What is Ethereum?

Learning outcomes:

1. What Ethereum is
2. How smart contracts and the Ethereum virtual machine work 
3. The difference between Ethereum and Bitcoin 
4. How ‘the merge' moved Ethereum from Proof-of-Work (PoW) to Proof-of-Stake (PoS) 
5. The different Ethereum uses cases and ecosystem

What is Ethereum?

Ethereum is an open-source blockchain-based platform for deploying computer programs called smart contracts without going through a central authority.

Often dubbed ‘the world computer’, Ethereum’s smart contracts power an open marketplace of digital applications (dApps). From finance and governance to gaming and social media, dApps disrupt the permissioned models of Amazon, Google, and Facebook.

Ethereum also operates a native cryptocurrency called Ether (ETH) to charge dApps for renting its processing power. A decentralised network of computers records the balance of ETH accounts and the state of smart contracts, storing this information in the Ethereum blockchain.

Ethereum was conceived in 2013 by Canadian programmer Vitalik Buterin. Buterin’s idea evolved from an alternate decentralised payment network when he realised that blockchains could be used for exchanging more than just new forms of internet money. 

Ethereum launched in July 2015 and its success has inspired a growing ecosystem that supports billions of dollars of value. Rival blockchains, such as Solana and Cardano, seek to emulate and improve on Ethereum’s concept of decentralised computing. 

State changes & the Ethereum Virtual Machine (EVM) 

As with any computer system, Ethereum has its own language – Solidity – in which smart contracts are written. There is also a means to process the coded instructions within smart contracts called the Ethereum Virtual Machine (EVM).

The EVM is shared across the computers that make up the Ethereum network. Their job is to maintain a canonical version of the EVM; an indisputable and immutable source of truth on the state of the applications and accounts that Ethereum supports. 

Every time there is a change in a smart contract, or the balance of an account holding ETH, the transaction will be submitted to the EVM, and its state updated and recorded in the Ethereum blockchain, with the whole network agreeing on its accuracy. 

Ethereum charges to execute smart contracts denominated in units of Ether, known as GAS. 

Ethereum’s network participants 

To maintain the accuracy and independence of its blockchain and allow open access to all users, Ethereum employs an open network with three different participants, known as Nodes.

A Node is a computer running athe software application (called client) that allows Ethereum to function, described as clients. Clients are available in different programming languages and from different independent sources, which produces a client diversity benefiting Ethereum’s overall security.

All nodes are connected to each other in a network that coordinates voluntarily to verify transactions and maintain the true state of the shared blockchain. 

Full Nodes

• Maintain and store a copy of the Ethereum blockchain 
• Periodically pruned to manage the size of the blockchain 
• Serve data on request  
• Can verify blocks and states 
• Can validate new blocks 

Lightweight Nodes 

• Maintain and store a limited copy of the Ethereum blockchain with only the minimum amount of data required to transact 
• Archive Nodes 
• A historical archive of all state changes; aren't required to validate blocks 

Ethereum’s consensus mechanism 

Full Nodes run two pieces of client software: one to execute the smart contract instructions or new transactions in the EVM; the other is the consensus software to ensure that the changes are valid.

By running a validator client, Full Nodes can also perform the function of a validator. A validator gets to propose new blocks containing a batch of the last state and balance changes to be added to the blockchain. In return for their service, validators earn a reward in ETH plus a portion of the fees charged for the transactions.

Ethereum's process to agree on the validity of information recorded in new blocks is called Proof-of-Stake (PoS).

In PoS, Full Nodes acting as validators (aka stakers) are chosen to create new blocks and validate transactions based on the amount of ETH they stake.

Validators must stake at least 32 ETH, but the more staked above that threshold, the more likely a validator will be chosen to propose a new block. The alternative is to contribute less than 32 ETH to a staking pool. 

Staking pools are run by a single validator with the power to propose a new block. The reward you earn will be proportionate to your contribution to the pool.

In Ethereum's PoS consensus system, validators are randomly chosen to propose new blocks and validate transactions in slots every 12 seconds. 

Staked ETH acts as collateral; a financial commitment to discourage validating an invalid transaction or attempting to double-spend, as your stake can be slashed or seized as a penalty. 

Proof-of-Stake  

We can combine the execution, consensus, and block proposal into a simplified end-to-end sequence for an ETH transaction to better understand how PoS works.

• New ETH transaction signed with private key via a crypto wallet, attaching a fee to encourage a validator to add the transaction to a new block. 

• The transaction is submitted to a Full Node that runs the execution client to ensure the sender's balance can cover the fee and check the private key is valid.

• The Node adds the block to a pending area for new blocks, called the mempool, and then broadcasts it to other nodes who do the same. 

• One validator is randomly chosen to propose a block for the current slot – building and broadcasting it. The execution client generates the updated state change and the consensus layer enables the network to agree on the sequencing of this beacon block. 

• The beacon block is broadcast to other nodes. The nodes execute it and validate it is the next sequential block added to their local version of the Ethereum blockchain. 

• The validator earns the reward plus fees.  

• The process repeats every 12 seconds, growing ETH supply and extending the Ethereum blockchain, its historical record of state and balance changes. 

Ethereum tokenomics 

Tokenomics describes how distribution and reward mechanisms influence the supply of cryptocurrencies and their change over time. Increasing supply creates inflation, reducing a currency’s purchasing power and effectiveness as a store of value.

A specific amount of Ethereum was released at its launch, known as a pre-mine. Some was made available for public purchase via an Initial Coin Offering (ICO) and some distributed to founders and contributors. 

When Ethereum launched, it used the same consensus mechanism as Bitcoin (Proof-of-Work). But without a supply cap, the block rewards produced an annual supply inflation in ETH of 4.5%.

In addition to block rewards, Ethereum validators are incentivised to add transactions and state changes to new blocks. This remains true under PoS, but a mechanism introduced in August 2021 for burning a portion of transaction fees had a crucial impact on its tokenomics, reducing Ethereum’s annual inflation close to zero.  

Bitcoin, Ethereum & the Merge 

The reduction in Ethereum’s inflation has important implications for the function of ETH as a reliable store of value and its comparison to Bitcoin, which has a fixed cap of 21 million coins.

Ethereum has a key differentiator, having transitioned from PoW to PoS in a September 2022 update called the Merge. 

PoS is seen as a more energy-efficient and environmentally friendly alternative to PoW, which requires significant electricity to provide the computing power to validate transactions and create new blocks.

Ethereum claims PoS has reduced its carbon footprint by approximately 99.992% but critics argue that the staking model and requirements lead to centralisation. 

The Future of Ethereum 

The Merge locked staked ETH, meaning that stakers were unable to withdraw either their original stake or their accumulated rewards until the Shanghai Update, which happened on April 12th, 2023. 

With staking now unlocked and inflation neutral, the hope is that Ethereum validator rewards will rival the fixed income returns of the bond market, which valued at $133tn is over 100x the market cap of the entire crypto ecosystem.

Post-Merge, Ethereum is still limited in the number of transactions processed per second, which drives up the cost of block space and has led to the proliferation of layer 2 solutions. However, the Merge laid the groundwork for improving Ethereum’s scalability through an upcoming feature called Danksharding. 

Danksharding will enable a new temporary form of block storage known as blobs that, over time, can be deleted. Thus freeing up block storage, the biggest contributor to fees.

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