What Is Ethereum and How Does It Work? A Beginner’s Guide

Published: January 31, 2024 | Last Updated: January 13, 2022

Markos Koemtzopoulos

Markos Koemtzopoulos is the founder and main writer of ElementalCrypto. He has been a lecturer at the University of Nicosia on cryptocurrencies and DeFi and has taught two courses on crypto and blockchain technology.

In this article, I will walk you through all you need to know about Ethereum. What is Ethereum and how does it work? Why is it so important? Who are the main characters and why is it more important than Bitcoin in some ways?

I will also introduce you to key concepts such as mining, ICOs, smart contracts, and the main characters involved in Ethereum.

After reading this article you will understand everything there is to know about the Ethereum platform.

This article is foundational. As you embark upon your crypto journey you will find that Ethereum is the source of all inspiration. It has played an instrumental role in morphing the crypto space into what it is today.

Now pay attention

What Is Ethereum and How Does It Work?

Ethereum was the first cryptocurrency that made use of smart contracts successfully and the second-largest cryptocurrency by market capitalization.

When you hear Ethereum you should immediately think of smart contracts. So before exploring Ethereum let’s first understand smart contracts. 

First: what are smart contracts? 

A smart contract simply refers to coding language for “if…then…” statements.

If you ever started a coding course on Python or javascript one of the first things you would learn about are “if… then…” statements.

So, for example, you could write something like: “If the price of bitcoin goes above $30,000 then sell this user’s bitcoin.”

Ethereum makes use of these self-executing contracts to turn itself into a platform that other developers can build more things upon. In the coding world, they refer to this as a protocol. Imagine it as an iOS or Android platform of the crypto world that allows any developers to build a decentralized application.

These apps are referred to as “Dapps” by the crypto community. The “d” in Dapps stands for decentralized.

In this context, you will also often hear the term DeFi which stands for decentralized finance. 

 Ethereum dApps vs  App Store and Play store apps
Dapps on the Ethereum Network are equivalent to apps on Google’s Play Store or Apple’s App Store.

And this is what the hype is about.

Because the smart contracts capabilities that are baked into Ethereum allow developers to build apps that can run on their own and offer financial services and more.

The app could, for example, execute a loan transaction without any intermediation from a human. 

Let’s see how this loan example would play out.

Imagine you sign up and join an app where you are willing to offer your Bitcoin as collateral to get a loan.

The app could accept your Bitcoin and offer you half its value as a loan. If you did not repay the installment the smart contract would instruct the system to sell part of your crypto. If you did repay in full it would return your bitcoin to you.

You see that with smart contracts it is pretty easy to have an automated system that does not require human intervention. It can simply exist on its own. 

Since the launch of the Ethereum network in 2015 over 3,000 Dapps have been launched. Some of the most famous ones are

  • Uniswap: a decentralized exchange for buying and selling digital assets
  • Compound: a decentralized lending and borrowing platform
  • MakerDAO and its DAI stablecoin. More on stablecoins another time
Diagram showing many of the dapps that are part of the Ethereum network
Ethereum’s ecosystem of Dapps is huge. Here are a few of them. Source: twitter.com

Back to what Ethereum is

Technically Ethereum is not a cryptocurrency.  Rather it is a network of computers that allows anyone to build a decentralized app.

Ethereum was first developed in 2013 by then-19-year-old Vitalik Buterin. A Canadian whizz kid, Vitalik had been studying cryptography at the University of Canada and writing articles for Bitcoin Magazine when he came upon the following realization :

If bitcoin is a decentralized currency that removes central authority (of government) from the picture could we use the same mechanisms to decentralize everything?

For example, imagine a social network with no central authority such as Facebook or Twitter controlling it in the background. Or imagine an Uber-like app with no Uber in the middle taking a cut in fees.

You could decentralize any field that has a gatekeeper or middleman managing the process whether that be a government managing a land registry or an internet company managing email. A decentralized app would purely exercise the smart contract baked into it.

Ether vs. Ethereum: what’s the difference?

Ether, denoted as ETH,  is the cryptocurrency that powers the Ethereum network.

If you want to launch a Dapp you need to pay in Ether, known as gas fees in the community. The transaction fees incentivize developers to write efficient code that does not use up too much of the Ethereum network’s bandwidth.

The more clunky or demanding your app is, the more Ether you need to pay. Similarly, any transaction that is broadcast to the network needs to be verified and hence incurs a fee in Ether.

Who does this Ether go to? Why it goes to a group of developers called miners, who, in a similar fashion to bitcoin blockchain miners, offer computational power to verify and add new blocks of transactions

Picture of hundreds of stacked servers in crypto mining farm
Ethereum miners use servers to provide fast computation to validate transactions. Source: Wikipedia

A small primer on mining

Wait, what?

Yeah so here is a small primer on mining: If I send you 10 ETH then this transaction needs to be verified. How does this system deduct 10 ETH from my account and credit 10 ETH to your account?

Well, these transactions are verified by multiple independent groups of people who offer their computer power to run the Ethereum Network. They all have to agree that this transaction took place.

The way they agree is by validating the transactions by expending some time and energy to prove that this happened. More on mining in a later article.

For now, all you need to understand is that developers require rewards for the energy and time they invest in. And the rewards occur in ETH. 

Ethereum market cap

Ether is the largest cryptocurrency by market cap after Bitcoin.

Market cap is simply the market price times the number of coins or tokens that are available for the respective cryptocurrency at the time. However, this is not the whole picture.

Ethereum also has the largest number of Dapps on its platform. This means that the value of Ethereum is the value of the Ethereum network plus the value of all the crypto assets built on top of it which is the majority of the crypto economy.

Ethereum TVL
Ethereum accounts for 57% of the total value of crypto assets locked on dApps. Source: defillama.com/chains

Some major competitors to Ethereum have risen such as Cardano, Polkadot, Avalanche, Cosmos, and Solana. All are still in their early stages. I’ll tell you more about these later.

By the way, I’ll let you in on a secret. You can build up your knowledge of crypto altcoins and DeFi by reading the articles on this site. To stay up to date you can sign up for my newsletter and follow me on Twitter where my Twitter handle is @lementalcrypto.

Very often people use Ether and Ethereum interchangeably to refer to the currency.

Token issuance

With the launch of the Ethereum network, it became very easy for developers to mint their own digital currency. There is a protocol in Ethereum called ERC-20 that allows you to do this.

With a few lines of code, a group of developers could issue new ERC-20 tokens, give them a random name, and accept Ether in return for it.

There is also another protocol called ERC-721 which allows you to mint non-fungible tokens. If you want to learn more about NFTs I recommend you read my deep dive on Ape Coin.

Initial Coin Offerings

The ERC-20 protocol allows people to raise funds for their projects through Initial Coin Offerings (ICOs).

An ICO is a play on words for IPO: Initial Public Offering.

IPOs come from mainstream finance when a company lists shares on the stock market for the first time. Initial Coin Offerings allowed developers who had written a conceptual white paper of the project they wished to start, to raise capital.

By issuing coins, known as tokens, they could raise capital to fund their project. This way they circumvented the lengthy and costly process of using banks as intermediaries.

ICOs allowed teams of developers to raise capital for projects that were also less fundable via traditional mainstream finance vehicles such as venture capital funds. A lot of the time attracting funds just required a white paper, a sleek website, and some publicity on Reddit and other social media.

Infographic showing ERC-20 ICO valuations 2014-2018
Value per coin and total capital raised during the ICO craze 2014-2018. Source: elementus.io

Why people overreacted to ICOs

ICOs were attractive to many people in the crypto community because it was like giving the middle finger to mainstream finance. It was a step towards the realization of the permission-less self-governed economy they had been trying to create.

Most people however just wanted to become millionaires and fast.

They had seen how Bitcoin and Ether had jumped from a few cents in the early days to thousands of dollars. Now they too wanted to get in early on the next opportunity. This caused a lot of hype.

Some companies were raising millions in just a few hours. By the end of 2018, ICOs raised more than $28Bn surpassing total venture capital investment at the time. 

The ICO coins were utility tokens in the same sense that you used Ether as gas for running a project on the network. For example, a gaming company might issue tokens that you need to make purchases inside the game.

The token was then able to trade on the market. In contrast to stocks, tokens don’t give you the right to own a part of the company.

This allowed them to clear a legal loophole in some countries in that they were not securities and therefore not subject to regulatory restrictions. You could consider them more like arcade or fun fair tokens. 

How the Ethereum consensus algorithm works

Proof-of-Work vs. Proof-of-Stake

We already mentioned that for transactions to be validated developers, known as miners, need to be rewarded.

To prove that a transaction is valid miners expend energy to solve complicated algorithms. This is known as Proof of Work and is energy-intensive.

Bitcoin comes under strong criticism by its detractors for its energy usage.

See What is a bitcoin and how does it work for more on Bitcoin.

To address this issue and scale in a more eco-friendly manner the Ethereum founders proposed an alternative model known as Proof of Stake.

With a Proof-of-Stake consensus algorithm, miners put their own coin holdings up as collateral. They then validate only the proportion of coins that they own. This requires much less energy consumption.

As of September 2022, Ethereum has successfully transitioned to a Proof-of-Stake model. 

You can participate in Staking

Anyone can delegate their ETH to a validator to be staked. This way they can earn a return on their ETH. If you plan on holding ETH for the long term then this is a good way to earn a yield on your assets.

You can find out more about staking ETH in the following resources

Layer 1 vs Layer 2

In addition to making the network more eco-friendly, the founders of Ethereum wanted to make Ethereum process more transactions per minute.

This would lower transaction costs for developers and make the network more competitive against traditional corporate entities such as Visa and Mastercard. One methodology that most Ethereum developers agree on is sharding.

Sharding breaks up a process into smaller components called shards which run in parallel. Ethereum plans to run 64 shards. While we don’t need to understand the technical details it is important to note that this solution is planned to be built into the Ethereum blockchain itself.

It is thus known as a layer 1 solution.

Now that Proof-of-Stake is complete, once sharding is complete, Ethereum will be operating an entirely new blockchain known as Ethereum 2.0.

The team believes it will be much more efficient compared to the previous version.

In the meantime, a host of separate entities are building a second layer. These are not part of the core base-level protocol but live on top of Ethereum to scale it. 

A layer 2 solution would run transactions on its own blockchain. Subsequently, it would hook up to Ethereum to validate batches of transactions together.

You may have come across the term optimistic rollups or zero-knowledge rollups that do precisely this.

One of the largest layer 2 blockchains is Polygon. I highly recommend reading this simple explanation about Polygon to complete your knowledge of the Ethereum ecosystem.

Depiction of how layer 2 operates separately from layer 1 on Ethereum
Layer 2 protocols bundle transactions separately before passing them on to the Ethereum Layer 1 blockchain network. Source: coincu.com

A short explanation of why EIP-1559 is significant for Ethereum

EIP stands for Ethereum Improvement Proposal.

The community voted in favor of EIP-1559 in August 2021.

It was significant because it reduced the amount of ETH in supply by burning a large part of the gas fees. It also simplified the process for paying gas fees thus making them cheaper for the average user.

Before EIP-1559 gas fees operated on an auction basis. The highest bidder would win the auction and their transaction would go through.

This led to a lot of very large ETH owners, known as whales, being able to dominate transactions. It also pushed gas fees up. The new algorithm for gas prices estimates a base fee.

You can then add a priority fee which is kind of like a tip to make your transaction go through faster. The base fee gets burned while tips still accrue to the validators.

When I say the base fee gets burned I mean it vanishes and no longer exists thus reducing the amount of Ethereum in circulation. While Ethereum does not have a fixed amount of ETH like Bitcoin does burning ETH is thought to be good for its price.

Why is it called Ether / Ethereum?

Vitalik chanced upon the term Ether while browsing online for a name for his decentralized platform. He came across a now disproved 19th-century theory that the air is permeated by a substance called Ether.

He liked the name (it does sound cool) and coined the term Ethereum. 

Why do some people think Ether is a shitcoin? 

Hardcore Bitcoin believers call Ether and other alt-coins “shitcoins”.

These “bitcoin maximalists” believe that Bitcoin is the only coin worth focusing on since there is a fixed number of bitcoins that can ever exist. This is not the case with Ether.

Because the amount of Ether is not fixed, more could be created in the future thus putting downward pressure on its price. 

Another criticism of Ether is that its strength is also its weakness. 

Apps on the Ethereum network are immutable. Once developers launch them on the network no one can tamper with them.

The fact that once launched, Dapps are immutable is a headache for anyone who needs to change something later. Basically, it cannot be done.

In real life, with central management, there is some flexibility built into the system. You can always escalate things to court or adapt to exceptions.

A smart contract, however, will always execute the contract with no exceptions. Hence, before launching an app, you need to think of all the extenuating circumstances that might occur. 

Another criticism is that Dapps needs to appeal to a wider audience beyond geeks. There needs to be someone working on them to improve the user experience such as the packaging and sign-up process.

Hence, Dapps are never 100% dis-intermediated. There will always need to be some entity overseeing the process. 

What is Ethereum Classic?

Before we go to Ethereum classic we need to understand the concept of forking. 

Forking

Coders will often host their code on platforms where others can copy and alter or improve it. So, for example, coder A may write version 1 of a program, and then someone might copy this and branch out to build version 2.

Going forward version 1 still exists and may continue to develop while at the same time, version 2 continues to grow, possibly morphing into something completely different.

So it’s like the programs were both the same until there was a fork in the road and each went their own separate ways. Similarly, cryptocurrencies can also have forks. 

Diagram showing how Ethereum blockchain is forked
How forking on Ethereum works

Back to Ethereum Classic

Ethereum Classic is version 1 of Ethereum i.e. the original version. In the early days, a major crisis caused a hard fork. 

During the early days of Ethereum, there was a group of developers who wanted to launch a decentralized fund. They called this protocol a decentralized autonomous organization (DAO) and the fund’s name was aptly named TheDAO.

This DAO was the inspiration for many of the decentralized autonomous organizations in existence today.

Participants would send Ether to the fund and the smart contract would allocate them a proportional number of tokens to vote with.

Token holders would then submit proposals or could vote on projects proposed by others. The smart contract would direct the Ether to the winning proposal.

Initially, the creators of the fund expected to raise about $20 million. However, people in the crypto community were so excited by the idea of decentralized governance that they ended up raising more than $70Mn. 

TheDAO Hack

Soon after raising the money someone managed to hack the fund and started bleeding it of money. In her book, “The Infinite Machine”, Camilla Russo goes into excellent detail about how the hacker and the Ethereum community were playing a game of cat and mouse.

To cut a long story short the hacker won. In order to save people’s money and return it to them and in order to punish the hacker, the community decided to create a fork.

This is kind of like saying: “ok everyone, let’s cancel the old path and start afresh on this new path. This way​ the real Ether is on the new fork and the hacker has worthless old Ether”.

Most people accepted this fork.

However, to everyone’s surprise, there ended up being still a minority that continued to verify transactions on the old fork. This is a community of people who believe that Ethereum is immutable and no one should change the rules (create a fork) no matter what. Otherwise, the whole idea of decentralization is a waste.

The old fork, named Ethereum Classic, still retains some value though nowhere near that of Ether. Hence the hacker didn’t completely lose as they retained Ethereum Classic tokens. 

Who are the founders and creators of Ethereum?

When Vitalik Buterin came up with the concept and wrote the white paper on Ethereum there were 7 other founders who joined him to build Ethereum.

Apart from Vitalik, there are two more people you need to know about. Both play an important role in the ecosystem. 

Portrait shots if the founders of Ethereum
The founders of Ethereum.I’m missing Jeffrey Wilcke. Source: Medium.com
  1. Gavin Wood: allegedly wrote the code for Ethereum in C++ in one night. After reading Vitalik’s whitepaper he wrote a “yellow paper” with all the technical details of how the Ethereum network could be built and designed Ethereum’s programming language called solidity.  He is now following his own path by developing a new protocol called Polkadot. Polkadot is trying to be the protocol of protocols. So you could use any other protocol on this platform to make Dapps, even Ethereum. You can read a simple explanation of Polkadot here
  1. Charles Hoskinson: Appointed himself as CEO when the Ethereum project got started. Charles wanted to run a for-profit model that raised money from venture capital funds. His vision clashed with that of the rest of the team who wanted a non-profit status. Charles ended up leaving to set up a blockchain called Cardano. Cardano is unique in that it uses peer reviewers (just like an academic project would) to progress on its code. 

Summary of the rest of the founders. 

  1. Mihai Alisie: was Vitalik’s co-founder of Bitcoin magazine. He helped set up the team in Switzerland and dealt with a lot of the legal aspects. He is now focusing on building a Social network Dapp on Ethereum called Akasha. 
  1. Anthony Di Iorio: was one of the first co-founders of Ethereum but later moved on to follow his own path and founded Decentral, a digital wallet. 
  1. Amir Chetrit: a US-Israeli who met Vitalik while working on Colored Coins. This was a project to tokenize stocks and other assets on the Bitcoin network. Vitalik invited him to join Ethereum as a founder. After not being able to contribute to the code development of the project he stepped down. He currently works on various crypto projects but shies away from publicity.
  1. Joseph Lubin: with a degree in computer science from Princeton and a career in the software and music production industry Joseph was the most experienced team member. 
  1. Jeffrey Wilcke: was so excited about the Ethereum white-paper when he read it that he started writing the code in Google Go code. Later, he met Gavin Wood who had done the same in C++ code. They found that it was good to have a second version as a backup. He quit after the DAO hack and after having a baby and has since set up a gaming company. 

Ethereum ecosystem projects and copycats

Ethereum is the original gangster. The “OG” in crypto-twitter speak. From there on you have two major movements.

The first reaction to Ethereum was the development of what we call alt-coins. These were other alternative projects that looked at Ethereum and thought, “Hang on we can do a faster, meaner, better than Ethereum. Everyone, get on the super-duper new shiny thing that I am building”. For example, one of the most famous contenders for Ethereum is EOS: Ethereum on Steroids. If you want to have a well-rounded knowledge of the crypto space then here are some major altcoins you should know about:

The second branch that emerged is what we call DeFi (Decentralized Finance) and Web3. The most famous and usually the largest Dapps to date are built on Ethereum. Some of these are:

infographic crypto ecosystem

Summing up what Ethereum is and how it works

All in all, Ethereum is the single most important cryptocurrency.

It was the first to introduce smart contracts and its ecosystem of decentralized apps has scaled massively. This scale has led to sustained demand for ETH.

Despite the presence of multiple alternative layer 1 solutions and despite the high gas fees users have to pay the Ethereum ecosystem continues to grow.

While there are other blockchains that can process transactions faster and cheaper, Ethereum maximalists believe that Ethereum’s network effects are so large that it will continue to dominate the crypto market.

Like I said there are some very cool projects that have built products on Ethereum. What’s mind-blowing to me is that despite the chaos in the market with multiple crypto projects exploding the core DeFi protocols are still functioning just fine. The first one you should read about is Compound a borrowing and lending platform that introduced some mighty innovations in finance.

If you are completely new to crypto then check my crypto starting guide. Have fun!

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Markos Koemtzopoulos is the founder and main writer of ElementalCrypto. He has been a lecturer at the University of Nicosia on cryptocurrencies and DeFi and has taught two courses on crypto and blockchain technology.