetic code. Cats are transferable and immutable. CryptoKitties was the first dApp to reach mainstream media in November 2017 and has provided inspiration for a host of new applications.

Etherisc
An insurance dApp which pays out its customers instantly through the Ethereum blockchain. This dApp uses oracles to determine outcomes of events, and pays out their customers accordingly. No trust from either party is required.

Augur
A prediction market dApp which allows users to create and bet on markets that reflect outcomes. Similar to Etherisc, Augur pays out each prediction market’s winner instantly based on the outcome given by one or more oracles (3rd party sensors/APIs which digitize outcomes).

Code deployed to the Ethereum blockchain is open source and visible for anyone to copy and use – as an example, you can see the code use for one of the CryptoKitties smart contracts here. The competitive advantage that dApp creators have is in the “front end” website that they build for users to interact with. CryptoKitties.co is the first great example of a simple front end experience which interacts with far more complex smart contracts under the hood. The complexities and usefulness of dApps will only expand, and it seems likely that the first mainstream Ethereum dApp will deploy within the next 5 years.

What is an Initial Coin Offering?

An Initial Coin Offering (ICO) is a new way for businesses to raise funds using – but not limited to – the Ethereum blockchain. The platform conducting the ICO creates a new “coin” and sets rules around its supply (deflationary/inflationary for example). This new coin is then issued to investors who purchase the token with US dollars, Ether or other cryptocurrencies. The pricing mechanism for the new coin is decided by the platform hosting the ICO; typically at a flat rate or as a reverse-auction. The investment case for an ICO is based around the utility of the token and future demand for it. Demand for the new coin is driven by its requirement as a means to interact with the platform who created it. Should the platform reach mainstream adoption, the demand for the coin will be large and a return on investment can be expected for those who bought during the ICO.

Initial Coin Offerings are a high risk form of investing and have been likened to venture capital. Unlike venture capital however, ICOs do not provide investors with equity, but the amount invested can be anywhere from a few dollars through to many millions and are accessible globally.

There are an array of risks associated with ICOs that go beyond other cryptocurrencies like Ethereum and Bitcoin.

Platform risk
Whether it is the failure of the team to deliver, or of the product to perform, the risk of platform failure is enormous. It is anticipated that as many as 90% of the first ICOs will fail within the next 10 years. The same is true in venture capital – it is rare to find a “unicorn” that provides the 10,000% returns many hope for in the cryptocurrency market.

Regulatory risk
At this point in time, ICOs are lacking regulation. Many ICOs may be considered illegal by the USA’s SEC in the near future. China’s PBOC have also taken steps to protect investors from the risks of ICOs.

Bad actors
Initial Coin Offerings raised over $2bn in 2017. The excitement around ICOs and the potential for several thousand percent returns has drawn investors en masse. Many token sales have been able to raise millions of dollars on the basis of a “whitepaper” alone – a multi-page document outlining the coin and its utility/economics. The unregulated nature of ICOs have allowed some platforms to raise thousands or millions of dollars with no intention to create a working product.

“Ethereum Is Like The Internet”

This analogy is thrown around often in the mainstream media. In a sentence, it helps those unfamiliar with Ethereum to quickly grasp an idea of a) the global scale of the network and b) its value to society. In some ways Ethereum is like the internet; it’s a distributed network of computers that allow communication (transactions) between peers. Ethereum is also developing an Ethereum Name Service (ENS), one which will allow human-readable addresses for both individual wallets and contracts. Rather than sending transactions to an unmemorable address 0xE2514983D93… the payment can be sent to myethereumname.eth. In the same way a web address like ethereumprice.org is simply a sidestep to visiting the unmemorable server I.P 172.104.250.117.

That’s where the comparison ends however. The reality is that Ethereum is a technology never seen before, and will have implications that we simply do not yet understand. Analogizing Ethereum to the Internet should be considered only as a concrete point of relatively for this complex and exciting new technology.

Is the future bright for Ethereum?

My article “Ethereum Investors Are Still Early To The Scene” remains relevant to this day. Ethereum (the protocol) may reach its final state in the next decade, however the dApps and use cases derived from its technology are likely to continue evolving indefinitely. Every dApp operating on the Ethereum blockchain – whether as a token or as Ether – requires that Ether is spent in the form of “gas” (consider it a transaction fee) for it to function. The more widely adopted the network, the more valuable Ether becomes – see Metcalfe’s Law.

Broad adoption is still some distance away as Ethereum still faces issues surrounding ts scalability of transactions. As an example, in November 2017, CryptoKitties became popular enough to slow down the entire network several fold. Scaling solutions are underway however, and during the course of 2018/19 two important software upgrades – Sharding and Casper – will go into place. These technology upgrades, which are elaborated on at the previous link, are estimated to provide 1000x greater transaction throughput on the Ethereum network.

Even still, if Ethereum is to become as widely used as expected with dApps as popular as Facebook and Uber operating on its blockchain, then the network will need to scale beyond what Sharding and Casper are capable of achieving. The practicality of scaling a network to this level without compromising on security or decentralization is unknown; however some of the greatest minds in computer science and cryptography are working on the Ethereum protocol, and despite inevitable challenges, the long term outlook remains optimistic.

What are the risks of Ethereum?

The risks of Ethereum are known and unknown (in the case of a “black swan event”) and there are risks to both users and investors. This guide will touch upon the most critical risks to the ecosystem, and further details have been discussed in this article on “what could destroy the price of Ethereum?”.

Platform Risk

Ethereum has faced DDoS attacks in the past however the network has sustained an impressive 100% uptime. The Ethereum blockchain itself is highly secure and funds stored on the blockchain face very low platform risk.

Application Risk

The largest attack vector on the Ethereum blockchain has been at the application layer and not the protocol layer as described above. Smart contracts have been exploited on several occasions, with multi-million dollar exploits being relatively common (these links are certainly not exhaustive). Users and investors should be very cautious when dealing with Ethereum applications – the code is guaranteed to execute in its specified manner, however the specification may well have been flawed.

Regulatory Risk

Ethereum has built a positive reputation among the mainstream media, however the continued success of its platform will eventually come as a threat to many governments and central banks. The risk of heavy handed regulation looms over the cryptocurrency space and Ethereum is no exception. Regulatory risk could see both user and investor funds being difficult to exchange for fiat currency, however the likelihood of this happening – so far at least – seems small. In addition to that, Ethereum has a strong leadership group (Ethereum Foundation) which has made significant inroads with promoting the technology as a cause for good.

Bitcoin vs Ethereum

The one question that comes to mind for many newcomers to Ethereum is how is Ethereum any different from Bitcoin? This article has gone to some lengths to explain the differences between the two, however for a more concise summary of the Bitcoin vs Ethereum debate, see below:

Smart Contracts
Ethereum has smart contracts built in at the protocol layer. A Bitcoin “sidechain” called Rootstock is being developed which will provide smart contracts that are settled on the main Bitcoin blockchain.

Leadership
Whilst centralized leadership could be seen as a shortcoming in the long run, the leadership from the Ethereum Foundation is demonstrating the quick progress that can be achieved with a clear vision (see previous discussion around scaling the network).

Transactions per second
Ethereum can process 15 transactions per second whilst Bitcoin is limited to roughly 7. See the next point for why this is not necessarily relevant.

Bitcoin is Gold, Ethereum is Oil
Following the failure of the Bitcoin block size increase from 1mb to 2mb; it has become apparent that Bitcoin will remain a “slow, stable and secure” blockchain and not the fast “peer to peer electronic cash” first envisioned by Satoshi. Instead, Bitcoin is now carving itself out as a highly reliable store of value, whilst Ethereum is demonstrating diverse utility.

Initial Coin Offerings
Ethereum enables token creation on its blockchain, Bitcoin does not. Again, this is not relevant to Bitcoin given its direction towards a global store of value.

Enterprise Involvement
Ethereum’s smart contracts have attracted the attention of thousands of corporations, entrepreneurs and merchants. The Enterprise Ethereum Alliance was formed in 2016 to develop an ecosystem for integrating the Ethereum blockchain at an enterprise level. Despite the existence of the Rootstock sidechain, there has so far been no commercial appetite for developing enterprise applications on the Bitcoin blockchain.

Summary of Bitcoin vs Ethereum
The comparison between these two blockchains is largely irrelevant, and the utility of each will only become more obvious as the ecosystem evolves. Bitcoin does not compete with Ethereum and the same is true vice versa. Andreas Antonopolous addresses this point in an extremely articulate way during his talk on “The Lion and the Shark”.

Ethereum Resources

To conclude this guide, please see a number of useful external resources covering both the technical and fundamental aspects of the Ethereum blockchain.