Informational

What Is Ethereum & How It Works

Caroline Bowler

If Bitcoin is the original cryptocurrency platform, network and coin, Ethereum is not far behind. In recent years, Ethereum, or ETH, trading and investment have become important parts of the crypto landscape. But what does all this talk of Ethereum mean? How does the network function, and what are its advantages and risks? Here at BTC Markets, we've compiled a handy guide to help you get the answers you need to all of these questions. Read on to learn more as we examine the practical aspects of buying Ethereum coins. In addition, we'll deliver the technical information you need to enrich your understanding of this exciting payment network.

The history of Ethereum

Ethereum is a little younger than other cryptocurrency big hitters, such as Bitcoin, but not much younger. Bitcoin emerged back in 2008 and was growing rapidly in value by 2009. Ethereum was a little slower off the mark. It first appeared as an idea from the developer Vitalik Buterin back in 2013 and was initially called Frontier. Development work began in 2014, and by the end of July 2015, the network was up and running.

When Ethereum was first floated on the market in August 2015, one coin was worth only US$1.25. This value fell sharply, halving by September of the same year before beginning its first rapid rise in January 2016. After a series of ups and downs, Ethereum was worth US$4,766.35 on November 11, 2021 — the currency's highest value to date.

There have been a number of milestones in the history of Ethereum. Between December 2020 and February 2021, for example, the currency more than doubled in value, rising from US$746.06 to US$1,495.81. In March 2016, the currency broke US$10 for the first time, while in May 2017, Ethereum broke US$100 and US$200 for the first time in the same month. It's been an exciting ride for anyone engaged in Ethereum trading or investing, and that exciting ride promises to continue.

The Ethereum blockchain

Like most cryptocurrencies, Ethereum works using a blockchain system that supports decentralised transactions. The blockchain is basically a distributed ledger that is used to record transactions across the Ethereum platform and the broader network of nodes. Whenever a transaction takes place, the information regarding this transaction is written into the blockchain. This process of writing a new block to be added to the blockchain is called mining, but we'll discuss this in more detail later on. Once a new block is mined, or written into the chain, a copy of the entire blockchain is sent to each node on the network. It is the consensus between all network nodes that protects the network from fraud, data corruption, or other discrepancies.

This is a generic look at how the blockchain works. But what makes Ethereum different? How does Ethereum's blockchain work? The Ethereum blockchain is in fact designed to do more than just store wallet data and transaction values — like the Bitcoin blockchain, for example. Ethereum is actually intended to help users store computer coding structures and even applications. These applications can then use the Ethereum network's enormous resource of computing power to complete tasks.

Basically speaking, this makes the scope of the Ethereum blockchain much broader than that of Bitcoin. With Ethereum, businesses can build and launch applications that then run on the CPU power of the nodes themselves. What's more, these applications integrate with the Ethereum (ETH) cryptocurrency itself, making it easy to carry out secure, digital transactions.

Mining Ethereum

What does "mining Ethereum" mean? As we've touched upon above, mining is the process of recording transactions in the Ethereum blockchain and then distributing a copy of this blockchain to all other nodes on the network — achieving full network integrity and reliability thanks to a consensus across each copy. Without mining, the network would not function, as transactions and other data could not be recorded into the blockchain. This is why miners are rewarded for their work as part of a process that builds value and makes crypto mining a lucrative endeavour. We'll explore this further in the Halving section below.

But what about Ethereum specifically? How does Ethereum mining work? One way in which Ethereum mining works a little differently from other similar networks lies in the type of consensus protocol it uses to ensure network integrity. Bitcoin has traditionally been based on a Proof-of-Work, or PoW, protocol. With the PoW protocol, when 51% of nodes agree on the state of the network, a consensus is said to have been reached. Anyone who wanted to defraud the network would need to have control of 51% of the nodes — something which would be very difficult, and expensive, to achieve.

Ethereum has also used this protocol over the course of its development, and so mining occurs in much the same way. However, it looks like Ethereum will eventually transfer to a Proof-of-Stake (PoS) consensus protocol. Under this system, users will need to put forward a stake in order to validate a transaction. Once the stake is paid, this node joins the validator pool and may be chosen at random, along with other user nodes, to perform a validation. They will be remunerated for this validation, but they risk losing their stake in the event that the node is unavailable or if something else goes wrong during the process. There are major advantages to this. The network becomes more scalable, for example, and Ethereum's carbon footprint is reduced. However, it will bring significant changes to the way in which Ethereum is mined. Traditional mining — the kind we see on the Bitcoin network — will be a thing of the past for Ethereum users.

Halving Ethereum

When a user mines a block into the Ethereum blockchain, their efforts — and those of their CPU — are rewarded. This reward is delivered in the form of an amount of Ethereum currency. This amount will be a percentage of the value of the transaction that is being recorded in the blockchain. In order to maintain the stability of the network and keep Ethereum supply steady, the rate at which Ethereum miners are remunerated will be reduced periodically over time, in a process known as "halving".

This may seem a little underhand at first glance. After all, nodes and miners support the network, and it seems unfair that the reward for this support becomes less and less over time. However, this is all part of the standard operation of a crypto network, and halving events will always be shared publicly well in advance so no one is left in the dark.

As the Ethereum currency is set up a little differently from Bitcoin, there was no planned halving built into its timeline. In other words, a halving event was not guaranteed. However, in April 2021, it was predicted that Ethereum will need to implement some kind of halving to stabilise its finances over the coming two years. Experts predicted something equivalent to "three Bitcoin halving events" would need to take place on the Ethereum network before 2023, so we may be heading for significant mining reward decreases in the near future.

Ethereum hashes

Before Ethereum hashes can be explained, we need to return to the topic of crypto mining and think about the technical aspects of how this works. Mining requires nodes to solve cryptographic calculations. Once the calculation is solved, the new block of information is written into the blockchain and the process is completed. This process creates a hash value — an encrypted representation of the data held within the block. Without hashing, the data in the blockchain rapidly becomes unwieldy and difficult to manage. Hashing solves this problem by ensuring that all input values produce an output of a fixed length.

The hash value is also secure. It is impossible for users to examine the hash value and to deduce any of the data from the transaction itself, as the hash's encryption is one-way only. All that other nodes can do is verify that the hash value is the same as the value they have recorded for the same block — i.e. checking and validating. The Ethereum network uses the KECCAK-256 encryption standard to create its hash values, which makes it different to some other crypto networks that use FIPS-202 (or SHA-3) to complete hashing tasks.

On the Ethereum network, the hash rate — or the frequency and volume of completed hashes — is increasing. As of November 18 2021, there were 892.22 terahashes per second on the network, up from 876.39 the day before and from 266.83 this time last year. In other words, the hash rate has grown by 1.81% in 24 hours, and by 234.4% in the last year.

Ethereum transactions

One of the most important Ethereum uses — just like with any other cryptocurrency — is peer to peer transactions. This is what the Ethereum coin and the network are designed for, at least in part — to provide a reliable network for peer to peer purchases and wealth transfers.

When you engage in an Ethereum transaction, you are effectively signalling to the network that you want to make a change. The most basic changes involve one to one transactions — you signal to the network that you want to send X amount of Ethereum tokens out of your wallet and into the wallet of another user, then the other user signals that they want to accept this amount. Provided that an agreement is reached regarding the size and nature of the transaction, this process should be completed quickly, and the Ethereum currency will be transferred between the two wallets. In most cases, information regarding the recipient, the transaction value and the signature of the sender will all be written as part of the transaction, along with other data related to the exchange.

Traditionally, Ethereum transaction protocols have been a little more sophisticated than Bitcoin's. This is because Ethereum utilizes smart contracts that provide more flexibility and agility to transactions. Smart contracts involve a series of agreed-upon parameters and an automated transfer of funds once these parameters are met. However, it was recently announced that Bitcoin will be working with something similar to a smart contract system after a major upgrade on its network, bringing the competing Bitcoin and Ethereum networks closer together.

Peer-to-peer technology in the Ethereum network

When you're learning how to use Ethereum, you don't necessarily need to know the technical aspects of what the network does and how it does it. In fact, it's likely that a great many Ethereum users do not know how Ethereum works on a technical level. With this handy guide, however, we want to shed some light on the more technical side of things to give you a better understanding of what is going on beneath the service.

The Ethereum network can function as a whole. This means it can bring together the vast resource of computing power and draw upon this power en masse. At the outset, this was the aim of the Ethereum network — to create a resource of computing power that application designers and developers could tap into. So, if Ethereum is basically a huge computer made up of lots of different distributed nodes, how do all these nodes come together? How do we achieve consensus and communication across the network?

Firstly, network nodes send data to one another using a shared protocol named RLPx. This protocol is different to the hash protocol mentioned above and supports the transfer of data that has been pre-encrypted and serialised. Before the data is encrypted and transferred, however, the sending node must make sure that the recipient node is indeed able to decrypt and access this data. A public key is sent to the recipient node to begin the data transaction process. We'll talk about keys in more detail in the Keys and Wallets section below.

This might sound complex, and that's because it is. Fortunately, users do not need to know what is going on down below in the Ethereum engine room and can execute tasks and transactions without this high level of knowledge. The reasoning behind all this complexity and encryption is actually quite simple — it's an effective way to ensure that there is no centralised control over the network and to make sure that Ethereum remains distributed and decentralised.

Ethereum keys and wallets

The Ethereum network relies upon wallets. These are effectively the interfaces by which human users can interact with the Ethereum network, arranging transactions and managing the amount of Ethereum in their user account. In addition to this function, these wallets also store the Ethereum coins or tokens in a secure fashion, ready for use.

In order to access the wallet, users need to have access to a private key. This is essentially the password that protects the wallet itself. We've already mentioned the public key above, i.e. the key that is shared between nodes during a transaction. This private key works in a similar way, but it is not shared — it is simply entered to allow a user to gain access to the wallet.

Generally, the wallet and user account will include the following information:

  • The balance— The amount of the Ethereum currency in the account
  • The nonce— The number of transactions created and sent by the account
  • The codeHash— The encrypted code that handles transaction processing
  • The storageRoot— The encrypted code relating to assets stored in the wallet

Ethereum risks

Ethereum can be a very exciting investment for crypto enthusiasts. What's more, the nature of the Ethereum network is ushering in a new era for application development — an era in which distributed networks provide vast computing power for software structures. That said, there are risks to using Ethereum, just like there are risks to using any technology, and any cryptocurrency for that matter.

Ethereum is a volatile currency

Ethereum has fluctuated wildly in value over the years. If you had purchased Ethereum at the very beginning, your investment would now be worth thousands of times its original value, making this a very shrewd purchase indeed. However, the nature of crypto makes this value unstable, and you are at risk of losing your investment at any time.

Ethereum is shifting from PoW to PoS

We've noted above that Ethereum is changing the way in which it is mined. While the network has traditionally used the Proof of Work mining system, it looks likely that Ethereum will adopt the PoS system in the future, which will require transaction validators to stake a certain amount of Ethereum before the validation can begin. In the unlikely event that there is a problem with the validation, this stake is put at risk. The user may even lose all of their stake in some rare cases.

Crypto is a competitive field

In this article, we've focused on Ethereum and the differences between Ethereum and Bitcoin. However, this is only scratching the surface. There are loads of other crypto networks out there — such as XRP and Litecoin — each with its own advantages and disadvantages. Some of these networks even use the smart contracts system made famous by Ethereum. Ethereum is still one of the main networks out there, but there is no guarantee that this will remain the case in the future.

Diversify your investment: buy Ethereum today

Ethereum is a great way to grow your wealth and to connect with a new and exciting way to handle digital transactions. Sign up for a BTC Markets account, and get started with an Ethereum investment today.


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