What is Ethereum? The Ultimate Beginner’s Guide
Ethereum is the second-biggest player in the cryptocurrency world today. Founded only 4 years ago by Vitalik Buterin, the Ethereum platform has seen remarkable growth in its short lifetime. If any coin is able to usurp Bitcoin’s position as the most valuable cryptocurrency in the world, Ethereum may just be the one.
In this guide we’ll explain what makes Ethereum so promising and tell you everything you need to know to start investing. Topics to be covered in this article include:
- What is Ethereum?
- What is the Technology Behind Ethereum?
- How to Buy Ethereum
- How Do Ethereum Transactions Work?
- Advantages of Ethereum
- Disadvantages of Ethereum
Let’s jump in!
While Bitcoin is first and foremost a blockchain currency, Ethereum is a blockchain platform. Ethereum allows developers to utilize blockchain technology for a wide range of purposes, with virtual currencies being just one of an infinite number of possible applications.
The Ethereum cryptocurrency is called ether. Ether is often referred to as the “fuel” of the Ethereum network. Anyone looking to make use of the Ethereum platform pays a transaction fee in the form of ether. These transaction fees cover computing costs and keep the network running smoothly.
The ether token can also be used for a number of other purposes, not least of which is buying alternative cryptocurrencies. Whenever you hear someone talking about the value of Ethereum, they’re more than likely talking about the value of ether. Though technically not the same, the terms are often used interchangeably.
This section will be pretty familiar to those of you who have already read our Ultimate Guide to Bitcoin, but here’s a refresher for those who haven’t.
The blockchain is a powerful technology pioneered by Bitcoin founder Satoshi Nakamoto that allows for secure, unalterable record-keeping without a trusted central authority. In Bitcoin, this takes the form of a public ledger which records every single Bitcoin transaction. A peer-to-peer network of nodes processes each new transaction and bundles them with other transactions in “blocks”. These blocks are then attached to the previous end of the blockchain using advanced encryption methods. Once a block is added, every single node in the network is notified and updates their copy of the blockchain.
This is an oversimplification of the process, but the point is that the public record of transactions is distributed across the whole network, rather than being stored in one central location. Blocks are essentially unchangeable once they are attached to the chain, which makes for a system that is both extremely secure and surprisingly transparent.
Ethereum has taken the blockchain and broadened its use beyond currency, instead focusing on decentralized applications.
The Ethereum network is maintained by volunteers known as Ethereum miners. Ethereum mining is very similar to Bitcoin mining. In short, miners carry out the computations required to process and validate new blocks.
Currently, Ethereum uses a proof-of-work system similar to Bitcoin’s to determine which miner gets to add each new block to the blockchain. Proof-of-work essentially requires miners to use computers to guess the answer to a difficult puzzle until one of them finds the answer. Mining requires extremely powerful computers in order to be competitive and is consequently very costly. Miners are rewarded for the valuable service they provide to the network with 5 ether for every new block they add to the blockchain. This incentivizes the miners and keeps the network running smoothly.
Ethereum will soon be transitioning away from proof-of-work toward a new system called proof-of-stake. This new system would randomly award blocks to users based on token ownership rather than their ability to compute the answer to a puzzle. This should be a less-costly option and result in a more distributed network of miners, rather than a handful of large mining operations.
The Ethereum Virtual Machine
While the idea of the blockchain was largely borrowed from Bitcoin, the Ethereum Virtual Machine (EVM) is something entirely new. Every node in the Ethereum network runs a copy of the EVM, creating a sort of world computer that allows any individual computer to run any application, if given enough time and memory.
In contrast to most other blockchains, which can generally be used for a very limited range of operations, this technology makes Ethereum extremely flexible. The most prominent examples of uses are smart contracts, decentralized autonomous organizations, and decentralized applications.
A smart contract is essentially a computer program that automatically executes a set transaction when certain conditions are met. Two individuals can anonymously “sign” a smart contract and the contract will be preserved on the public blockchain. When the conditions of the contract are met, it executes itself and this new state is updated on the next block in the blockchain.
Smart contracts aren’t limited to only monetary transactions either. Content, property, and anything else you can think of can be used as a reward for meeting the contract’s conditions. Smart contracts are appealing because they are anonymous, secure, flexible, and they don’t require any third-parties to be carried out.
Decentralized Autonomous Organizations
Decentralized Autonomous Organizations (DAOs) are essentially smart contracts taken to the scale of an entire organization. Organizational processes could be written into code and run automatically rather than relying on an actual hierarchy of individuals to carry them out.
DAOs are an incredibly ambitious application of the Ethereum network. The upshot of this kind of an organization would theoretically be extreme efficiency and lack of corruption. The downside though is that implementing this kind of a system would require incredible foresight. Smart contracts are very difficult if not impossible to alter once they’re live, so any oversights or coding errors would be a major liability. This is exemplified by the most famous DAO in Ethereum’s history, simply called The DAO, which was exploited by hackers to steal about $60 million of investors’ funds. The money was eventually returned, but The DAO Event serves as a stark warning for what can happen if coding is flawed.
Probably the most exciting use of the Ethereum network is decentralized applications, better-known as dapps. A dapp is exactly what it sounds like: an application that utilizes the decentralizing power of the blockchain.
Dapps have several advantages over traditional applications. Perhaps the biggest is that dapps have no central point of failure. It’s common today to hear about thousands or millions of people’s data being compromised or stolen as a result of hacks or server malfunctions — the Equifax scandal in 2017 comes to mind. Dapps don’t suffer from these types of problems because of the security and decentralization of the blockchain.
Beyond security, another advantage of dapps over traditional applications is that dapps are not susceptible to server outages. Dapps are maintained by a network of thousands of nodes which act as mini-servers. A dapp could only be “down” if the entire network were down.
Best of all, dapps don’t require any change in the front-end user interface, meaning that dapps can reap all the benefits of decentralization while remaining indistinguishable to most users from the traditional applications they are used to.
The most convenient way to buy Ethereum is on an online exchange. Exchanges allow users to buy, sell, or trade Ethereum for fiat currency or alternative cryptocurrencies. There are many exchanges to choose from and they each have their pros and cons.
Here’s a quick look at some of our favorites exchanges:
- Coinbase – Coinbase is one of the oldest and most trusted exchanges around today. Its website is very intuitive and allows users to easily buy or trade 4 of the most popular cryptocurrencies: Ethereum, Bitcoin, Litecoin, and Bitcoin Cash. Coinbase charges very low transaction fees and allows users to purchase the above cryptocurrencies using credit cards, debit cards, and bank transfers. Coinbase is particularly good if you’re new to cryptocurrency, though it may lack some of the bells and whistles of other exchanges.
- Gemini – Gemini is a great option for those looking for a slightly more advanced trading platform. Founded in 2015, Gemini is a relatively young exchange but it’s quickly become one of the most popular. Gemini offers some more sophisticated trading technology compared to Coinbase but still remains pretty user-friendly. One of Gemini’s big selling points is its very low fees, averaging around 0.25% or less. Gemini allows users to buy either Ether or Bitcoin using ACH bank transfers and bank wires.
- GDAX – GDAX is another great option for more advanced cryptocurrency trading. This exchange is owned by the same company as Coinbase and holds a similar industry reputation. The difference is that GDAX is less user-friendly and geared more toward serious traders. Like Gemini, GDAX charges very low fees of 0.25% or less and accepts ACH bank transfers or bank wires.
These are just three of the numerous exchanges on which users can buy Ethereum. For a more in-depth look at these and other exchanges, check out our guide to the Best Bitcoin, Ethereum, and Altcoin Exchanges of 2018.
Before purchasing any Ethereum though you’ll first want to make sure that you’ve set yourself up with an Ethereum wallet. Wallets serve the important function of protecting your Ethereum when it’s not in use.
Your wallet doesn’t actually store your ether. Instead, wallets store the alphanumeric keys and addresses that allow you to send or receive ether.
Private Keys and Ethereum Addresses
A private key is a long string of alphanumeric characters that is used to “sign” transactions to verify that you are the one sending your ether. As the name suggests, it is critical that you keep your private key secret. Anyone with knowledge of your private key would be able to steal your ether. Protecting your private key is your wallet’s primary purpose.
Ethereum wallets also store your Ethereum addresses. An Ethereum address is another long string of alphanumeric characters, but an address is used for receiving ether instead of sending it. It is not necessary to keep your Ethereum address secret in the same way you keep your private key secret. Your Ethereum address is cryptographically derived from your private key, but there is no way to determine your private key simply by looking at the address. Giving someone your address allows them to send ether to your wallet.
Ethereum wallets fall into 5 main categories:
- Online – Online wallets are accessible through a web browser. The main advantage of online wallets is that you can easily access them anywhere you can access the internet. The major downside is that your private keys are typically stored on the wallet’s servers, which means your ether is only as secure as their servers. For this reason, we only recommend using online wallets for small amounts of ether.
- Desktop – Desktop wallets are software programs that you install onto your computer. These wallets are typically more secure than web-based wallets because your keys are stored on your computer rather than online. That being said, your computer is still susceptible to viruses or other malware that might have the potential to steal your ether, so they still are not ideal for large amounts of ether.
- Mobile – Mobile wallets are apps installed onto your phone or tablet. Mobile wallets either store your private key locally on the device (similar to a desktop wallet) or they store your private key online (like a web-based wallet). Mobile wallets offer the convenience of being able to use your ether on the go, but they also suffer from the same security risks as online or desktop wallets.
- Hardware – Hardware wallets are physical devices that store your private keys offline in “cold storage”. These devices are small and plug into your computer via USB whenever you need to access your ether. These hardware devices are immune to viruses and are generally considered to be the most secure wallets available. The only real downside of hardware wallets is that you have to pay for the physical hardware, though recent wallets like the Nano Ledger S are very affordable.
- Paper – Finally, paper wallets are an alternative method of offline cold storage. They are physical pieces of paper with your public and private keys written on them. Paper wallets are generally inferior to hardware wallets, as they are both less convenient and less secure.
Once you’ve selected wallet type and purchased some Ethereum from an exchange, you’re ready to start making transactions using Ethereum.
Ethereum transactions work in much the same way as Bitcoin transactions. Paying someone in Ethereum is as simple as entering in their address along with the amount you’d like to send.
Receiving ether is equally simple. Just give the other party your address and they can send you the ether.
- Broad range of applications – The biggest thing Ethereum has going for it is that it is much more than just a cryptocurrency. Ethereum is first and foremost a blockchain-based software platform. Ethereum’s blockchain is already being used as the foundation for thousands of applications, and the possibilities for future applications are limited only by programmers’ imaginations.
- Supported by other coins – One kind of application that naturally lends itself to being built on a blockchain is of course a cryptocurrency. Sure enough, the Ethereum network serves as the foundation for hundreds of smaller coins. Most of these small tokens adhere to what’s called ERC-20, which is essentially a set of rules that define how tokens should operate on the Ethereum network. Because most tokens follow these rules, tokens of different types can be used the same all across the Ethereum network. These smaller coins bolster the value of the Ethereum network as a whole.
- Central leadership – Ethereum is backed by an organization with leaders and developers actively trying to make Ethereum succeed. This stands in contrast to Bitcoin, which was created by an almost mythical individual going by the name Satoshi Nakamoto, who wrote the Bitcoin white paper and then disappeared not long after. The team behind Ethereum regularly updates the platform and advocates for it in the world. This type of leadership could help Ethereum grow and adapt to the needs of its users over time.
- All the other benefits of a cryptocurrency – As a blockchain-based cryptocurrency, ether enjoys many of the same advantages as other cryptocurrencies like Bitcoin. Namely, the Ethereum network is secure, pseudoanonymous, decentralized, and international.
- Volatility – Much as Ethereum shares many of the same advantages as other cryptocurrencies, it also shares many of the disadvantages. Probably the most significant of these is that Ethereum is very volatile. The value of 1 ether rose by over 10,000% over the course of last year, so the overall trajectory has been incredibly positive. But market swings can be drastic, and it’s common to see the value of Ethereum go up or down by 5 percent or more in a single day. As with any other investment, only invest what you can afford to lose.
- Smart contracts are only as secure as they are programmed to be – This one is fairly self-explanatory. The Ethereum network as a whole is incredibly secure. Individual smart contracts, however, may be less-so. That being said, this is becoming less of an issue as developers on the platform are becoming more experienced coding these types of applications. Plus, many of the basic smart contracts that most users use have become standardized and are completely safe.
- Central leadership, again – It might seem silly to have central leadership as both an advantage and a disadvantage, but some cryptocurrency insiders see Ethereum’s leaders as more of a threat to the network than a benefit. This is exemplified by how The DAO Event was resolved. I mentioned earlier that investors in The DAO whose money had been stolen eventually had their money returned. Technically this shouldn’t have been possible as all Ethereum transactions, like Bitcoin transactions, are final. But the Ethereum leaders decided to step in and essentially rewrite the block on which the money was stolen. Some thought this move was justified, while others said that it compromised the integrity of the network. This divided the Ethereum community and resulted in two separate networks: Ethereum (the primary network and the subject of this article), which was built off of the rewritten block, and Ethereum Classic, which continued their own blockchain based off of the original unchanged block. The decision is still contentious and raises questions about how decentralized the network truly is.
Calling Ethereum a cryptocurrency feels insufficient, because it is so much more than that. Ethereum is a platform that allows developers from all around the world to utilize the power of blockchain technology for any application they want to create. Smart contracts and dapps have the potential to revolutionize a wide range of industries, and given that Ethereum has only been live for about 2 years, that potential has only just begun to be explored.
This expansive network puts Ethereum in a truly unique position in the cryptocurrency world. Owners of ether have more than just a piece of digital currency; they have a stake in something special.
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