What Is Ethereum and How Does It Work?

Few investments have drawn as much notice as cryptocurrencies in the past decade, thanks largely to the meteoric rise of Bitcoin that made millions and even billions of dollars for some early investors. But that’s hardly the only crypto on the block.

The No. 2 crypto by market capitalization is the platform Ethereum. It’s much larger than the thousands of other cryptos, boasts high daily trading volume, and offers important features like smart contracts. It’s also the crypto of choice for trading non-fungible tokens (NFTs).

What is Ethereum?

The Ethereum network is community-run technology that powers its crypto, called Ether (ETH), and decentralized applications (DApps). Ethereum was created largely to give app developers more freedom: It’s the brainchild of Vitalik Buterin, who in 2013 imagined the platform as a way for developers to build their apps there—and wrest control from major tech platforms like Apple and Google, which take a large cut off the top for purchases made on their app stores. Buterin, a Russian-Canadian programmer, created Ethereum and the Ethereum Foundation with seven co-founders.

How does Ethereum work?

The Ethereum community launched in 2015, and it calls itself “the world's programmable blockchain.” Users can send Ether and other cryptocurrencies, as well as digital assets, and pay  transaction fees. Its platform includes a marketplace of financial services, games, and apps that “can't steal your data or censor you,” as the Ethereum website puts it. 

Ethereum also launched the concept of smart contracts: programs that execute automatically, without human intervention, when predetermined conditions are met. This makes transactions and programs faster and cheaper because there’s no time spent processing paperwork and no need to pay an intermediary to help make the deal happen. They can be used for decentralized finance (DeFi), apps, and games. Smart contracts also have advantages in business contexts like supply-chain processes, signaling the next action to begin automatically when the previous step’s conditions are met.

In 2021, Ether soared to all-time highs, partly because of its wide use to buy NFTs: digital art, trading cards, and other collectibles that have become white-hot in the art, sports, and media worlds. In March 2021, for example, a piece created by digital artist Beeple sold for a record-setting equivalent of $69.3 million—paid for in Ether. But in yet another example of the extreme volatility in the crypto market, Ether lost almost half its value from its 2021 peak to early 2022.

Ethereum vs. Bitcoin

Ethereum and Bitcoin share a number of features, including their underlying technology. Like many crypto platforms, Bitcoin and Ethereum use blockchain technology—an open-source public ledger that relies on complex cryptography to record every transaction. It’s a decentralized system spread across thousands of computers around the world, and users are identified not by name but by the ID numbers of their digital wallets. Transparency and security are high, as every user can see the transactions and they’re nearly impossible to alter once they become part of the blockchain.

However, the two differ in several key ways. Bitcoin was created primarily as an alternative currency to fiat currencies, such as the dollar and yen, that are backed by a government and typically involve banks or other intermediaries. The Bitcoin blockchain was built to trade only Bitcoin, and a rule states there can never be more than 21 million Bitcoin.

Ethereum, by contrast, defines itself around its status as a programmable blockchain. Though Ether can also be used as a store of value and Ethereum powers financial transactions, Ethereum is mainly a marketplace of apps that also offers the ability to trade all types of cryptocurrencies without going to other cryptocurrency exchanges. And Ethereum doesn’t have a limit on the amount of Ether that can be created.

What’s next for Ethereum?

Ethereum is evolving in a different direction than Bitcoin in another important way: the algorithm underlying its blockchain. Both Ethereum and Bitcoin were built around proof of work (PoW), a consensus protocol that’s used to create, or mine, new tokens by requiring computers to solve arbitrary, complex math puzzles. It essentially means people can’t copy and paste tokens, confirming that every transaction and newly minted token is neither a duplicate nor a forgery.

But PoW’s benefits come with significant costs: The computers used to solve these complicated math puzzles consume vast amounts of energy. That drives up electricity bills for the miners, and it leaves a large carbon footprint. According to Cambridge University's Bitcoin Electricity Consumption Index, Bitcoin mining alone uses more than 100 terawatt hours of electricity a year as of October 2021. That’s more than the Philippines’ energy consumption in 2019, and about a third as much as the U.K. used that year.

So Ethereum planned to move past proof of work in favor of a newer technology called proof of stake (PoS). In the simplest terms, Ether owners are incentivized with a reward, paid in Ether, to stay on the network.

Here’s how it works: Unlike PoW blockchain, PoS chains don’t rely on the scale and speed of mining in order to expand. Instead, PoS aligns the creation of new blocks with the number of tokens that miners hold. That means miners don’t have to add more computing power, ad infinitum—they can simply mine new tokens in proportion to their ownership stake in the given cryptocurrency.

The Ethereum Foundation cites a recent estimate that says PoS could cut Ethereum’s total energy consumption by 99.95%. “The energy expenditure of Ethereum will be roughly equal to the cost of running a home computer for each node on the network,” they explained.

The bottom line

Ethereum is community-run technology that powers a cryptocurrency called Ether (ETH), as well as a marketplace of decentralized applications (dApps). It was created to give developers an environment to release apps without intermediaries like Apple and Google that take a large cut for payments made in their app stores, but users can also send Ether and other digital assets, including alternative cryptocurrencies. Ethereum also launched the concept of smart contracts, which are programs that self-execute when predetermined conditions are met, while also serving in many transactions involving NFTs. 

Like Bitcoin, Ethereum is underpinned by blockchain technology. But Ethereum focuses on having more uses than Bitcoin, and unlike Bitcoin there is no limit to the amount of Ether that can be created. Ethereum also planned to transition from the traditional PoW protocol, which requires heavy computing power, to the much more energy-efficient PoS to expand its network in the future.