What Is Ethereum And How Does It Work?

by David Rodeck

Forbes Advisor

Thursday April 22, 2021

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Stock image  (Source:Getty Images)

Ethereum is often referred to as the second most popular cryptocurrency, after Bitcoin. But unlike Bitcoin — and most other virtual currencies — Ethereum is intended to be much more than simply a medium of exchange or a store of value. Instead, Ethereum calls itself a decentralized computing network built on blockchain technology. Let's unpack what that means.


How Does Ethereum Work?

Like all cryptocurrencies, Ethereum works on the basis of a blockchain network. A blockchain is a decentralized, distributed public ledger where all transactions are verified and recorded.

It's distributed in the sense that everyone participating in the Ethereum network holds an identical copy of this ledger, letting them see all past transactions. It's decentralized in that the network isn't operated or managed by any centralized entity — instead, it's managed by all of the distributed ledger holders.

Blockchain transactions use cryptography to keep the network secure and verify transactions. People use computers to "mine," or solve complex mathematical equations that confirm each transaction on the network and add new blocks to the blockchain that is at the heart of the system. Participants are rewarded with cryptocurrency tokens. For the Ethereum system, these tokens are called Ether (ETH).

Ether can be used to buy and sell goods and services, like Bitcoin. It's also seen rapid gains in price over recent years, making it a de-facto speculative investment. But what's unique about Ethereum is that users can build applications that "run" on the blockchain like software "runs" on a computer. These applications can store and transfer personal data or handle complex financial transactions.

"Ethereum is different from Bitcoin in that the network can perform computations as part of the mining process," says Ken Fromm, director of education and development at the Enterprise Ethereum Alliance. "This basic computational capability turns a store of value and medium of exchange into a decentralized global computing engine and openly verifiable data store."


Ether and Ethereum: What's the Difference?

You can use Ether as a digital currency in financial transactions, as an investment or as a store of value. Ethereum is the blockchain network on which Ether is held and exchanged. As mentioned above, however, this network offers a variety of other functions outside of ETH.

"These can be simple movements of funds, but they may also be complex transactions that do anything from exchanging assets to taking out loans to acquiring a piece of digital art," says Boaz Avital, head of product at Anchorage. The transactions are processed and stored on the Ethereum network.

The Ethereum network can also be used to store data and run decentralized applications. Rather than hosting software on a server owned and operated by Google or Amazon, where the one company controls the data, people can host applications on the Ethereum blockchain. This gives users control over their data and they have open use of the app as there's no central authority managing everything.

Perhaps one of the most intriguing use cases involving Ether and Ethereum are self-executing contracts, or so-called smart contracts. Like any other contract, two parties make an agreement about the delivery of goods or services in the future. Unlike conventional contracts, lawyers aren't necessary: The parties code the contract on the Ethereum blockchain, and once the conditions of the contract are met, it self-executes and delivers Ether to the appropriate party.


Ethereum vs Bitcoin

Bitcoin's primary use is as a virtual currency and store of value. Ether also works as a virtual currency and store of value, but the decentralized Ethereum network makes it possible to create and run applications, smart contracts and other transactions on the network. Bitcoin doesn't offer these functions. It's only used as a currency and store of value.

Ethereum also processes transactions more quickly. "New blocks are validated on the Bitcoin network once every 10 minutes while new blocks are validated on the Ethereum network once every 12 seconds," says Gary DeWaal, chair of Katten's Financial Markets and Regulation group. And future developments could speed up Ethereum transactions even more, he notes.

Last, there is no limit on the number of potential Ether tokens while Bitcoin will release no more than 21 million coins.


Ethereum Benefits

  • Large, existing network. "The benefits of Ethereum are a tried-and-true network that has been tested through years of operation and billions of value trading hands," says Fromm. "It has a large and committed global community and the largest ecosystem in blockchain and cryptocurrency."
  • Wide range of functions. Besides being used as a digital currency, Ethereum can also be used to process other types of financial transactions, execute smart contracts and store data for third-party applications.
  • Constant innovation. A large community ot Ethereum developers is constantly looking for new ways to improve the network and develop new applications. "Because of Ethereum's popularity, it tends to be the preferred blockchain network for new and exciting (and sometimes risky) decentralized applications," says Avital.
  • Avoids intermediaries. Ethereum's decentralized network promises to let users leave behind third-party intermediaries, like lawyers who write and interpret contracts, banks that are intermediaries in financial transactions or third-party web hosting services.


    Ethereum Disadvantages

  • Rising transaction costs. Ethereum's growing popularity has led to higher transaction costs. Ethereum transaction fees, also known as "gas," hit a record $23 per transaction in February 2021, which is great if you're earning money as a miner but less so if you're trying to use the network. This is because unlike Bitcoin, where the network itself rewards transaction verifiers, Ethereum requires those participating in the transaction to cover the fee.
  • Potential for crypto inflation. While Ethereum has an annual limit of releasing 18 million Ether per year, there's no lifetime limit on the potential number of coins. This could mean that as an investment, Ethereum might function more like dollars and may not appreciate as much as Bitcoin, which has a strict lifetime limit on the number of coins.
  • Steep learning curve for developers. Ethereum can be difficult for developers to pick up as they migrate from centralized processing to decentralized networks.
  • Unknown future. Ethereum continues to evolve and improve, and the ongoing development of Ethereum 2.0 holds out the promise of new functions and greater efficiency. This major update to the network, however, is creating uncertainty for apps and deals currently in use. "Many new validators will be required for Ethereum 2.0 to function," says DeWaal. "The question is will the migration work? There are a lot of new elements that have to fall into place!"


    How to Buy Ethereum

    It's a common misconception to people who are new to the Ethereum network. You don't buy Ethereum itself—that's the network. Instead, you buy Ether and then use it on the Ethereum network. Given Ethereum's popularity, it's very easy to buy Ether:

  • Pick a cryptocurrency exchange. Crypto exchanges and trading platforms are used to buy and sell different cryptocurrencies. Coinbase, Binance and Kraken are a few of the larger exchanges. If you are just interested in purchasing the most common coins like Ether and Bitcoin, you could also use an online brokerage like Robinhood or SoFi. Be prepared to pay some amount of trading or processing fees almost universally.
  • Deposit fiat money. You'll need to deposit cash, like dollars, in your trading platform or link your bank account or debit card to fund purchases of Ether.
  • Buy Ether. Once you've funded your account, you can use the money to purchase Ether at the current Ethereum price along with other assets. Once the coins are in your account, you could hold them, sell them or trade them for other cryptocurrencies in the future. Keep in mind you may incur taxes whenever you sell or trade cryptocurrencies.
  • Use a wallet. While you could store the Ether in your trading platform's default digital wallet, this can be a security risk. If someone hacks the exchange, they could easily steal your coins. Another option is to transfer coins you aren't planning on selling or trading soon into another digital wallet or a cold wallet that's not connected to the internet for safety.


    Should You Buy Ether?

    You might consider investing in the Ethereum network for a few reasons, according to DeWaal. "First, it has value and use as a virtual currency; second, the Ethereum blockchain could become more attractive when it migrates to the new protocol; and third as more people utilize Ethereum distributed apps, demand for ETH may increase," he says.

    Besides buying Ether directly, you could also try investing in companies that are building applications using the Ethereum network. If you'd like help managing your investment, you could also buy into a professional investment fund like the Bitwise Ethereum Fund or Grayscale Ethereum Trust, though these are currently only open to accredited investors.

    Before making any significant investment in Ether or other cryptocurrencies, consider speaking with a financial advisor first about the potential risks. Given the high risk and volatility in this market, make sure it's money you can afford to lose, even if you believe in Ethereum's potential.

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