April 9

What is Ethereum: The Ultimate Investor Guide

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What is Ethereum?

In the space of a decade, cryptocurrency has exploded from an obscure technology used mainly by geeks and hackers into an emerging asset class worth more than a trillion dollars. Mainstream financial institutions like Blackrock and Fidelity have now entered the Bitcoin market, and major corporations are adding it to their balance sheets too. 

Much of the hype surrounding cryptocurrency has been focused on Ethereum. Some believe it’s going to revolutionize every aspect of human life. Others think it’s the most grandiose scam in history. This article will bring you up to speed on what Ethereum is, where it comes from, how it works, and the main arguments for and against it as an investment.

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Ethereum Explained to a Six Year Old

Computers work by using programs which tell the computer what to do. A math quiz program could look like this: ASK {What is 2+2?} IF the answer is “4,” THEN say “Right!” IF the answer is not “4,” then say “Wrong!"

The problem is that the program is stored in the memory of the computer. So if someone wants to cheat, they can go into the memory and change the program so that it says “IF the answer is 5, then say “Right!” This way, even if the cheater gets the question wrong, they still get the point. 

With Ethereum, programs are stored on thousands of computers all around the world in a way that makes it so no one can change the program, so no one can cheat. This is especially important if programs are going to be sending money. 

If programs can send money, they can do all kinds of things that right now have to be done by people, like buying, selling, and paying fees and taxes, and even counting votes. This can save a lot of time, which means saving a lot of money. And that makes some people think Ethereum could be worth a lot of money in the future.

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The Origin of Ethereum

When Satoshi Nakamoto developed Bitcoin, he included a feature called OP_RETURN. This feature was originally intended to support Bitcoin’s functionality, but it also made it possible to store any kind of data on the blockchain.

The invention of Bitcoin enabled people to trust the authenticity of a transaction without the need for a third party to verify it. This worked very well with financial data, so some people started to wonder if you could store executable computer code on blockchains. This would make it possible to achieve the same kind of trust in programs. Since all data on the blockchain is “written in stone,” so to speak, it would be possible to be assured that no one could tamper with a program.

In 2013, Russian-Canadian programmer Vitalik Buterin, who was 19 years old at the time, began exploring this possibility. One project called “Counterparty” was using OP return to create the world’s first digital asset exchange on Bitcoin’s blockchain. Bitcoin developers were concerned about the blockchain becoming bloated with data, so they reduced the amount of data supported by OP return from 80 bytes to 40 bytes, making Counterparty non-functional. 

At this point, Buterin realized that it wouldn’t be possible to build his idea of a medium for decentralized applications on Bitcoin. Instead he turned to Primecoin, another smaller blockchain project, before deciding to build his own blockchain from scratch. 

He then teamed up with Anthony Di Iorio, Charles Hoskinson, Mihai Alisie, Amir Chetrit, Joseph Lubin, Gavin Wood, and Jeffrey Wilcke to launch Ethereum as an independent platform. Most of these founders have since gone on to start other lucrative blockchain projects, some of which now directly compete with Ethereum. 

The project was first announced at a Bitcoin conference in Miami in January of 2014. Six months later, the founders met in Switzerland where a company, EthSuisse, as well as a non-profit, the Ethereum Foundation, were established to oversee development.

The team financed development through a crowdsale of Ether, Ethereum’s native currency. This was the first crowdfund in what became the ICO craze just a few years later. The team raised over 30,000 Bitcoin by selling over 50 million Ether, worth around $18 million USD at the time. 

Related: How to Add Cryptocurrencies Like Bitcoin and Ethereum to Your IRA (Tax & Penalty Free)

How Ethereum Works

Ethereum works much like Bitcoin, except that much more data can be stored on the blockchain. Like Bitcoin, thousands of computers around the world (nodes) store complete copies of the blockchain, meaning the data is immutable. 

Miners compete for the privilege of adding a block to the blockchain by collecting transactions and data from anyone seeking to add it. In exchange for their efforts, they have a chance at winning a block reward and fees.

This makes it possible to create decentralized applications, or dapps, since the code that applications and programs are made up of can be stored on the blockchain. The simplest type of dapp is a smart contract. A smart contract is a program which can move money automatically and trustlessly. 

Ethereum’s native currency is called ether and is often represented by the symbol ETH. Ether also functions as gas, which is used to pay for operations on Ethereum. The price of gas in terms of Ether may increase or decrease according to supply and demand.

Buterin developed a programming language called Solidity especially for Ethereum smart contracts. Solidity is relatively easy for both machines and humans to read, making it well suited to contracts. Ethereum also contains the Ethereum Virtual Machine (EVM) which is a runtime environment for applications on Ethereum.

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Differences Between Ethereum and Bitcoin

Since Ethereum runs applications, it needs to be much faster than Bitcoin. With Bitcoin, a block is added to the blockchain approximately every 10 minutes. Ethereum adds new blocks at a rate of 1 per 13 seconds. 

Ethereum’s supply is not capped, which means the total number of ether will always continue to grow. This reflects the fact that Ethereum, unlike Bitcoin, is not designed to be money. 

In terms of economic philosophy, the Ethereum community tends to be more politically liberal, whereas Bitcoin is dominated by a more libertarian outlook. This is one reason why Ethereum is moving to the less energy intensive Proof of Stake instead of Proof of Work.

Related: Ethereum IRA Rollover Guide - How to Buy Bitcoin, Ethereum, Litecoin, and Other Cryptocurrencies with Your 401(k)

Ethereum’s Value Proposition

Ethereum has a huge range of theoretical applications, and it’s likely that many uses have still not been discovered. Only a few of these applications have actually been tested as real world services, while others have been tested as prototypes. 

Following is a discussion of a few of the uses of ethereum and the industries they could potentially disrupt.

Smart Contracts

Traditional contracts depend on a number of actors. Consider a real estate purchase contract, for example. You might need:

  • a real estate agent to draft it 
  • a notary to notarize it 
  • a government to guarantee it 
  • a bank to transfer the money 
  • an escrow service to hold the money while the title transfers 
  • another bank to transfer the money to the seller. 

It’s necessary to trust the notary to verify the identity of the buyer and seller. You have to trust the government to keep accurate records of the property ownership (a big problem in some countries). You need to trust the banks that transfer the money not to disappear with your money (which has also been a problem at some times in history), and you need to trust the escrow service to hold the money. 

Theoretically, it’s possible to use Ethereum to do all of this. With Ethereum, you can use a unique and unforgeable private key for digital identity, making fraud almost impossible. The blockchain is secure and fully transparent, so you can verify the availability of funds without trusting any third party. 

The title of the real estate can be securely stored on the blockchain, and the funds can be held inside the smart contract. The transfer of funds and ownership can take place securely and automatically without the need for any other intermediaries.

This works with any kind of contract, and there are far more contracts in our lives than we even realize. Even elections are a form of contract. Voters agree that they will cast their votes, and whoever gets more votes will be elected. Gambling is also a contract; for example, if Brazil wins the world cup, you pay me. If they lose, I pay you. 

Dapps (Decentralized Apps)

If you think about it, many apps are just a framework for contracts. Uber, for example, facilitates contracts between someone who has a car and someone who wants a ride. AirBnB facilitates contracts between a person who has a room, house, or apartment to rent, and someone who needs a place to stay. 

Uber and AirBnB achieved massive valuation by disrupting the taxi and hotel industries, respectively, but they charge hefty fees for their services. This is partly because they act as a guarantor between the two parties, securing the transfer of money and data between transacting parties. 

With a decentralized network, there is no need for a trusted third party to secure the transfer of money or data since the network is already secured. This means a large amount of legal and administrative tasks can be automated, lowering costs for end consumers and increasing profits for service providers.

Digital Assets (Tokens)

One of the things that a smart contract on Ethereum can do is issue a token. These tokens exist on the Ethereum blockchain, but act as their own currencies. They may be fungible or non-fungible, and can represent any kind of asset in the same way that shares of stock represent ownership in a company.

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Industries that Could be Disrupted by Smart Contracts and Dapps

There’s a wide range of industries where smart contracts and dapps could add value.

Accounting.  Trust in corporate accountability and government would be greatly enhanced by transparency in accounting.

Arbitration. Deposits can be a means of incentivizing arbitration, for example in international trade deals.

Crowdfunding. The most prominent use of Ethereum to date, tokens generated by smart contracts are used to crowdfund projects.

Education and Academia. It may be possible to eliminate the need to verify the authenticity of degrees through correspondence with universities. 

Car Leasing and Rental. ID verification, security deposits, verification of all documents, and funds transfers can all be automated.

Insurance. Ownership of assets and issuance of insurance policies can be automated.

Loans and Credit. In conjunction with blockchain based credit algorithms, loan underwriting and disbursement can be automated.

Finance, Markets and Exchanges. Financial markets require large institutions to regulate the authenticity and issuance of all kinds of financial assets. Many of these institutions could be rendered obsolete by tokens and decentralized, online exchanges.

And much more... There are many other theoretical applications which have been proposed or are currently being investigated by researchers.

Related: Invest in Ethereum with Coinbase.com - the Oldest and Largest U.S. Based Cryptocurrency Exchange

Ethereum’s Future Valuation 

The number of industries that could be disrupted by Ethereum is quite broad, so if it can even capture a fraction of this potential market, Ether’s valuation would be huge. The overall supply of Ethereum is unlimited, but the expansion of the supply is scheduled to slow such that price growth in the long term would be likely if it catches on. 

Criticism

Ethereum has received its fair share of criticism.

Proof of Stake

Many cryptocurrency advocates strongly oppose proof of stake consensus. Although it is more energy efficient, it awards money to those who already own Ether. Many worry that this could lead to centralization of the network, rendering it more vulnerable to 51% attacks. Another theoretical problem with proof of stake is the “nothing at stake” problem.

Centralization

The reason Bitcoin developer nixed those trying to run more operations on the blockchain is concerns about centralization. Bitcoin’s main value proposition is its immunity to government intervention. Storing more code on the blockchain means a much larger blockchain, and much more intensive technical requirements to maintain a copy of it.

This means that Ethereum’s blockchain is growing at a much faster rate than Bitcoin’s, which makes it much more difficult for ordinary people to mine Ether. Some fear this could render the network vulnerable to government censorship or attacks. 

Premine

Ethereum had a substantial premine which has been the subject of much criticism. A large percentage of the initial supply was distributed to a relatively small group. The majority of Ethereum’s total supply, approximately 70 million ether, were distributed to the developers and initial investors.

This already centralized distribution will become more centralized under proof of stake consensus, which some worry could lead to manipulation.

Competition

Ethereum faces intense competition from a wide range of projects aiming to set the standard for application platforms. Most prominent among these are Polkadot and Cardano, both founded by Ethereum co-founders. Both Polkadot and Cardano surged in value in 2020 and early 2021, narrowing Ethereum’s lead on the market. 

These projects argue that they were able to learn from some of Ethereum’s early mistakes and build their platforms with better technology from the ground up. 

User Experience

Although Ethereum’s block speed is much faster than Bitcoin’s, dapps on Ethereum are still no match for normal apps running on centralized servers. Running apps on a decentralized network is much more expensive, which raises the question, how many applications actually need to be decentralized?

There are many centralized blockchain networks attempting to compete with Ethereum. Like IBM’s Hyperledger, by offering better performance to those who don’t care as much about decentralization. While Ethereum’s theoretical potential is impressive, the user experience will have to get much faster to achieve mainstream adoption.

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Scaling 

Ethereum developers have spent the last several years trying to make the network more scalable. The much hyped Ethereum 2.0 update was hoped to improve the amount of operations the network can handle without slowing down, but has been delayed several times. 

Scams

Ethereum has enabled a huge number of scams, most notably during the ICO craze. Many hucksters and charlatans happily used Ethereum to scam investors out of millions, or even billions of dollars, with empty promises of revolutionary technology. Ethereum advocates argue that Ethereum should not be blamed if bad actors abuse the technology for personal gain. After all, the same can be said of the internet in general.

Ethereum has also been accused many times of being a scam itself. The valuation of Ether is still largely speculative, and it’s hard to say if the network is really on track to fulfill its lofty potential. Some accuse it of being vaporware, a term for software which is sold before it is actually functional so that developers can live off of investor money.

These accusations are countered by those who point out the many functional dapps running on Ethereum, but the user counts of these dapps remain relatively low. In traditional valuation schemes of software development, the levels of adoption would not be sufficient to justify the network’s valuation. But then again, cryptocurrency is a very different animal than traditional investment.

The Future of Ethereum

The main advantage Ethereum has going for it at the moment is first mover’s advantage. As the first network of its kind, a huge amount of momentum has gathered behind it. Many developers are now comfortable working with Solidity, and there’s a large library of resources for anyone wanting to build on Ethereum. 

This is not likely to be a “winner takes all” scenario, however. Ethereum places more emphasis on decentralization than many of its higher performance competitors, so those applications that don’t need decentralization are likely to end up on other platforms. If Ethereum can overcome its scaling challenges, however, it may still have a chance at realizing its dream of becoming a “world computer.”

At present, much of Ethereum’s value is based on speculation about potential future uses. To sustain or expand that valuation, Ethereum will need to become useful enough to generate strong demand for Ether. 

To assess if this is happening, it will be important for investors to keep a close eye on real progress and distinguish hype from reality. What kind of revenue are Ethereum dapps actually generating? What real productivity gains are they enabling? 

It will be equally important to watch Ethereum’s competitors. There has already been some migration of projects to other platforms. Ethereum is still dominant, but cryptocurrency moves fast, and the tide could quickly turn.

It’s too early to say if Ethereum will be an Amazon or a Yahoo of the current wave of development. In fact, it’s too early to say for sure if blockchain platforms in general will be able to live up to the grand expectations surrounding them. If they do, though, Ethereum remains poised to remain a dominant player in the space. 

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About the author 

Ilir Salihi

Ilir is passionate about personal finance, investing, and digital marketing. He's written about precious metals and cryptocurrencies since 2013. When he's not publishing new content, he's spending time at home in Washington, D.C. with his family.

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