What is Ethereum and how does it work?

Ethereum represents a form of digital currency or cryptocurrency, operating purely in the digital realm. As one of the leading cryptocurrencies, it stands second in market capitalization (as of April 2022), trailing only Bitcoin, which is often seen as synonymous with cryptocurrency.

The world of cryptocurrency is marked by diverse opinions, ranging from advocates who see it as the future of payments to skeptics who regard it as a speculative bubble. This section aims to explain what Ethereum is and the mechanics of how it functions.

What is Ethereum?

Ethereum, among the myriad of cryptocurrencies emerging in recent years, was launched in 2015 by a team of eight co-founders. It’s not just a cryptocurrency but also a platform, with the cryptocurrency known as Ethereum and its units referred to as ether (e.g., 2 ether, 17 ether).

Functioning on a decentralized computer network or a distributed ledger known as a blockchain, Ethereum meticulously records and manages every transaction. This blockchain can be visualized as a continuous ledger documenting every transaction in the cryptocurrency’s history. Network computers validate these transactions, maintaining the data’s integrity.

The decentralized nature of Ethereum, like other cryptocurrencies, is a significant draw. It enables users to transfer funds without a central authority like a bank. The absence of a central banking system grants the currency a high degree of autonomy. Furthermore, Ethereum facilitates nearly anonymous transactions, even though these transactions are recorded on the public blockchain.

While commonly referred to as a currency, it’s perhaps more accurate to view crypto as a token with specific applications enabled by the Ethereum platform. Beyond monetary transactions and trading, Ethereum’s capabilities extend to supporting smart contracts and various applications.

What does Ethereum do?

Ethereum serves as a multifunctional platform enabling various applications:

• Currency Usage: Through a digital wallet, individuals can transfer and receive Ether. It’s also used for payments where digital currency is accepted. Platforms like Coinbase offer options to store coins in digital wallets, potentially reducing vulnerability to hacking.
• Smart Contracts: These are self-executing contracts with the terms directly written into code. They automatically implement when predefined conditions are met, operating without the need for intermediaries.
• Decentralized Apps, or dApps: Ethereum is the backbone for various digital applications. These dApps enable activities such as gaming, investing, money transfers, portfolio management, social media engagement, and more.
• Non-Fungible Tokens (NFTs): Ethereum facilitates the creation of NFTs, enabling artists and creators to directly sell artworks and other items to purchasers through smart contracts.
• Decentralized Finance (DeFi): Ethereum’s platform allows users to conduct financial transactions outside the realm of centralized government oversight, potentially offering more freedom in the movement of money and assets.

It’s perhaps more precise to view Ethereum as a token fueling a variety of applications, rather than just a cryptocurrency facilitating peer-to-peer monetary transfers.

Where do ether coins come from?

As of April 2022, the total number of Ether, Ethereum’s cryptocurrency, was approximately 120.4 million. Unlike Bitcoin, which has a capped limit of 21 million coins and sees diminishing new issuances each year, Ethereum’s annual coin production is restricted but not capped. This is in stark contrast to Dogecoin, which has no limit on coin production.

In the realm of cryptocurrencies like Ether, coins are ‘mined‘ by network computers through complex mathematical computations, unlocking coins or their fractions.

However, significant changes are on the horizon. Both Bitcoin and Ethereum currently operate on a ‘proof-of-work’ system for mining new coins and validating transactions, a process known for its high energy consumption and time intensity, often leading to network congestion. To address these issues, Ethereum is transitioning to a ‘proof-of-stake’ system, commonly referred to as Ethereum 2.0.

Under this new system, coin creation is linked to the role of validators, who are responsible for managing and authenticating transactions within the cryptocurrency network.

Ethereum moves to proof-of-stake

In 2022, Ethereum is set to transition to a proof-of-stake protocol, an upgrade commonly referred to as “The Merge.” This significant change will alter the operational framework of the Ethereum network.

Under this new system, the process of verifying transactions will shift from miners to holders of substantial Ethereum stakes. These validators will ‘stake’ their Ethereum as a guarantee and receive ether rewards for accurately validating transactions. However, there is a risk involved: if they approve transactions that violate Ethereum’s guidelines, they could lose their staked investment. This system also opens opportunities for smaller investors, allowing them to participate and earn rewards by allocating their coins to a validator.

The transition is anticipated to reduce the overall supply of ether, as transaction fees will be ‘burned’ or permanently removed from circulation. This reduction in supply could potentially trigger a deflationary trend, potentially increasing the value of the cryptocurrency.

Is Ethereum a good investment?

Ethereum’s value has seen a significant increase in recent years, benefiting long-term holders. However, rather than being swayed by past price trends and the fear of missing out, it’s crucial to comprehend the nature of your investment. Ethereum, like many other cryptocurrencies, lacks backing by tangible assets or cash flows.

This distinction may seem minor, but it’s a fundamental difference between cryptocurrencies and stocks. Owning a stock means holding a share in a company, with its value linked to the company’s profitability and growth. Stockholders legally own a part of the company’s assets and earnings.

On the other hand, Ethereum and most other well-known cryptocurrencies have no physical backing. Their value is primarily upheld by the optimism of investors, who hope to sell at a higher price to others in the future. This concept, known as the “greater fool theory,” implies that speculation is the primary driver of Ethereum’s and other cryptocurrencies’ value increase.

Consequently, investment experts like Warren Buffett remain skeptical about cryptocurrencies, with Buffett even labeling them as extremely risky. His stance offers insight into the long-term value proposition of such digital assets.

Should you buy or mine Ethereum?

When considering investing in Ethereum, purchasing and trading the cryptocurrency through well-known platforms like Robinhood or Binance.US is a straightforward option. These platforms offer round-the-clock market access and high liquidity, which means your transactions are less likely to significantly impact the market price. The profit calculation is straightforward: you gain when you sell your coins for a higher price than your purchase cost.

On the other hand, mining Ethereum requires a business-minded approach. This involves a substantial investment in mining hardware to generate the cryptocurrency, alongside the ongoing expense of electricity. It’s crucial to evaluate whether the cost of mining is outweighed by the value of the mined coins.

It’s also essential to note that Ethereum is transitioning to a proof-of-stake model, eliminating the need for miners. In this new system, validators will be responsible for verifying transactions. Given this shift, Ethereum developers advise against investing in new mining equipment.

Ultimately, buying Ethereum tends to be simpler and less labor-intensive than mining. While mining may still offer profit opportunities, it’s necessary to carefully assess whether the potential returns justify the investment.

Bottom line

Investors have the option to directly invest in cryptocurrencies like Ethereum, or alternatively, they can invest in businesses that stand to gain from the shift towards digital currencies.

For those trading in Ethereum, Bitcoin, or related cryptocurrency companies, it’s crucial to be aware of the inherent risks, which can include the total loss of the investment. Given the volatile nature and numerous uncertainties associated with cryptocurrency, a cautious investment strategy is advised. Investors keen on exploring this arena should ensure they only invest what they can afford to lose.

Learn more:

• 12 most popular types of cryptocurrency
• Cryptocurrency taxes: A guide to tax rules for Bitcoin, Ethereum and more
• How to bear the bear market: Web3 tips

Editorial Disclaimer: We strongly recommend that all investors conduct thorough independent research into investment strategies prior to making any investment decisions. It’s important to note that past performance of investment products does not guarantee future price appreciation.