What Is Ethereum – A Complete Guide to the #1 Smart Contract Platform

What Is Ethereum – A Complete Guide to the #1 Smart Contract Platform

If you have ever wanted to get an answer to the question “What is Ethereum?”, you couldn’t have come to a better place. This article delves deep into the basics of the #1 smart contract platform. It will attempt to give you a good understanding of the Ethereum blockchain and its cryptocurrency, ETH.

So, what’s the big deal behind Ethereum? Isn’t it just another cryptocurrency like Bitcoin? Well, not exactly. There are actually some good reasons behind the hype. Ethereum is much more than just a digital currency for transferring value over the internet. The second-largest cryptocurrency by market cap provides us with a worldwide supercomputer that developers can use to decentralize almost every industry known to man, starting with finances.

To better understand the Ethereum meaning in the grand scheme of things, let’s first try to give you a more thorough Ethereum definition before we go further down the rabbit hole.

What is Ethereum?

To put it short, Ethereum is an open-source blockchain with smart contract capability. This means that, from a comparative standpoint, if Bitcoin is decentralizing currency, Ethereum is decentralizing the Internet.

Ethereum changes everything: from the way we exchange value over the Internet to the way we use our computers. It revolutionizes the development of applications, communications, and ultimately, our future.

Since its release in the early 90s, the internet has become increasingly centralized. Dozens of different governing bodies have their say on how we can use its services.

But with the introduction of Bitcoin, and moreover, the blockchain technology behind it, humanity gained an alternative, decentralized financial system. Through this technology, anyone can unilaterally join and contribute to its maintenance. One can leave whenever they want, without any consequences to them, or the system.

Ethereum emphasizes these benefits and provides us with a programmable platform that runs decentralized software. There’s no governing body, no censor, no central point of control. All in all, Ethereum was the exact upgrade the Internet needed. It offers the required tools to improve the way we distribute, update, or use any software.

A Vastly More Powerful Idea than Bitcoin

The team behind the Ethereum blockchain first affirmed its central idea in the eponymous white paper.

In summary, Ethereum provides an alternative protocol for providing decentralized applications. To paraphrase the whitepaper – “Ethereum builds an abstract foundational layer – a blockchain  with a built-in Turing complete programming language, allowing anyone to write smart contracts and decentralized applications where they can create their own arbitrary rules for ownership, transaction formats, and state transition functions”

This means that, in essence, Ethereum is a programmable blockchain.

Note that Ethereum is not a Bitcoin fork, and runs on a completely new blockchain with different technical intricacies. It is based on a peer-to-peer network and doesn’t have a governing central authority. Instead of providing users the ability to use a few predefined operations (like cryptocurrency transactions) as Bitcoin does, the Ethereum protocol allows users to run pretty much any code they want, through the Ethereum Virtual Machine (EVM).

EVM is a “supercomputer” that consists of the combined computing power of the nodes in the network. This decentralized virtual supercomputer runs the smart contracts (the code) submitted by the users. The Ethereum blockchain then stores this code, where it remains forever, without being subjected to any change (immutable).

Let’s get down to the nitty-gritty of Ethereum:

We can define Ethereum as having two different components: accounts and applications (or use-cases).

What are Accounts on Ethereum?

To better help you understand what is Ethereum, we need to explain its basic functionalities. There are two types of accounts on the Ethereum protocol:

  • externally owned accounts, or Ethereum addresses controlled by private keys, like in the Bitcoin network.
  • contract accounts or smart contracts, which are addresses or “entities” controlled by the code within them.

An externally-owned account is used to create, send and receive transactions, where the private key signs the transactions. You can think of your externally owned account as similar to a bank account. Your private key is the security code used to access your bank account.

Every Ethereum account has a public address, or what looks like a string of random numbers and characters in a Hexadecimal format that looks something like this:

0x84dbb737eac3002103e721b9ab7ch67a6850a310

You can think of this address as the “name” of your bank account. You will use this address to send and receive Ether, ERC-20 tokens, NFTs or use other services on the Ethereum protocol.

In order to send a transaction, you have to sign it with your private key. This key is called private for a good reason.

If anyone, through any means gets your private key, he has ownership of your account and can send transactions. If you lose your private key as many people have done, your funds will be gone forever. The luxury of using decentralized platforms comes with responsibilities, and your primary responsibility is to keep your private key safe.

What are Smart Contracts?

Answering the “What is Ethereum?” question would be impossible without introducing you to the notion of smart contracts.  The concept of smart contracts was first initiated by Nick Szabo in 1996 in his publication “Smart Contracts: Building Blocks for Digital Markets.

The basic idea of smart contracts is that many kinds of contractual clauses (such as liens, bonding, delineation of property rights, etc.) can be defined as a series of relations or logical steps. Therefore, they can be written in code and embedded in the hardware and software we use today.

How do Smart Contracts work on Ethereum?

The Ethereum team created Solidity, a brand new programming language for the smart contracts on the blockchain network. The language itself may be simple, but due to the immutable and self-executing nature of the contracts, once they have been added to the blockchain, any mistake embedded in them cannot be changed.

This means that writing more complex smart contracts requires more than just knowledge in Solidity and some programming logic. Instead, it requires some pre-existing knowledge of “real world” contract writing and legal reasoning. Vitalik Buterin, the co-founder of Ethereum, defines smart contracts in his white paper: as  “autonomous agents” that live inside of the Ethereum execution environment.

The logic behind smart contracts is similar to that of a drive-through; you choose your order and, the restaurant executes a protocol in the background according to your demand. The protocol here is the smart contract – or more precisely its code – that specifies a sequence of actions that need to happen on the network. In the end, your meal with a side order of fries awaits you once you complete the payment.

In other words, smart contracts not only define the rules, rights, and obligations that constitute the agreement but also execute the agreement itself automatically. They are self-executing pieces of computer code that define and enforce contractual agreements between two parties.

What are Decentralized Applications (DApps)?

Now that we have a general sense of smart contracts and their application in regulating transactions made on the Ethereum network, we can take a look at the so-called Decentralized Apps – or DApps for short.

DApps are essentially pieces of software that implement smart contracts to achieve the functionality of a decentralized program. Once the DApp is added to the blockchain, it is immutable. Therefore no single entity can exercise control over it.

Main characteristics of DApps

To understand the value of this characteristic of the DApps, we will make a simple parallel with YouTube.

Namely, when you use YouTube, the traffic that your usage generates – whether that’s views, comments, uploaded videos, etc. – is stored somewhere and subject to inspection that allows censorship (of your uploads), as well as tailored advertising (based on your view history).

This brings us to the key problem that decentralized apps aim to address: giving back users control over their data. To ensure that the solution to this problem truly lays in the architecture of the DApp, there are three key requirements that all DApps must meet:

  1. Immutable – Once the application is added to the blockchain, its content, aggregated user data, and any other information necessary for the app to work cannot be changed by any single entity.
  2. Decentralized – The concept of immutability is tightly linked to the fact that all of the DApp’s data is encrypted and stored on a decentralized public blockchain.
  3. Open Source – The DApp’s source code must be publicly available so that users who wish to look behind the curtains are free to do so. Therefore, anyone can see for themselves how the data that they provide is being used for the proper functioning of the application, and nothing more.

Now we will take a closer look at the role that smart contracts play in decentralized apps by explaining the basic functionality of a DApp.

How do DApps work?

A DApp consists of the same aspects as any other application:

  • a front-end, the application’s user interface, or a website.
  • a back-end, the Ethereum blockchain, and the smart contracts the applications use.

The front-end of a DApp isn’t of great importance for understanding decentralized apps. It comes down to simple web, desktop, or mobile design, much like it is with a normal application. When it comes to the back-end, however, it’s a bit more complicated.

Smart contracts are the building blocks of a DApp. Therefore we can look at a DApp as nothing more than an aggregation of mutually-interacting smart contracts. In the case of more complicated DApps, multiple smart contracts execute sequentially to achieve the final purpose of the application.

For the not-so-tech-savvy readers, we will reduce this unintelligible technobabble to a simple example:

Let’s say we have a DApp that’s supposed to receive payment from one user, validate the transaction, then send the user a certain URL address as a response.

As the basis of this DApp, there will be at least one smart contract that will:

  1. Take the user’s information (like public and private key, and the required amount for making the transaction).
  2. Validate the information (in other words, make sure that the provided keys exist).
  3. Try to execute the transaction (transfer the given amount from the user’s wallet).
  4. Validate the transaction (make a public record on the blockchain that the transaction did, in fact, successfully occur and the funds were transferred).
  5. Generate or acquire that URL address we mentioned above, then send it to the first user as a response.

Advantages of DApps

Thanks to their decentralized nature, DApps provide multiple benefits to users.

First, the contracts are stored and executed on the blockchain, which means they don’t require the element of trust. Anyone can take a look at the smart contract beforehand and see what happens behind the scenes.

In addition, the user can be assured that what he sees is what he gets. No one can change or hack them because of the immutability of the blockchain.

Lastly, all the code in the contracts is available for the Ethereum community to audit and make sure it works as intended or advertised.

All in all, DApps are a decentralized, transparent, peer-reviewed alternative to regular apps. They aren’t subject to control, abuse, or change by the original developers due to their immutability.

But how does all of this work? What’s the magic in the background that helps everything fall into place?

How does the Ethereum network function?

To understand what is Ethereum, let’s take a look at what happens behind the scenes. On the Ethereum blockchain, transactions are organized in blocks and chained together through the aforementioned cryptography of private keys and public addresses.

Ethereum runs on a proof-of-work (PoW) consensus mechanism. In this model, miners compete for rewards by solving intricate mathematical puzzles to add new blocks at the end of the blockchain. To achieve this, miners use powerful computers called mining rigs.  This means that they spend electricity to gain rewards in the form of new ETH tokens and transactions fees.

This mining process has three crucial roles:

  • The creation of new ETH tokens.
  • Confirming the transactions on the network and adding them in block to the end of the blockchain.
  • Securing the Ethereum platform from 51% attacks.

Over the years, this model has shown to be inherently flawed, to the extent of being unusable. Ethereum is aimed at mass usage, which means that its network is supposed to scale as more users join.

With mining, this is hardly the case. As the network grows, Ethereum transactions become slower to execute and require more energy. Ultimately, the cost of a transaction becomes so big that it becomes impractical to deploy DApps or conduct smaller transactions on the network.

What is Ethereum 2.0?

This is why Ethereum developers have been working relentlessly to push out the most significant upgrade of the network to date – the switch to a proof-of-stake (PoS) consensus model. The Ethereum 2.0 update has the goal to turn Ethereum into a scalable, fast, and cost-effective decentralized software platform.

To achieve this, Ethereum will entirely do away with miners and the current PoW mechanism. To secure the network and create new coins, users stake their ETH holdings on the network and lock them for determined periods of time.

The network will be run by validators that will stake at least 32ETH and will confirm the transactions on the network by reaching a consensus. Users that can’t afford to stake this high amount of ETH will be able to delegate their tokens through various centralized and decentralized staking pool solutions.

Validators receive rewards for their effort in the form of new tokens and transaction fees contained within the blocks. The protocol dynamically adjusts the rewards to reflect the total number of ETH tokens staked on the network. The more ETH tokens users stake on the network, the lesser the rewards.

Staking also makes the network highly secure, as hackers would need to control more than half of the funds staked on the network to initiate a 51% attack. Moreover, a blockchain mechanism called slashing can penalize malicious validators and confiscate all of their staked funds.

The switch to PoS is planned for 2022, and mining will become completely obsolete at that point. The main advantage is that the network will become much more manageable and power efficient. It is believed that Ethereum 2.0 will consume 99% less energy than the current PoW model.

What is sharding?

That being said, PoS is not the only scaling upgrade that is being implemented with Ethereum 2.0. Developers are working on a sharding system to break down the complex Ethereum network into smaller, easily manageable blockchains.

In essence, the Ethereum sharding will consist of one beacon chain (the main Ethereum blockchain) and 64 shard chains that are managed by the beacon chain. By breaking down the complexity of the network, we can decrease the processing power requirements considerably, making it much easier to process smart contract data.

The beacon chain selects random validators to manage the transactions of different shard chains. At the same time, shard chains will have smart contract capability, just like the current Ethereum blockchain.

In addition to the increased energy efficiency of PoS, sharding ensures mass-usage scalability, providing a solid ground for the future growth of the network.

The Economics of Ethereum

The Ethereum network includes its own built-in currency called “ether”. The currency serves the dual purpose of providing a liquidity layer to allow for efficient exchange between various types of digital assets and a mechanism for paying transaction fees.

Why does Ether have an Inflation Rate?

Unlike Bitcoin, Ether is an inflationary currency. This means that the total number of Ether in the Ethereum network will increase gradually over time without a market cap.

The idea behind the permanent linear supply growth model is to reduce the risk of hoarding or concentration of wealth as a typical phenomenon found in deflationary currencies like Bitcoin.

The idea is to stimulate the usage of Ether and encourage spending instead of holding it.

The free market determines the price of ETH. This means that Ether is a free currency, it is not tied to any other currency in the world and it is not backed up by any government in the world (as of now).

Can Ethereum become deflationary with EIP-1559?

In August 2021, the Ethereum network underwent a critical upgrade that aims to turn Ethereum into a deflationary currency. The London hard fork that took place at that time implemented the coin burn proposal (EIP-1559) into the Ethereum transaction protocol.

In a nutshell, the EIP-1559 introduced a mechanism where the protocol automatically sends a portion of the transaction fees of a new Ethereum block to a dead address. This means that every time miners mine a new block of transactions, a small portion of existing ETH tokens are “burned” or destroyed.

This serves a purpose to ultimately reduce the total supply of ETH and introduces a notion of scarcity. Even though more ETH tokens are created than they are burned, the coin burn effectively reduces the inflation rate of the ETH token. This allows newly issued tokens to never outpace the demand in the future.

What is Gas on the Ethereum Platform?

“Gas” is the name for a special unit of account used in Ethereum.

It measures how much “work” an action or set of actions takes to perform. Every operation that can be performed by a transaction or contract on the Ethereum platform costs a certain amount of Gas, proportional to the complexity of the operation and the computational power that’s required to execute it.

So Gas is essentially a transaction fee that you have to pay to use the EVM. Make no mistake, Gas is not a currency, and there is no separate Token for Gas. Gas is calculated and paid in Ether.

What are Tokens in Ethereum?

Tokens are a new sort of digital property that is issued by a certain DApp, and it grants certain rights to its owner.

To be more precise, developers use the ERC-20 smart contract protocol to issue these tokens and launch their proprietary cryptocurrencies that run on top of the Ethereum network. This functionality of Ethereum was one of the main catalysts of the 2017 bull run and the ICO craze that ensued. Worth noting is that every ERC-20 token transaction requires a transaction on the Ethereum blockchain. Consequently, they are subject to the aforementioned gas fees in ETH.

So what are tokens used for?

A token serves a wide variety of functions, depending on the idea of the issuer. It can act as access to a DApp, it can grant the user different rights depending on the business model of the DApp, it can serve to implement different use cases like voting, payments, and so on.

Before Ethereum came out everyone had to make their own blockchain to issue a cryptocurrency token, or fork the Bitcoin blockchain and make a new currency with different specs which is a fairly difficult process.

Ethereum solved this problem by virtue of being Turing-complete and allowing the creation of tokens on top of its blockchain.

How do DApps and Crypto Tokens connect to form decentralized finance (DeFi)?

Tokens and DApps are closely intertwined, to say the least. Programmers push out third-party solutions that use these tokens to access certain functionalities of the blockchain platform. This has enabled the creation of decentralized cryptocurrency exchanges (DEX) and peer-to-peer lending platforms that offer traditional financial services such as lending, borrowing, and trading cryptocurrencies, without any other intermediary than the smart contract of the protocol.

Here’s how this works, in a nutshell:

In decentralized finance (DeFi), smart contracts allow developers to lock funds in liquidity pools and make them available to users. This provides the needed liquidity so that users don’t need to wait for their order to be filled by another party. The users that choose to lock their funds in these DeFi protocols are commonly referred to as liquidity providers (LPs).

Every time individuals use the functionalities of these platforms, the smart contracts collect a small fee. And because the funds in the liquidity pools are provided by the users themselves, a portion of these fees is redistributed to the LPs as a reward for their service.

In addition to the fee rewards, some decentralized services choose to incentivize the LPs with proprietary tokens as well. These incentives can range in double-figure annual percentage returns, which is the main reason for the incredible growth of the DeFi ecosystem.

What are non-fungible tokens?

A trending functionality of smart contracts is the ability to use the ERC-721 protocol to create non-fungible tokens (NFTs). Unlike ERC-20 tokens that are identical and can be exchanged for one another, NFTs are not. The smart contract allows developers to embed a wide variety of characteristics of the NFT metadata, making each NFT unique.

Thanks to this, we can use NFTs to tokenize anything of value in the real world. These include real estate, artworks, insurance contracts, gaming items, only to name a few. What’s more, they also benefit from Ethereum’s blockchain characteristics, such as proof of ownership, immutability, and ease of transfer.

This tokenization has many benefits in the real world in various industries. For example, they can be used to record designer fashion pieces on the blockchain, so that the user is ensured of their originality, effectively eliminating fraud and counterfeit items.

Currently, NFTs are mainly used to record digital art pieces on the blockchain. They allow collectors to invest in digital, immutable art that can be bought and sold for profit on specialized NFT marketplaces.

Ultimately, NFTs in combination with tokens can contribute to the birth of a metaverse based on the Ethereum blockchain. In the future, we can hope to see an intricate virtual world with a proper economy, where virtual assets will provide real-world value.

Conclusion

Together with Bitcoin, Ethereum is one of the biggest contributors to the growth of the cryptocurrency industry. Although BTC drives the market as a solid store of value, it’s Ethereum that popularized smart contracts and DApps, increasing the use cases of blockchain by tenfold.

There’s no denying that Ethereum has some problems. Scalability sucks, the PoW algorithm is expansive and taxing for the environment.

However, with the upcoming Ethereum 2.0 upgrades, these issues will be eventually polished out. With a more scalable network and a neutral carbon footprint, there’s little that can stand in the way of Ethereum as the #1 development platform for DApps.

Hopefully, this article gave you a decent idea of what is Ethereum and its main functionalities and benefits.

What’s your take on Ethereum? Let’s talk in the comments below!

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