How Does Ethereum Work?

Get ready to become an Ethereum expert.

Updated: October 17, 2023
Matt Crabtree

Written By

Matt Crabtree

 
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Ethereum is one of the world’s most popular cryptocurrencies and attracts a large percentage of investors due to its user-friendly applications and incredible investment opportunities. For beginners, understanding the technology behind Ethereum and its various investment options can feel overwhelming.

However, this doesn't have to be the case. In this article, we will dispel any confusion you may have and explain the basics of Ethereum, its benefits, and the numerous investment opportunities that come along with it. Get ready to become an Ethereum expert!

What is Ethereum?

An Overview of Ethereum & How it Works

Ethereum is an open-source, public, blockchain-based distributed computing platform that enables the development of smart contracts and other decentralised applications (dApps). Unlike Bitcoin, it is not just a cryptocurrency but a world computer through which developers can create decentralised applications, smart contracts, and use blockchain technology.

It functions on a decentralised virtual machine that uses the proprietary Ethereum blockchain to store, execute, and secure transactions. These transactions can take place much more efficiently with Ethereum's modified version of the Proof-of-Work consensus algorithm.

Ethereum's native cryptocurrency, Ether (ETH), is used to pay for transactions and execute smart contracts.

Smart contracts are one of the major advantages of Ethereum. These are digital programs written into the Ethereum virtual machine (EVM) designed to execute when certain conditions are met automatically.

This allows users to set up automated contracts with one another, ensuring that all parties will meet their obligations and receive the agreed-upon payment or services.

In addition to smart contracts, Ethereum is also home to decentralised applications. dApps are applications that are hosted on the Ethereum blockchain and are decentralised, meaning no single person or entity has control over them.

dApps are becoming increasingly more commonplace as they let users directly interact with the Ethereum network to make an assortment of tasks much more efficient.

Overall, the Ethereum platform is compelling and can be used for various applications, from finance to the gaming industry to healthcare. It is revolutionising the way developers create and interact with decentralised applications, and its potential is just now beginning to be explored.

With its incredibly secure and efficient platform, Ethereum improvement proposals will surely spur new and unique applications in the near future. Let's take a closer look at some of the key components of Ethereum.

Distributed Network

Ethereum operates in a decentralised manner, meaning it is not managed or controlled by any one central entity. Instead, it is powered by thousands of computer nodes located around the world. An Ethereum node is part of a global network that has a responsibility to validate transactions and generally run the Ethereum protocol.

Blockchain

At the core of Ethereum is its blockchain, which is a secure, tamper-proof digital ledger. All transactions on the Ethereum network are permanently stored on this ledger, ensuring that all of the data stored on the blockchain is available to view by anyone who has access to the network.

Cryptocurrency

Ethereum also serves as a platform for cryptocurrency, much like Bitcoin. Ether is used to pay for computing power on the network. In addition, it is also used to make transactions on the Ethereum blockchain and to pay for gas, which is the fee for processing transactions.

Advantages of Ethereum

Cryptocurrency has become increasingly viral in recent years as more people are starting to use digital assets for their everyday purchases.

One of the most popular forms of cryptocurrency is Ethereum, the second-largest crypto after Bitcoin.

Ethereum has various advantages that make it an attractive option for investors, businesses, and everyday users:

1. Highly Scalable

As blockchain-based technologies grow, scalability becomes a significant factor in determining the success of a platform. Ethereum is designed with scalability in mind, allowing it to remain flexible and handle higher transaction volumes. This scalability allows the Ethereum platform to provide an efficient for applications and transactions.

At its core, Ethereum's scalability is enabled through a technique called sharding. Sharding allows Ethereum's blockchain to divide its consensus process into several smaller parts.

In doing so, each part of the consensus process is able to act independently while the rest of the network continues to perform its consensus process. This allows the network to process multiple transactions simultaneously, increasing its scalability.

2. Fast Transaction Speed

Where traditional payment methods can take days or even weeks to complete a transaction, Ethereum transactions take approximately one minute. This significantly reduces the time needed to complete a transaction, allowing businesses to increase their efficiency and profitability.

Unlike traditional payment methods, Ethereum can also be used anonymously. This means that users can keep their personal information private when conducting a transaction. This anonymity allows users to securely and quickly move funds without having to worry about the privacy of their data being compromised.

3. Programmable

Ethereum is one of the most well-known and widely used blockchains in the world, and it is programmable with the Solidity programming language. Solidity is a language that enables developers to create and manage smart contracts, programmable transactions, and decentralised applications on the Ethereum network.

Solidity was explicitly created to be used with Ethereum and provides developers with the tools they need to build and deploy distributed applications on the blockchain. With Solidity, developers can write code directly interacting with the Ethereum blockchain, create new accounts, send and receive digital assets, store data, and create complex logic for custom use cases.

Smart contracts are one of the most frequent and vital uses of Solidity, which, as covered earlier, are automated, self-executing contracts stored on the Ethereum blockchain. With Solidity, developers can create smart contracts, store data, and create custom logic that is secured and executed on the Ethereum network. This makes Ethereum highly programmable and incredibly useful for distributed applications.

4. Robust Community

Ethereum's success is heavily rooted in its large community of supporters and their commitment to the project's development. Ethereum's community is made up of developers, entrepreneurs, organisations, investors, and enthusiasts from all around the world.

The Ethereum community has contributed immensely to the project’s success by creating and maintaining a vibrant open-source development environment, sharing resources and knowledge about the platform, and working together to further Ethereum’s progress.

In addition to the community, Ethereum is also supported by the Ethereum Foundation. The Ethereum Foundation is an organisation that was created to help promote, develop and expand Ethereum's capabilities. The foundation has helped fund and incubate various projects built on the Ethereum network and provides resources to developers and entrepreneurs building the Ethereum ecosystem.

The Ethereum Foundation also funds various research initiatives designed to explore the possibilities of Ethereum's technology. These research initiatives help to develop new applications and tools that make the Ethereum network more secure, efficient and powerful.

As touched on previously, smart contracts play an essential role in the way Ethereum works. Let's explore the significance of them and the way they're implemented.

Smart Contracts

What are Smart Contracts?

These have been a buzzword lately due to their role in blockchain technology. But what exactly are they and how do they work in the Ethereum ecosystem?

Smart contracts are computer protocols that facilitate the transfer of digital assets between two or more parties. They can be used for all sorts of things, from digital currency payments to automated contracts for a variety of purposes.

In the Ethereum network, smart contracts allow people to write code that will execute on the Ethereum blockchain.

This code contains the rules and regulations that govern the contract and how it will execute. It can be as simple as defining a payment method between two parties, or as complex as a distributed application that runs on the Ethereum network.

Smart contracts are extremely powerful because they’re immutable. Once a contract is written and deployed, no one can tamper with it. This ensures fairness and trust among parties involved in the contract, as they can all be assured that it will execute as described.

Smart contracts also have the ability to store data, including the state of the contract. This makes it easier to trace the progression of digital assets and other elements within the contract.

Overall, they're an essential part of the Ethereum network. They are digital agreements secured and enforced by the Ethereum blockchain, allowing for secure and transparent digital transactions between parties.

Smart contracts are used extensively in Decentralized Finance. They enable users to engage in various financial activities, such as borrowing and lending, trading digital assets, and providing liquidity to decentralised exchanges.

What is DeFi and How Does it Relate to Ethereum?

An Overview of Decentralised Finance

Decentralised Finance, or DeFi for short, is the reconciliation of traditional financial products into a blockchain-based infrastructure that is secure, trustless and open to anyone. This rapidly emerging form of financial technology is changing the face of financial services as we know them and providing an alternative to the traditional, centralised banking industry.

At the heart of it, DeFi is a way for anyone to take control of their financial destiny. It does this by utilising the blockchain– the technology behind cryptocurrency– to replace traditional third-party companies like banks. Rather than relying on centralised services, DeFi uses smart contracts and decentralised networks to allow users to access a wide array of financial services.

Some of the most useful applications of DeFi are lending, savings, and payment services. With DeFi, lenders can offer loan services without the risk of default, as all payments are made via a smart contract. DeFi lending platforms have additionally seen traction for providing low-cost loans, with rates being set by the platform users and not by a single arbitration institute.

Additionally, DeFi is commonly used in trading and investments. Through decentralised exchanges (DEXs), users can trade digital assets without needing a third party. This means that users can buy and sell digital assets without having to trust a middleman with their funds. Furthermore, there are DeFi applications that provide access to automated trading and investing strategies that can be used by anyone.

In addition, DeFi has applications in the banking sector as well, with DeFi applications providing users with savings and loan products, as well as the ability to issue their own credit cards and debit cards.

Lastly, DeFi is also being used to develop alternative financial products and create new use cases for blockchain technology. For example, projects such as MakerDAO are creating new ways to manage digital assets. At the same time, projects like Compound provide an alternative to the traditional banking sector by allowing users to lend and borrow digital assets.

DeFi is poised to revolutionise the financial sector and provide greater access to financial services to people all around the world.

Going beyond the traditional banking system, DeFi is creating new use cases and applications for blockchain technology and ushering in an era of financial autonomy.

How Does DeFi Benefit Ethereum?

Firstly, it enables users to take advantage of the power of the Ethereum Blockchain and access financial services anywhere. This allows for increased interoperability, cross-chain transactions, and the ability to access a wide range of products and services at any time.

As mentioned, Ethereum is also more secure than centralised systems, meaning users can securely store their funds without worrying about the risks associated with third-party custody.

Borrowers can take out loans without a bank, while lenders can earn interest and rewards for their investments. This eliminates the need for high-interest rates, fees and lengthy approval processes, allowing users to access financial services quickly and easily.

Furthermore, DeFi provides a complete range of financial services, from investments to insurance and hedging. This makes it possible for users to access various services and products from one platform, providing greater flexibility and control over their assets. The range of options and services supplied by DeFi also makes it easier for users to diversify their portfolios and access more efficient and cost-effective investments.

Non-Fungible tokens also play a role in the DeFi world. For example, some DeFi protocols allow users to take out a loan by putting up uncommon digital assets – like an NFT – as collateral. This means that the value of the NFT serves as security to the lender, guaranteeing that the loan will be paid back.

What are Non-Fungible Tokens?

Understanding The NFT Space

Non-fungible tokens (NFTs) are a form of cryptocurrency token designed to be unique and authentic. They represent ownership of digital or physical assets, with each token having its own distinct characteristics that are impossible to duplicate. NFTs are now emerging as a powerful player in the digital asset market, providing a way to quickly transfer and record who owns digital goods or services.

NFTs differ from other digital tokens, such as Bitcoin, which are used to facilitate the exchange of currency or value. Unlike Bitcoin, NFTs are not interchangeable or divisible. Each token is a distinct unit and can be used to represent a specific asset, such as a digital image, a piece of art, a video clip, or a token used to authenticate the ownership of physical goods.

This means no two NFTs are identical, making them secure and reliable when it comes to verifying the ownership of a digital or physical asset.

Because NFTs are digital, they are easy to store and transfer between users on the Ethereum blockchain. The blockchain provides a secure, encrypted system for exchanging NFTs and a way to track the ownership of each token. This makes it difficult to counterfeit or manipulate the digital goods or services associated with NFTs.

NFTs are becoming increasingly popular as the technology and infrastructure surrounding them continue to evolve. Companies such as Samsung and Mattel have already begun to issue their own NFTs, while some artists have started using NFTs to authenticate and securely transfer intellectual property rights.

As the technology behind NFTs continues to improve, we'll likely see even more companies and individuals using them in the near future.

Use Cases for Non-Fungible Tokens

Are you intrigued by the idea of NFTs but need clarification on how they are used in the real world? With their applications only just starting to become apparent, here are some of the use cases of NFTs.

Digital Collectibles

Many people may be familiar with digital collectibles already, such as the extremely popular CryptoKitties, which are essentially digital cats bought, sold, and ‘bred' as collector items. These items allow users to trade, own, and display digital items, each being unique or scarce.

This has since been applied to other digital assets, such as sports memorabilia, virtual real estate, and artwork. With their underlying technology, NFTs can be bought, sold, and paid for using cryptocurrencies – providing a secure, digital immutable measure of ownership.

Verifiable Digital Files

Digital files are ubiquitous in today’s world and are often used as proof of ownership or authorization. For example, when buying or selling a vehicle or home, a title must be presented as proof of ownership.

Similarly, when proving your identity online, such as when signing up for a new account, digital documents are required for verification. However, verifying the authenticity of these digital files can often be difficult, and in some cases, impossible.

Fortunately, NFTs provide a novel way of verifying digital files. For example, say you have a digital document that needs to be verified. With an NFT, the document is associated with a unique token that is stored on the blockchain. 

Whenever someone needs to verify the document's authenticity, they can check the token, ensuring that the file has not been modified or tampered with. Likewise, the NFT acts as proof of ownership and can be used to track and monitor the document over time.

Asset Tokens

NFTs are also being used to represent ownership of ‘real-world' assets, such as buildings, cars, and shares in companies.

This is a great way to tokenise assets and make them easier to transfer or trade – reducing friction between parties and eliminating the need for intermediaries or third-party institutions to facilitate the transactions. With blockchain-based tokens, these assets can easily be tracked and owned in a secure, immutable way.

How to Trade Ethereum

Benefits

So, now that we've learned about Ethereum, you may be interested in investing. Ethereum has become a major platform for investing and trading as investors seek to capitalise on its growth potential.

Let's discuss how different types of traders can benefit from this digital asset.

Day Traders

Day traders look to enter and exit positions within the same day, making a profit from the short-term price movements. Ethereum is one of the most liquid digital assets in the market, making it an attractive option for day traders.

Swing Traders

Swing traders aim to capitalise on price movements that occur over a more extended period of time. Ethereum's long-term growth potential and general adherence to support and resistance channels are perfect for those seeking a more prolonged investment.

Long-term Investors

Long-term investment involves taking a position on an asset and staying with it for an extended period of time. It can be a more profitable strategy than quick trades and has been found to be more profitable in the long run, as long as it is done in an informed way.

Ethereum is particularly well-suited for long-term investors due to its wide range of utility applications, relative stability and potential for organic growth.

The Ethereum price stability has been attributed to its wide use and the strength of its network. The Ethereum network is constantly developing and its developers have plans to introduce some major upgrades, such as the Ethereum 2.0 upgrade.

This upgrade could greatly increase Ethereum’s throughput, paving the way for even more uses in the future. Additionally, it can contribute to further organic growth in Ethereum’s value and make it an even more attractive option for long-term investors.

Exchanges

When choosing an Ethereum exchange, it's essential to consider a few key factors. First, it's important to understand the different types of exchanges available and choose the one that best suits your needs.

For example, if you're new to trading, you may want to opt for a centralised exchange with a user-friendly platform. On the other hand, if you're more experienced, you may find more value in a more advanced platform like Kraken.

1. Coinbase

Coinbase is a popular exchange that allows users to trade many established cryptos, including Ethereum. It's available in over 100 countries and supports multiple payment methods, including bank transfers, credit and debit cards, and PayPal.

Their user-friendly interface also makes it perfect for beginners who are new to cryptocurrency trading.

2. Binance

Binance is the leading cryptocurrency exchange that offers an abundance of trading pairs. It is known for its low transaction fee and speed, making it a wise choice for traders who want to quickly buy and sell their assets.

Binance also offers many advanced trading features, making it a good choice for experienced traders as well.

3. Kraken

In addition to Binance, Kraken's well-established exchange also offers a range of advanced trading tools and features, making it a good choice for experienced traders.

4. Bitfinex

With its user-friendly interface, advanced security protocols, and deep liquidity, Bitfinex is a great choice for both beginner and experienced traders.

In addition to its trading capabilities, Bitfinex also offers a range of tools and resources to help traders make informed decisions. For example, the platform provides real-time market data, charts, and analytics, as well as a variety of educational resources such as tutorials and webinars.

5. eToro

eToro is a leading social trading and investment platform that offers a wide range of features and tools to buy Ethereum and sell other cryptocurrencies.

With its intuitive interface and extensive community of users, eToro is a great choice for traders of all levels of experience.

One of the key features that makes eToro stand out is its social trading functionality. Users can connect with other traders and follow their trades, allowing beginners to learn from more experienced investors and experts to share their insights with the community.

This feature is especially useful for those who are new to cryptocurrency trading, as it allows them to gain valuable knowledge and insights from other users.

eToro logo

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Conclusion

The world of Ethereum is an ever-evolving and exciting space, as more and more users are beginning to explore the potential of this technology. Risk management is always a vital aspect to take into consideration when trading Ethereum.

With a firm understanding of the Ethereum network and how to manage risk effectively, traders can maximise their profits and build confidence in their knowledge of the asset. With enough research and effort, you can become a successful Ethereum trader!

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