How Does Ethereum Work?

Welcome to another article from Run The Chain’s Crypto Classroom. Today we’ll be discussing how does Ethereum work? As we’ve just learned, Ethereum is “programmable money” powered by the blockchain. Now you understand that though, you no doubt want to know how it works.  

We’re going to look under the hood of the Ethereum Network and examine a few of the technologies that make it possible.  These technologies are what allow developers to deploy smart contracts, creating more complex ways to move capital around the blockchain. This is what has given rise to DEXes, DeFi, and many NFT projects.

Distributed Public Ledger Technology

Like Bitcoin and other cryptocurrencies, Ethereum is based on a distributed public ledger that will verify and store all the transactions on the network. We estimate the Ethereum Network to contain over 300,000 different nodes, each one of which is hard at work verifying the over 1 million transactions that occur on the network everyday. 

Every single transaction can be verified by every single node. If there are any discrepancies between nodes, whichever ledger that has the most votes from across the network adopts as the legitimate one. This prevents malicious actors from creating their own version of the ledger that attributes them an unfair amount of funds.

We’ll go into a lot more detail about what a distributed public ledger is in our “What Is Blockchain?” lesson.

Proof-of-Work

In the last lesson, you learned a little about proof-of-work and proof-of-stake. Now we’ll explain exactly why these mechanisms are necessary. 

One potential problem with verifying transactions through a voting process is that users could potentially set up many cheap nodes which could see a small party gain a large proportion of the voting rights. This would, of course, be a major problem as this party could add ineligible transactions to the ledger and send funds to their own account. 

The way around this, is to weight each node’s vote according to the amount of computational power they contribute. Each node must solve complex cryptographic problems. The shorter the period the problem is solved in, the more weight that node’s vote carries. It costs money to run a machine that will solve these problems which makes it too costly to hold a controlling voting stake on the network. Owners of nodes are compensated through newly minted Ether, Ethereum’s native token, that is added to their accounts.

This year, however, Ethereum is undergoing a massive overhaul that will see it change from proof-of-work to proof-of-stake. This means that we weigh votes on the amount of Ether that you stake on the node. By removing the need to perform complex computation problems it will dramatically decrease the energy output of the Ethereum network.

Programmable Money

All of these features, apart from the upcoming transition to proof-of-stake, are shared by Bitcoin. It is the Ethereum Network’s programmability that has made it the most used cryptocurrency. Each node on the network can also perform computational calculations as asked of it by developers. This allows developers to create smart contracts that provide more complex processes for users’ money. 

For example, AAVE is an open-source, decentralized lending protocol built on the Ethereum platform. Users can borrow many different cryptocurrencies from a smart contract, with funds by other users, by locking in collateral in the form of another currency. Users who have contributed to the pool will earn a return from interest paid out. This system is completely trustless. If they do not return the loan the collateral releases to the lender. 

This is just one example though. Through its programmable nature Ethereum has facilitated the rise of a completely decentralized ecosystem offering hundreds of different financial services and consisting of thousands of different protocols.

Layer-2 Settlement

One constant issue with Ethereum is that fees regularly run into the hundreds of dollars. Because every single transaction needs validation by every single validator, there is a massive cost every time exchanging any currency on the network. 

This has given rise to layer-2 settlement protocols. Protocols will settle many different transactions themselves and then send the transactions as a bundle to the main Ethereum Network. This can dramatically decrease both the time and cost of each transaction paving the way for the Ethereum Network to become much more accessible to smaller crypto holders. There are many of these layer-2 protocols, sometimes called roll-ups, on Ethereum but the most popular include Polygon, Cartesi and Arbitrum.

Conclusion

Ethereum is the second biggest chain in the crypto sphere by its market cap. However, it is by far the biggest considering the amount of capital and daily transactions. Ethereum is a far more flexible tool for developers than Bitcoin. Furthermore, this has led to many investors espousing its potential to integrate with NFTs, the metaverse, and other huge shifts that are leading us towards Web3.0.

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