What Is Ethereum and How Does It Work? [2023]

In the ever-evolving world of digital innovation, cryptocurrencies have taken center stage, capturing the attention of investors, tech enthusiasts, and the curious alike. Among these digital currencies, Ethereum stands out as a groundbreaking platform, not just as a cryptocurrency but as a foundational technology that is reshaping the way we think about digital transactions and decentralized applications. This article delves into the world of Ethereum, exploring its nuances, capabilities, and the revolutionary concepts it brings to the digital table.

What is Ethereum?

At its simplest, Ethereum is a blockchain-based platform that extends beyond the functionalities of a typical cryptocurrency. While it does offer a digital currency called Ether (ETH), Ethereum’s real power lies in its ability to host and execute smart contracts and decentralized applications (dApps) on its network. These features make it a versatile and robust platform, setting the stage for a more detailed exploration of its capabilities and impact.

How does Ethereum work?

Ethereum operates on a complex blockchain technology framework, distinguished by its ability to execute smart contracts and host decentralized applications (dApps). At its core is the Ethereum Virtual Machine (EVM), which interprets and executes smart contract code. Transactions on Ethereum are validated and recorded on its blockchain, ensuring security and immutability. Initially utilizing a Proof-of-Work (PoW) consensus mechanism, Ethereum transitioned to Proof-of-Stake (PoS) with Ethereum 2.0 in September 2022, aiming to increase scalability and reduce energy consumption.

Ethereum Blockchain

At the heart of Ethereum’s functionality is its blockchain, a decentralized and distributed digital ledger. Similar to other blockchains, the Ethereum blockchain records, verifies, and stores transactions in a secure and immutable manner. Each node in the Ethereum network stores a copy of the entire blockchain, ensuring transparency and security. Transactions on Ethereum are validated through the PoS consensus mechanism.

What gives value to Ether?

The value of Ether (ETH), Ethereum’s native cryptocurrency, is influenced by several factors:

• Utility: As the fuel for the Ethereum platform, Ether is required for executing smart contracts and conducting transactions, driving its demand.
• Supply and Demand: While Ethereum does not have a fixed supply cap like Bitcoin, mechanisms such as EIP-1559 introduce a burn rate for transaction fees, potentially reducing supply over time and influencing value.
• Staking: With the shift to Proof-of-Stake, Ether can be staked to secure the network, offering rewards and reducing the circulating supply, which can impact its value.
• ERC-20 and ERC-721 Tokens: Ethereum’s role in the creation and use of ERC-20 (fungible tokens) and ERC-721 (non-fungible tokens) tokens also drives demand for Ether, as it is often used in these token transactions.
• Large and Active Community: Ethereum boasts a vast and active community of users, developers, and enthusiasts. This community not only contributes to the network’s resilience and continued development but also fosters a robust ecosystem that adds intrinsic value to Ether.
• Extensive Network of Developers: The extensive network of developers building on Ethereum further enhances its value. As more applications and solutions are developed, the utility and demand for Ether increase, reflecting the network’s health and potential for future growth.

ETH Supply

Unlike Bitcoin, which has a capped supply of 21 million, Ethereum does not have a fixed supply limit. Hence, the maximum supply of Ethereum is, in technical terms, limitless. Nonetheless, the fact that Ethereum’s maximum supply is theoretically unlimited shouldn’t raise concerns about significant inflation in its supply. Actually, the quantity of ETH in circulation has been on a downward trend lately, thanks to continuous improvements and upgrades over the past few years.

For example, the introduction of EIP-1559 has introduced a mechanism where a portion of the transaction fees is burned, effectively reducing the overall supply over time. This mechanism creates a deflationary pressure on Ether, potentially increasing its value as the network grows.

Staking

Staking is a critical component of the Ethereum 2.0 upgrade, contributing to the value of Ether. Under the PoS mechanism, validators stake their ETH to participate in the network’s consensus process. This staking process secures the network and validates transactions, and in return, stakers earn rewards, typically in the form of additional ETH. This not only incentivizes network participation but also ties the value of Ether to the security and stability of the network.

ERC-20 and ERC-721 Tokens

Another aspect contributing to the value of Ether is its role in the creation and exchange of ERC-20 and ERC-721 tokens. ERC-20 tokens are a standard for fungible tokens, often used for ICOs (Initial Coin Offerings) and as tokens within dApps. ERC-721 tokens, on the other hand, represent non-fungible tokens (NFTs), each unique and irreplaceable, commonly used in digital art and collectibles. Transactions involving these tokens typically require Ether, bolstering its demand and, consequently, its value.

Smart Contracts on Ethereum

Smart contracts are at the core of Ethereum’s revolutionary approach. These are self-executing contracts where the terms of agreement are written into lines of code. They operate autonomously, executing predefined actions when certain conditions are met, without the need for intermediaries. This capability not only enhances efficiency and reduces costs but also brings a new level of trust and transparency into digital transactions. On Ethereum, smart contracts can be used for a variety of purposes, ranging from financial agreements to automated supply chain management.

Ethereum Virtual Machine (EVM)

The Ethereum Virtual Machine (EVM) is a key part of the Ethereum blockchain, acting like a global, decentralized supercomputer. It allows for the execution of smart contracts and decentralized applications by interpreting and running code written in languages like Solidity. Each contract operates in an isolated environment within the EVM, ensuring network security. The EVM’s Turing-complete design enables complex computations, and its operations are fueled by a gas system, paid in Ethereum’s native currency, Ether (ETH). While not handling consensus directly, the EVM operates within Ethereum’s Proof-of-Stake framework, making it a central element in Ethereum’s broader functionality beyond cryptocurrency.

Ethereum dApps (Decentralized Applications)

Delving into the dynamic world of Ethereum, a key feature that stands out is its support for Decentralized Applications, commonly known as dApps. These applications leverage Ethereum’s blockchain technology to operate autonomously, offering a new paradigm of user interaction, free from central control.

Examples

These apps run on the blockchain and are powered by smart contracts. DApps are diverse, ranging from decentralized finance (DeFi) platforms to games and social networks. For instance, Uniswap, a popular decentralized exchange (DEX), allows users to swap various cryptocurrencies without central intermediaries. Another example is MakerDAO, a prominent player in the decentralized finance (DeFi) space on Ethereum. It’s best known for its stablecoin, DAI, which is pegged to the US dollar and is generated by locking collateral assets in smart contracts. MakerDAO’s system allows users to borrow, save, or earn interest on their holdings without relying on traditional financial intermediaries. Its decentralized and autonomous nature makes it a prime example of Ethereum’s capabilities in creating complex financial systems.

Ethereum applications in the real world

Ethereum’s technology has also found applications in various real-world sectors. Its smart contracts have been used in supply chain management, providing transparency and traceability. In finance, Ethereum enables decentralized finance (DeFi) solutions, offering financial services without traditional banking institutions. Additionally, its ability to handle digital identities and assets has implications in areas like voting systems and intellectual property.

Ethereum 2.0

A significant milestone in the Ethereum narrative is the advent of Ethereum 2.0. This major upgrade marks a pivotal shift in the network’s infrastructure, focusing on enhancing scalability, security, and sustainability, and represents a forward leap in the evolution of Ethereum’s blockchain technology.

From Proof-of-Work to Proof-of-Stake

Transitioning from a Proof-of-Work (PoW) to a Proof-of-Stake (PoS) consensus mechanism marks a significant evolution of the network. This change aims to address issues like scalability, energy consumption, and transaction speed. In PoS, validators stake their ETH as collateral to validate transactions and maintain the network. This shift not only reduces the environmental impact of Ethereum but also enhances its efficiency and capacity to handle a larger number of transactions.

Who invented Ethereum?

Ethereum was invented by Vitalik Buterin, a programmer and co-founder of Bitcoin Magazine. Buterin first proposed Ethereum in late 2013, envisioning it as a platform that could go beyond the financial use cases offered by Bitcoin. His vision was to create a more versatile blockchain that could execute smart contracts and host decentralized applications.

Who runs Ethereum?

Unlike centralized systems, Ethereum is run by a global community of developers and users. The Ethereum Foundation, a non-profit organization, plays a key role in coordinating the efforts of the community. The decentralized nature of Ethereum means that no single entity or person has control over the network. Decisions regarding upgrades and changes in the Ethereum protocol are made through a community-driven process, involving various stakeholders in the Ethereum ecosystem.

The history of Ethereum

From its conceptualization to its ongoing development, the history of Ethereum is a fascinating journey of innovation, community engagement, and technological breakthroughs that have shaped its current state.

The genesis of Ethereum

Ethereum’s journey began with its white paper in 2013 called “Ethereum: A Next Generation Smart Contract & Decentralized Application Platform”, and the network officially went live in July 2015. This launch introduced the concept of a blockchain that could execute more complex transactions than Bitcoin, through its novel feature of smart contracts.

Hard Fork

A significant event in Ethereum’s history was the hard fork of 2016, following the DAO (Decentralized Autonomous Organization) hack. The DAO was a complex smart contract that was meant to function as a venture capital fund for the crypto and decentralized space. The hack led to the theft of around $50-70 million worth of Ether. The Ethereum community decided to execute a hard fork to reverse the transactions from the hack, which resulted in two separate blockchains: Ethereum (ETH) and Ethereum Classic (ETC).

Ethereum (ETH) Price Performance

Ethereum’s price performance has been notable since its inception. Starting from a price of about $0.31 during its initial crowdsale in 2014, ETH’s value has seen significant fluctuations, reflecting both the volatile nature of the cryptocurrency market and Ethereum’s growing importance. Its price has been influenced by various factors, including network upgrades, adoption by developers, and the overall interest in cryptocurrencies. At the time of publication of this article the recorded all-time high (ATH) of Ether (ETH), the native cryptocurrency of the Ethereum network, was approximately $4,891.70 USD, reached on November 16, 2021.

What is the difference between Ethereum and Bitcoin?

While Ethereum and Bitcoin are both prominent players in the cryptocurrency world, they have distinct purposes and architectures. Bitcoin, created by the pseudonymous Satoshi Nakamoto, was the first cryptocurrency and is primarily a digital alternative to traditional currencies. Its primary purpose is to serve as a decentralized currency for peer-to-peer transactions and as a store of value.

Ethereum, on the other hand, was developed by Vitalik Buterin with a broader vision. It is not just a cryptocurrency but an entire platform and ecosystem for executing smart contracts and building decentralized applications (dApps). While Bitcoin’s blockchain is focused on tracking ownership of the digital currency, Ethereum’s blockchain is designed to serve as a general-purpose computing platform.

Ethereum’s energy consumption

The energy consumption of Ethereum has been a topic of concern, particularly under its original Proof-of-Work (PoW) consensus mechanism, which required significant computational power and, consequently, a large amount of electricity. However, with the transition to Ethereum 2.0 and the adoption of the Proof-of-Stake (PoS) mechanism, Ethereum aims to drastically reduce its energy consumption. PoS is a more energy-efficient process as it eliminates the need for intensive mining activities.

Taxes and legal aspects

Navigating the tax implications of Ethereum transactions is crucial for users and investors. The taxation of cryptocurrencies like Ether (ETH) varies by country, with each jurisdiction having its own set of rules.

Tax Implications in the United States

In the United States, the Internal Revenue Service (IRS) treats cryptocurrencies as property for tax purposes. This means that buying, selling, trading, or otherwise using Ether can trigger capital gains taxes or capital losses. For instance, if you buy ETH and sell it at a higher price, you realize a capital gain, which is subject to taxation. Conversely, selling ETH for less than the purchase price results in a capital loss, which may be used to offset other capital gains.

Tax Implications in Germany

In Germany, the taxation of Ethereum is slightly different. If an individual holds Ether for more than a year before selling or trading, any gains are tax-exempt. However, if the ETH is sold or used in a transaction within a year of acquisition, the gains may be subject to income tax. This tax only applies if the total gain exceeds 600 Euros in a fiscal year.

Is Ethereum Legal?

The legality of Ethereum varies by country and is subject to an evolving regulatory landscape. In most jurisdictions, Ethereum is legal and operates under specific regulations, especially concerning its use in financial transactions, ICOs, and taxes. However, it’s important for users to be aware of their local laws as some countries may have restrictions or different regulatory approaches to cryptocurrencies and blockchain technology.

Conclusion

Thanks to the versatility of smart contracts and the far-reaching potential of decentralized applications, Ethereum goes far beyond the boundaries of a pure cryptocurrency. This product diversity also offers a lot of opportunities for investments – CoinTracking offers an optimal solution for portfolio management in order to maintain an overview and effectively supports the preparation of tax reports.