What is Ethereum? The Ultimate Guide to Understanding ETH

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If you are starting to explore blockchain technology, the first two names you will likely encounter are Bitcoin and Ethereum. These two giants hold the majority of value in the blockchain industry. While Bitcoin primarily functions as a digital asset and a system for transferring value, Ethereum is built to be much more.

Think of Ethereum as a global, decentralized computer. Its protocol allows users to run programs and perform various operations, offering a platform for decentralized applications (DApps) and smart contracts. This innovation laid the foundation for the rise of Decentralized Finance (DeFi), Real World Assets (RWAs), Non-Fungible Tokens (NFTs), and nearly every other use case within the Web3 ecosystem.

This guide explores Ethereum’s structure, uses, and underlying mechanisms to help you understand what makes it a foundational technology in the blockchain space.

Understanding Ethereum: A Blockchain Network

At its core, Ethereum is a blockchain network. It operates as a public database maintained by a vast network of computers, known as nodes, which update and sustain the system collectively in real time. Ethereum records and updates this database's state in units called blocks. Each block references its predecessor, forming a continuous chain known as the blockchain.

To ensure all nodes agree on the state of the blockchain, Ethereum employs a consensus mechanism called Proof of Stake (PoS). This system is energy-efficient and enables the network to process transactions and execute smart contracts reliably.

Broad Use Cases of the Ethereum Network

Ethereum’s versatility allows it to serve multiple functions within the digital economy.

A Peer-to-Peer Network and Decentralized Ledger

The Ethereum network uses Ether (ETH) as its native cryptocurrency. Similar to Bitcoin, Ethereum enables peer-to-peer (P2P) transfers of Ether, allowing users to send and receive value without intermediaries. The Ethereum protocol facilitates these P2P transactions and compensates validators—participants who help secure the network—with ETH.

A Decentralized, Censorship-Resistant Computer

Beyond simple value transfers, Ethereum functions as a single, canonical computer known as the Ethereum Virtual Machine (EVM). Nodes can request the EVM to perform computations, which every participating node executes to verify correctness. These computation requests consume resources and are paid for using a metered system called gas, measured and paid in denominations of Ether.

This setup ensures the network remains efficient and resistant to censorship. As long as you have an internet connection, no one can prevent you from interacting with the network. Cryptographic mechanisms ensure that once transactions are verified and added to the blockchain, they cannot be altered.

A Source of Credible Block Space

Ethereum’s block space is considered one of the most credible, decentralized, and secure data spaces available. This credibility stems from Ethereum’s extensive validator network and substantial monetary resources, which collectively guarantee its security.

Other blockchain networks can leverage Ethereum’s credible block space to run their operations in a sandboxed environment within the Ethereum network. This allows them to benefit from Ethereum’s security and decentralization without building their own networks from scratch.

Transformative Use Cases Enabled by Ethereum

Fundamental Concepts in Ethereum Protocol

To grasp Ethereum’s full potential, it’s essential to understand its foundational components.

Ether (ETH)

Ether (ETH) is the native cryptocurrency of the Ethereum protocol. While it shares some similarities with Bitcoin, Ether’s purpose extends beyond being a store of value. It powers an ecosystem of decentralized applications, smart contracts, and financial instruments.

Ether and Bitcoin: Similar Foundations, Different Purposes

Ethereum maintains a canonical and immutable ledger of Ether transactions, much like Bitcoin does for BTC. Once a transaction is confirmed, it becomes part of Ethereum’s immutable ledger, meaning it cannot be altered or erased. This immutability is crucial for trust in the system.

Ether as the Medium of Exchange within Ethereum

On Ethereum, Ether is more than just a currency—it is also a network exchange medium. Running programs on the Ethereum Virtual Machine (EVM) requires computational power, which incurs a fee known as gas. Gas fees, paid in Ether, compensate validators for their work in verifying and securing transactions.

Ether’s Monetary Policy: Inflation and Burning

Ethereum’s monetary policy includes both inflationary and deflationary elements. New units of Ether are minted when a new block is created, contributing to a controlled inflation rate. However, a portion of gas fees is "burned" or permanently removed from circulation. This burning mechanism can reduce the total supply of Ether over time, depending on network activity.

Ether as a Tool for Network Security

Securing the Ethereum network requires participants to stake Ether. Validators must lock up a certain amount of Ether, which acts as a deterrent against malicious behavior. By staking, validators have a vested interest in the network’s success and integrity, as they risk losing their staked Ether if they act dishonestly.

Denominations of Ether: Wei and Gwei

Ether can be divided into smaller units, allowing for precise transactions. Common denominations include:

Ethereum Accounts

Ethereum accounts are fundamental to interacting with the network. They come in two primary types: Externally Owned Accounts (EOAs) and Contract Accounts.

Private Keys and Public Keys: The Cryptographic Foundation

Every Ethereum account is built on a private and public key pair, created using Elliptic Curve Digital Signature Algorithm (ECDSA) cryptography. The private key is a randomly generated 256-bit number kept secret, while the public key is derived from it and can be shared freely.

Externally Owned Accounts (EOAs) and Key Pairs

Most users interact with Ethereum using Externally Owned Accounts (EOAs), which are controlled by private keys. Each EOA has a public address—a simplified form of the public key—that represents the account. This address is used to send and receive Ether and tokens.

Wallets: A Practical Interface for EOAs

A wallet is a software or hardware interface that allows users to manage their EOAs. Wallets store and manage private and public keys, enabling users to send, receive, and view their assets. Wallets can be categorized as:

Contract Accounts: Extending Ethereum’s Utility

Contract accounts are controlled by code called smart contracts, not by private keys. They are created when users deploy smart contracts to the Ethereum blockchain. Unlike EOAs, contract accounts cannot initiate transactions independently; they must be triggered by an EOA.

Smart Contracts: The Core of Contract Accounts

Smart contracts are programs deployed on the Ethereum blockchain. When deployed, they become contract accounts with unique addresses, enabling others to interact with them. For example, a decentralized exchange (DEX) contract account could execute trades automatically based on predefined conditions.

Triggering Smart Contracts: Example of an EOA-Contract Interaction

Consider Alice wants to swap Ether for a token using a DEX smart contract:

  1. Alice’s EOA initiates the transaction by sending a message to the DEX’s contract account.
  2. The DEX contract account executes the predefined swap function and sends the token to Alice’s account.
  3. The transaction updates the balances and finalizes the blockchain’s state.

Each step consumes computational resources, paid for in gas fees.

Solidity: The Language of Smart Contracts

Smart contracts on Ethereum are typically written in Solidity, a programming language designed for the platform. Solidity allows developers to define functions, storage, and rules for contract accounts, making Ethereum a flexible platform for decentralized applications.

Ethereum Token Standards: Enabling Versatile Digital Assets

Ethereum supports various token standards, each designed for different types of digital assets.

ERC-20 Tokens: The Standard for Fungible Tokens

ERC-20 is the most common token standard, used to create fungible tokens—identical and interchangeable tokens. They follow standardized functions, ensuring compatibility across Ethereum-based applications. Examples include USDT (Tether), LINK (Chainlink), and UNI (Uniswap).

ERC-721 Tokens: The Non-Fungible Token Standard

ERC-721 is designed for non-fungible tokens (NFTs)—unique digital assets that cannot be interchanged. Each ERC-721 token has a unique identifier, allowing it to represent individual ownership. Examples include CryptoKitties and Bored Ape Yacht Club.

ERC-1155 Tokens: The Multi-Token Standard

ERC-1155 combines features of ERC-20 and ERC-721, ideal for creating collections that contain both fungible and non-fungible tokens. This standard is useful for gaming and other applications requiring multiple asset types. Examples include Enjin Coin and Gods Unchained.

Tokens as Token Contracts

Tokens on Ethereum are implemented as token contracts—specific types of smart contracts. Each token contract maintains its own ledger of transactions and balances. When you transfer a token, the contract updates its internal ledger to reflect the change.

Is Ether an ERC-20 Token?

Ether is not an ERC-20 token. It is Ethereum’s native currency, and the protocol natively tracks Ether transactions. ERC-20 tokens are additional assets created on Ethereum using smart contracts.

Ethereum Blocks: The Building Blocks of the Blockchain

Ethereum blocks are fundamental to the structure of the blockchain. They contain batches of transactions, essential data, and references to previous blocks.

Blocks as Batches of Transactions

Each block contains a hash of the previous block, linking it to the chain and forming an unbroken sequence. This structure ensures that every block is connected, making it impossible to modify a single block without altering the entire chain.

Ensuring Synchronization and Consensus

Blocks ensure all network participants maintain a synchronized state of Ethereum. When a new block is added, it updates the entire network with the latest set of confirmed transactions, achieving consensus among nodes.

Creating a Block: The Role of Validators

In Ethereum’s Proof of Stake (PoS) system, validators create new blocks. A validator is randomly selected to propose a block, which is then verified by other validators. Once validated, the block is added to the chain, and the proposer is rewarded.

Inside an Ethereum Block: Key Components

Ethereum blocks contain:

Proof of Stake: Ethereum’s Transition to Energy-Efficient Consensus

Ethereum transitioned from Proof of Work (PoW) to Proof of Stake (PoS) in September 2022 to improve sustainability, security, and efficiency.

Understanding Proof of Stake and the Role of Validators

In PoS, participants become validators by staking a minimum of 32 ETH. Validators propose and validate new blocks, participating in the finalization process to secure the transaction history.

Key Metrics of Ethereum’s PoS System

Liquid Staking and the Rise of LST Projects

Liquid staking allows users to retain liquidity on their staked assets. Users receive Liquid Staked Tokens (LSTs), representing their staked ETH, which can be used in other parts of the ecosystem. Popular liquid staking providers include Lido, Rocket Pool, and Puffer Finance.

Decentralized Applications (DApps) and DeFi

Decentralized Applications (DApps) operate on the Ethereum blockchain, leveraging its decentralized infrastructure to provide services without centralized control.

Execution in the EVM

DApps run within the Ethereum Virtual Machine (EVM), ensuring consistent execution across all network nodes. They are programmable through smart contracts written in Solidity.

Turing Completeness

The EVM is Turing complete, meaning it can perform any computation given enough resources. Gas fees prevent infinite loops and excessive resource consumption.

Prominent Categories of DApps in the Ethereum Ecosystem

  1. Decentralized Finance (DeFi)
  2. Real-World Assets (RWAs)
  3. Decentralized Physical Infrastructures (DePINs)
  4. Game Finance (GameFi)
  5. Social Finance (SocialFi)
  6. Liquid Staking
  7. Restaking
  8. Yield-Bearing Stablecoins
  9. Non-Fungible Tokens (NFTs)
  10. Decentralized Exchanges (DEXs)

What is Decentralized Finance (DeFi)?

DeFi refers to financial applications built on blockchain networks, primarily Ethereum, that operate without traditional intermediaries. It aims to create an open, permissionless, and transparent financial system.

Significance of DeFi

DeFi contrasts with centralized finance by offering more inclusive and censorship-resistant alternatives. Stablecoins, pegged to stable assets like fiat currencies, are integral to DeFi, serving as a stable medium of exchange.

As of November 2024, the total value locked (TVL) in Ethereum's DeFi ecosystem is approximately $192 billion, signaling renewed growth in the sector.

Blockchain Explorers: Windows into the Blockchain

Blockchain technology is transparent, with every transaction visible to the public. Blockchain explorers like Etherscan make this data accessible, allowing users to track transactions, inspect contracts, and analyze on-chain metrics.

Functions of Blockchain Explorers

Understanding Ether Monetary Policy

Ethereum has an infinite supply model, but mechanisms like EIP-1559 balance new ETH issuance with burning to control supply.

Ethereum Blocks and Supply Control

With Proof of Stake (PoS), ETH supply is influenced by network demand and gas fees. Validators create blocks in response to transaction demand, adjusting the overall ETH supply.

What is Gas?

Gas measures the computational resources required for on-chain transactions. Gas fees are determined by units of gas consumed multiplied by the current gas price.

EIP-1559 introduced a new gas fee structure:

Ethereum Block Breakdown and Gas Management

Ethereum targets a block size of 15 million gas, with a maximum limit of 30 million gas. The base fee adjusts based on block usage: increasing if blocks exceed 15 million gas, decreasing if they fall below.

Insights into ETH Inflation and Deflation

New blocks mint a small amount of ETH, but the base fee burn can make Ethereum deflationary during high-demand periods. This balance keeps Ethereum’s supply responsive to market conditions.

Ethereum Blockchain Layers: The Foundation of the Ethereum Network

Ethereum’s mainnet is organized into three core layers: Data Availability, Consensus, and Execution.

Data Availability Layer

Makes transaction data accessible to all participants, ensuring transparency and preventing data withholding.

Consensus Layer

Coordinates Proof of Stake (PoS), where validators agree on the blockchain’s state, ensuring security and decentralization.

Execution Layer (EVM)

Processes smart contracts and transactions, handling computations and updating account balances.

How These Layers Create the Ethereum Mainnet

These layers combine within validator nodes to form the Ethereum mainnet, providing distinct functionalities while remaining interconnected.

The Scalability Trilemma

Ethereum faces the challenge of achieving scalability, security, and decentralization simultaneously. The trilemma arises because emphasizing one goal can strain the others.

Rollup-Centric Roadmap: Ethereum’s Solution to the Trilemma

Ethereum adopted a rollup-centric roadmap, offloading scalability to Layer 2 solutions while the mainnet focuses on security and decentralization. Layer 2 protocols handle execution off-chain and submit data to the mainnet for security.

Scaling the Ethereum Ecosystem: The Rollup-Centric Roadmap

Ethereum’s rollup-centric roadmap involves separating core functions into distinct layers to achieve higher scalability.

Ethereum's Core Strength: Source of Credible Block Space

Ethereum’s extensive validator network provides the most secure and decentralized block space in Web3. Other networks can rent this space to secure their operations.

What is the Rollup-Centric Roadmap?

The roadmap outlines a strategy where the mainnet specializes in Data Availability and Consensus, while Layer 2 solutions handle execution. Rollups process transactions off-chain and return data to the mainnet for security.

The Ethereum Layer 2 Ecosystem

Layer 2 solutions (L2s) are separate blockchain networks that work alongside Ethereum to execute transactions efficiently while leveraging Ethereum for security.

How Ethereum Layer 2s Work

  1. Sequencer Nodes: Collect, validate, and execute transactions in batches.
  2. Batching Transactions and Validity Proofs: Construct validity proofs for batches.
  3. Posting Batches to Ethereum: Submit batches and proofs to the mainnet.
  4. Leveraging Ethereum’s Credible Block Space: Data is stored on Ethereum, ensuring availability.
  5. Cost Efficiency and Security: Batching reduces costs per transaction while maintaining security.

Proto-Danksharding: Making Credible Block Space Cheaper

The Dencun upgrade introduced EIP-4844 (Proto-Danksharding), which reduced the cost of credible block space for Layer 2 solutions by nearly 90%. It introduced blob data and blob gas, making data storage more efficient and affordable.

The Ethereum Roadmap: History and Future of Upgrades

Ethereum’s evolution is guided by Ethereum Improvement Proposals (EIPs), which propose changes to the network.

What Are EIPs?

EIPs are documents proposing new features or improvements. They undergo community discussion, testing, and incorporation into network upgrades.

Key Upgrades in Ethereum’s History

Account Abstraction: Simplifying Ethereum User Interactions

Account abstraction aims to make user interactions more flexible by allowing all accounts to operate like smart contracts.

EIP-4337: Decentralized Account Abstraction Without Consensus Changes

Introduces "User Operations" and "bundlers" to handle transactions without altering core consensus.

EIP-7702: Temporary Smart Contract Code for EOAs

Allows EOAs to set temporary smart contract code for individual transactions, enabling enhanced functionality.

Proposer-Builder Separation (PBS): Enhancing Security and Scalability

PBS divides validator responsibilities into block builders and proposers to optimize block space usage and address Maximal Extractable Value (MEV).

What is Maximal Extractable Value (MEV)?

MEV refers to profits validators can make by reordering, including, or excluding transactions. It can lead to security concerns like sandwich attacks.

How PBS Works

Block builders construct efficient blocks, which are auctioned to proposers. Proposers verify and accept the highest bid, ensuring transparent and efficient block production.

Danksharding: Ethereum's Vision for Full Scalability

Danksharding builds on Proto-Danksharding by increasing the blob limit per block from 6 to 64, enhancing capacity for rollup data.

Managing Increased Storage Requirements

Pruning blob data older than one month can free up space while maintaining data integrity.

Pectra: The Ethereum Meta EIP

The Pectra upgrade, scheduled for 2025, combines multiple enhancements:

What is Ethereum: Closing Thoughts

Ethereum has evolved from a single-layer blockchain into a complex ecosystem supporting a broad range of applications. Its versatility and adaptability have positioned it as the most comprehensive blockchain in scope.

Today, Ethereum resembles the internet itself—a vast, interconnected network of networks. It underpins the broader Web3 ecosystem, reflecting its continued expansion and profound influence on the digital world.

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Frequently Asked Questions

What is the difference between Ethereum and Bitcoin?
Bitcoin is primarily a digital asset and payment system, while Ethereum is a programmable blockchain supporting smart contracts and decentralized applications. Ethereum’s native currency, Ether, is used to power operations on its network.

How does Ethereum’s Proof of Stake work?
Proof of Stake (PoS) requires validators to stake ETH to participate in block validation. Validators are randomly selected to propose blocks, and others verify them. This system is more energy-efficient than Bitcoin’s Proof of Work.

What are gas fees?
Gas fees are payments made in Ether for computational resources used in transactions or smart contract executions. They compensate validators for their work and prevent network abuse.

Can Ethereum be used for purposes other than financial transactions?
Yes, Ethereum supports a wide range of applications, including decentralized finance, gaming, supply chain management, and digital identity verification, thanks to its smart contract functionality.

What is the role of Layer 2 solutions on Ethereum?
Layer 2 solutions enhance Ethereum’s scalability by processing transactions off-chain and submitting data to the mainnet for security. They reduce congestion and lower transaction costs.

How can I start using Ethereum?
You can start by setting up a wallet to hold ETH and interact with decentralized applications. Educate yourself on security best practices, and consider using Layer 2 solutions for a more efficient experience.