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What Is Ethereum?

A Step-by-Step Primer on Ethereum’s Blockchain, Gas Fees, Scalability and dApps

What Is Ethereum?

When Bitcoin first launched in January 2009, it was effectively valueless. 

In fact, it took two years for Bitcoin to reach $1. It took many subsequent years for the cryptocurrency to popularize the concept of blockchain assets, paving the way for other types of blockchain networks.

The most important alternative to Bitcoin is Ethereum. Only, it’s not really an alternative but an entirely different proposition. Unlike Bitcoin, which is designed to be a form digital money, Ethereum is a network that enables software developers to create decentralized programs, called dApps, and smart contracts which automate agreements. Ether, Ethereum’s native token, is an intrinsic part of its operational program.

Ethereum vs. Bitcoin Explained

As with any blockchain network, Ethereum relies on multiple computers, known as nodes, to maintain a distributed database on the internet. This public ledger is not just synced up with other nodes for data redundancy, but each record in the database is chained together and time-stamped. This creates a data blockchain that is immutable because no record could be forged without creating another blockchain branch.

This is why blockchain platforms are commonly viewed as immutable public ledgers that provide inherent value despite just being a “piece of code.” Over time, Bitcoin proved beyond doubt that such a peer-to-peer (P2P) network can ensure value without being controlled by a central authority.

However, Bitcoin is a conservative network where its data blocks only serve to record transactions. After all, the original Bitcoin whitepaper describes it as a P2P payment network. In other words, the cryptocurrency is an electronic money but decentralized, so it can’t be tampered with.

Specifically, Bitcoin’s smart contracts, developed with Script programming language, determine how much of Bitcoin is locked and how much is spent. Between these two conditions, a unit known as BTC is created. In other words, all transactions on the Bitcoin network are just executed smart contracts.

How Does Ethereum Stand Out, Then?

Executing programs when conditions are met is nothing new. It has been an integral part of digital technology ever since the first computer was invented. However, when code is executed on a blockchain — as smart contracts — a completely new landscape opens up. 

It is then possible for two critical processes to happen:

  • For users to directly interact with each other over the network without mediators.
  • For that interaction to be verified in a secure manner because of blockchain’s inherent immutability. 

These two building blocks effectively create conditions for an evolutionary shift in how money is perceived and how financial services are provided. Ethereum accomplishes this with its Solidity scripting language and Ethereum Virtual Machine (EVM). The latter is the platform that runs smart contracts.

The EVM is the computational engine that runs smart contracts.  In practice, this means that Ethereum can change how the internet itself works.

Case in point: When people use YouTube, they are accessing a computer network run by Google. Their accounts are controlled and leveraged into new products by a traditional corporation. In contrast, when people access Ethereum, they access a network maintained by other people.

Because Ethereum is open-source, anyone can run an Ethereum node that syncs up with other nodes to verify and update the blockchain — a public ledger composed of smart contracts.

As of July 2022, there are 1,224 Ethereum nodes in operation across the world. Each one holds an entire Ethereum ledger. Source: Etherscan.io

Therefore, no single entity runs the network or the smart contracts it supports. Users interact with Ethereum’s smart contracts via decentralized applications (dApps). Anyone can create and launch a dApp with the Solidity programming language without asking for permission.

Because DApps run on a blockchain, with its backend code tied to smart contracts, no overseer can intercept or block the use of dApps. A vending machine, for example, doesn’t hold a tiny person inside the box to deliver beverages and snacks. Instead, it has an electronic mechanism that automatically detects payments. When this payment condition is met, the vending machine delivers the user-selected outcome.

Add blockchain’s security and immutability aspect into the mix, and this basic principle applies to the entire Ethereum network. In turn, Ethereum’s “vending machines” can replace an enormous range of intermediaries: banking clerks, fund managers, market makers, stockbrokers, real estate agents, ticket booths, auction houses, etc.

What Kind of dApps Does Ethereum Offer?

Thanks to its open-source nature, anyone can deploy dApps on Ethereum. Furthermore, because Ethereum was among the first smart contract blockchains, it gained a first-mover advantage. This propelled Ethereum to a dApp king, offering 2,970 dApps out of 4,073 dApps across all blockchains. 

In the meantime, 989 DApps were abandoned. Still, this translates to a 73% Ethereum DApp dominance. Likewise, Ethereum holds the bulk of total value locked (TVL) in smart contracts, at $45.3B out of a total of $69.2B. 

Source: The Block

The most popular Ethereum dApps are spread between blockchain gaming and decentralized finance (DeFi). For example, Axie Infinity marketplace, running on a Ronin sidechain, regularly has over 300k users. The play-to-earn (P2E) blockchain game made $1.3B in revenue last year, accruing massive wealth practically overnight.

This did not happen by accident. For decades, gamers could play video games that have their own internal economies, but none of the assets inside them could have been exported and exchanged for real money. Axie Infinity is an exceedingly successful proof of concept that demonstrates what happens when in-game assets are tradeable as blockchain assets.

Specifically, Axie has its own AXS token that monetizes the P2E experience in tandem with NFTs — non-fungible tokens. The latter can either be in-game fantasy creatures (Axies) or virtual land plots. Alongside blockchain gaming and NFT marketplaces like OpenSea, Ethereum’s most popular dApps are decentralized exchanges (DEXes), such as Uniswap and Curve.

Image credit: The Block

Likewise, lending and borrowing dApps like Aave, Maker, and InstaDApp recreate fundamental banking services without banks. Whether one deals with decentralized exchanges or banking dApps, the principle is the same:

  • Smart contracts create liquidity pools.
  • Users add liquidity into these pools by locking up their tokens.
  • When other traders use these pools, whether for borrowing or swapping tokens, they automatically provide a transaction fee to liquidity providers (LPs). 

This is why liquidity providers are commonly called liquidity miners or yield farmers. Speaking of fees, it must be inherently incentivized for a decentralized platform to work.

Why Ethereum Can’t Be Free

Ethereum runs on thousands of nodes, but why would anyone be motivated to employ their computer as an Ethereum node? Although anyone can run a node if they want, only those who are miners or validators receive a fee when users execute transactions. In the case of Ethereum, things are more complicated, as it is presently in a transitory stage between proof-of-work (PoW) and proof-of-stake (PoS) consensus (this is Ethereum 2.0).

Case in point, Bitcoin uses PoW consensus, in which miners solve cryptographic puzzles to verify and add transactions as new data blocks to the blockchain. In return, they receive rewards. PoS blockchains operate on the same principle, but use staking instead of computational power.

That’s why PoW blockchains proof transactions with CPU power (electricity as work), while PoS blockchains proof transactions with economic staking. That means users lock up their tokens as a stake to validate and add new transactions.

Ethereum Monetizes the Network With Economic Staking

Ethereum has a minimum 32 ETH requirement to become a validator. With these staked funds, the user then installs an Ethereum execution/consensus client that connects to the internet to maintain the network with other validators/nodes.

Based on the total amount of ETH staked, a network validator can earn up to 5% annual percentage yield (APY). In contrast, if one were to deposit money in a traditional bank’s savings account, the APY would be stuck at a ceiling of 0.05–0.08%.

Presently, Ethereum has over 406,000 validators, having staked 13.6M ETH at an interest rate of 4.2% APR (annual percentage rate is the same as APY but without compounding interest). Conversely, according to the Staking Rewards calculator, a modest $1,000 stake would yield $40.89 per year.

Paying for Ethereum’s DApps

On the other end of that network monetization spectrum, users have to pay for their transactions as ETH gas fees. 

Just like one cent is 1/100th of a dollar, so is one Gwei 1/billionth denomination of ETH. Therefore, 1 Gwei = 0.000000001 ETH.

However, Ethereum’s gas fees are highly volatile, depending on the traffic load. This creates a significant “ouroboros” problem, as the more popular Ethereum becomes, the more prohibitively expensive it becomes to use it. 

Ethereum’s gas fee volatility creates much uncertainty when to use the network to avoid transaction fees. Source: Statista.com

Suffice it to say, this is a problem with a decentralized platform that is supposed to erect a new financial infrastructure. After all, if it is more expensive to swap or transfer cryptocurrencies on Ethereum, why not just use traditional platforms like Western Union instead?

Ethereum deals with this problem by relying on Layer 2 (L2) networks.

Layer 2 Networks Alleviate Ethereum’s Traffic Load

It will never be possible to create a network that is frictionless to such an extent that it is free to use. That’s because there will always be a cost associated with computing power, internet bandwidth, and storage. Accordingly, every PoS blockchain has its own way to deal with the balance between transaction fees and traffic load.

For example, Algorand (ALGO) employs a two-tier network architecture. One network layer handles simple transactions (like token transfers), while the second layer deals with complex transactions, usually associated with DeFi dApps such as yield farming. Ethereum was designed differently.

Instead of inherently holding two types of highways, Ethereum relies on external highways that link with the main chain (Layer 1) to offload the network traffic. One such Ethereum side chain was already mentioned — Ronin for the Axie Infinity blockchain game. Other L2 networks are more universal, each having their own imported DApps.

Top 10 Ethereum L2 networks. Source: l2beat.com

Although this makes Ethereum more cumbersome to use, the savings on gas fees is drastic. For example, the most popular L2 network, Arbitrum, with a 52% L2 market share, lowers the transaction fee to a completely negligible level. 

What Does Ethereum’s Future Hold?

Contrary to popular belief, the upcoming Ethereum’s transition from PoW to PoS, dubbed the Merge, isn’t supposed to directly affect the network’s gas fees. 

However, it most certainly is poised to drastically reduce Ethereum’s energy usage. According to the Ethereum Foundation, the network’s power consumption will be reduced by a factor of 2,000x, or by 99.95%.

Given the importance of the ESG (environmental, social, and governance) framework imposed on institutional investors, one could easily see green Ethereum opening the investing floodgates. Case in point, BlackRock, the world’s largest asset manager with $10 trillion AUM and a stake in nearly every company, pursues  ESG across its investment portfolios.

After the greenifying Merge, Ethereum’s next big upgrade comes in the form of sharding. This is the update that is most likely to take a swipe at volatile gas fees. In conjunction with L2 networks, sharding will partition Ethereum’s network into smaller chunks — shards. Precisely, into 64 shards.

Sharding is nothing new in the network arena, as video gaming companies have been using this method to make online gaming faster and cheaper. Lastly, Ethereum’s Merge will reduce the issuance of its native ETH token, making it a scarcer asset. Following the fundamental law of supply and demand, a resource that is scarcer gains value.

After all, this is how Bitcoin went from <$1 to >$40,000, thanks to its 21M hard cap. While Ethereum will not have such a hard coin limit, the ETH burning mechanic introduced with the EIP-1559 update continually reduces ETH supply the more the network is used. If the Merge goes without major code exploits, Ethereum is poised to significantly increase in value.