Ethereum is the world’s biggest utility-based blockchain, sitting up with Bitcoin amongst the crypto space’s most popular decentralized networks.
With code handling everything, Ethereum is used for a wide range of purposes including purchases, staking, lending, and borrowing, as well as being at the heart of the NFT and decentralized finance (Defi) movements.
But while the network is growing in notoriety and use, it’s still largely misunderstood with users of Ethereum not really sure how it works. In this article, we’ll answer the question how does Ethereum work? We’ll also explain how Ethereum is used by users and why the network’s potential is still yet to be fully realized.
Ethereum’s main components
Launching in 2015, Ethereum was the first blockchain network with the ambition to be more than just a store of value or alternative to fiat currency.
Instead, Ethereum’s unique approach to blockchain technology allowed the development of other tokens, decentralized apps (dApps), and decentralized autonomous organizations, as well as challenging traditional financial institutions by birthing Defi.
The network itself is comprised of several components:
The Ethereum blockchain itself is a digital ledger system distributed across a decentralized network of computers. In simple terms, it’s a bunch of computers (called “nodes”) all running the same code and using the internet to keep track of transactions. Highly secure computer code ensures these computers are all in agreement about which transactions are valid with new ones added one after another in “blocks” to form a “chain”.
Anyone can access this ledger of transactions meaning a pseudo-anonymous record is publicly available to make censorship impossible. Having many different computers involved means there is no one point of failure in the network as well as keeping the data consistent and immutable.
While Bitcoin and some other blockchains just keep track of transactions, Ethereum’s ledger also records the “state” of the network. This is the information about all of the applications running on Ethereum at the current moment.
Applications running on Ethereum’s network make use of smart contracts which are essentially relatively small, pieces of code that form agreements within the ecosystem.
Smart contracts are what set Ethereum apart from Bitcoin, allowing certain codes to execute automatically upon fulfillment of certain conditions. Anyone can write and launch smart contracts on Ethereum. Because they are self-executing, they can be trusted by all parties involved to fairly fulfill agreements once conditions are met.
This trustless system further enhances the utility of blockchain beyond currency. Smart contracts eliminate the need for mediating parties or middlemen to act as deal brokers.
Examples of smart contract use include only releasing collateral when a certain amount of paid back by a borrower, royalties for NFT artists or even the settling of a sports bet using oracle data feeds.
Ether is the native currency of Ethereum. It is a valuable asset in its own right appreciating in value greatly since launch. It also has utility within the ecosystem as it is used to pay “gas fees” which is the expense users pay to cover the costs involved in validating transactions and maintaining the network.
As it stands, Ethereum uses a proof-of-work consensus model which involves nodes solving complex cryptographic puzzles to validate transactions. This is the same system as Bitcoin with the energy-intensive nature of the task partly giving tokens their value, similar to the way gold derives some of its value from how difficult it is to extract from the earth.
The proof-of-work consensus model is now being replaced by what’s called a proof-of-stake system as the network begins rolling out “Ethereum 2.0” which will use significantly less energy.
Instead of “miners” proof-of-stake allows users to lock up 32 Ether into the network to be considered a validator and be rewarded for supporting Ethereum. Users with fewer funds can still deposit funds into staking pools where rewards are shared relative to your stake, called “yield.”
The new proof-of-stake consensus model is also laying the groundwork for a faster and more scalable network, with the implementation of “sharding” coming at a later date. Sharding involves the network splitting into 64 mini-blockchains each with its own role in handling certain data. This will allow many hundreds of times more transactions to be handled per second.
Another key aspect of the network is the Ethereum Virtual Machine (EVM). This is the software used to create decentralized apps (dApps) and where Ethereum smart contracts and accounts are executed.
It can be thought of as a virtual computer that all the computers in the network are used to emulate. As all the nodes in the network run the same code, together they can act as a virtual, single-threaded machine while still enjoying the benefits of decentralization such as immutability and removing the need for trust.
Types of Ethereum accounts
There are two kinds of accounts you need to be aware of when asking how Ethereum works. They are:
Also known as Externally Owned Accounters (EOAs), these are normal accounts controlled by those in possession of the respective private key. This is the type of account users are given when opening a new wallet. They are human-controlled, free, and can transfer ETH and messages to other accounts.
Where can I get ETH from and how do I store it?
You can buy ETH from crypto exchanges such as Swyftx. These exchanges are considered custodial where funds are held for you unless you send them to external wallets. Alternatively, decentralized exchanges are available where funds can be bought and sent directly to a non-custodial wallet of your choosing.
While, under the surface, Ethereum is highly complicated, using it need not be. The more time that passes the more crypto becomes user-friendly with both centralized and decentralized financial solutions opting to use the network.