What Is Ethereum and How Does It Work?
A complete guide to Ethereum: the programmable blockchain that powers decentralised applications, DeFi, NFTs, and smart contracts.
Ethereum is the world’s second-largest cryptocurrency by market capitalisation and the most widely used programmable blockchain platform. While Bitcoin is primarily a store of value, Ethereum is a platform for building and running decentralised applications.
What makes Ethereum different from Bitcoin?
Bitcoin was designed to do one thing well: transfer value without an intermediary. Ethereum was designed to be programmable.
Developers can write code that runs on the Ethereum blockchain, called smart contracts. These are self-executing programmes that automatically carry out actions when predefined conditions are met, without any human intervention.
What are smart contracts?
Imagine an escrow service: a neutral party holds your funds until a condition is met, then releases them. A smart contract does the same thing, but the code is the neutral party. Once deployed to the blockchain, it cannot be altered, and it executes exactly as written.
This has enabled entirely new categories of financial products: decentralised exchanges, lending platforms, stablecoins, and more.
What is Ether (ETH)?
Ether is the native token of the Ethereum network. It serves two main purposes:
- Transaction fees: Every operation on Ethereum costs a small amount of Ether, called “gas.” This prevents spam and pays validators who process transactions.
- Staking: Since Ethereum switched to proof-of-stake in September 2022 (an event called “the Merge”), validators stake ETH to participate in securing the network and earn rewards.
Proof of stake vs proof of work
Bitcoin uses proof of work, where miners compete by burning electricity. Ethereum now uses proof of stake, where validators lock up (stake) ETH as collateral. This reduced Ethereum’s energy consumption by approximately 99.95%.
The Ethereum ecosystem
Ethereum hosts a vast ecosystem:
- DeFi (decentralised finance): Platforms like Uniswap and Aave allow lending, borrowing, and trading without traditional financial intermediaries.
- NFTs (non-fungible tokens): Most of the early NFT market was built on Ethereum.
- Stablecoins: USDC and DAI, two of the largest stablecoins, run primarily on Ethereum.
- Layer 2 networks: Optimism, Arbitrum, and Base process transactions off the main Ethereum chain at much lower cost, then settle on Ethereum.
What are Ethereum’s limitations?
During periods of high demand, gas fees on the Ethereum mainnet can become very expensive, sometimes reaching tens or hundreds of dollars per transaction. This has driven activity to Layer 2 networks.
Ethereum also processes fewer transactions per second than newer blockchains like Solana, though ongoing upgrades aim to address this.