What is Ethereum and how does it work?
Ethereum is a type of digital currency or cryptocurrency, a medium of exchange that exists exclusively online. Ethereum is among the most popular cryptocurrencies and ranks second in terms of total size (as of October 2021), behind Bitcoin, a coin that has become synonymous with crypto.
Cryptocurrency has created a lot of controversy, from those who see it as the next payment system in the world to those who see it simply as a speculative bubble. Here’s what Ethereum is and how it works.
What is Ethereum?
Ethereum is one of the thousands of cryptocurrencies that have emerged over the past few years. From the imaginations of 8 co-founders, Ethereum debuted in 2015. The cryptocurrency or platform is called Ethereum, while the individual unit is called an ether (2 ether, 17 ether, etc.)
Ethereum operates on a decentralized computer network, or distributed ledger called a blockchain, which manages and tracks the currency. It can be helpful to think of a blockchain as a running receipt for every transaction that has ever taken place in the cryptocurrency. Computers on the network verify transactions and ensure data integrity.
This decentralized network is part of the allure of Ethereum and other cryptocurrencies. Users can exchange money without the need for a central intermediary such as a bank, and the absence of a central bank means that the currency is almost self-sufficient. Ethereum also allows users to transact almost anonymously, even though the transaction is publicly available on the blockchain.
Although the whole area is mentioned in terms of currency, it may be more useful to think of crypto as a token that can be spent for a specific purpose activated by the Ethereum platform. For example, sending money or buying and selling goods are coin-activated functions. But Ethereum can do a lot more and can also form the basis of smart contracts and other applications.
What does Ethereum do?
Ethereum can power a number of applications offering a wide range of functions:
- Cash: With a cryptocurrency wallet, you can send and receive ether or pay for goods and services, if digital currency is accepted as a form of payment. Some platforms, like Coinbase, even allow you to keep your coins in a digital wallet, in order to make them less exposed to hackers, in theory.
- Smart contracts: Smart contracts are a kind of unauthorized app that runs automatically when the contract conditions are met.
- Digital applications, or dapps: Ethereum powers digital apps that allow users to play games, invest, send money, follow an investment portfolio, follow social media, and more.
- Non-fungible tokens: These tokens can be powered by Ethereum and can allow artists or others to sell artwork or other items directly to buyers using smart contracts.
- Decentralized financing: By using Ethereum, some people can avoid centralized (government) control over the movement of money or other assets.
Again, it might be fairer to think of Ethereum as a token that powers various applications rather than just a cryptocurrency that allows users to send money to each other.
Where do the aether coins come from?
As of October 2021, there were approximately 118 million ethers. And although new coins may be “mined,” the total annual issuance is limited. This is in stark contrast to Bitcoin, where a maximum of 21 million coins can be mined and new issues get more difficult every year. And that contrasts even more with Dogecoin, where the issuance is completely unlimited.
Ether coins and coins from other cryptocurrencies are “mined” by computers on the network. They perform mathematical calculations that effectively unlock coins or parts of coins.
This configuration is however changing. Bitcoin and Ethereum blockchains use what’s called a “proof of work” to mine new coins and validate transactions. It is an expensive, energy intensive and time consuming process that can clog the network. So the minds behind Ethereum decided to change their system to a “proof of stake” system, which is dubbed Ethereum 2.0.
The new system makes it difficult for miners to generate new coins. Instead, those who own the currency are essentially “gambling” their own crypto holdings and validating transactions. Players could lose their investment if they verify transactions that do not comply with Ethereum’s rules.
It is expected that the change along with the ‘burnt’ transaction fees – destroyed forever – will lead to a dwindling ether existence and a deflationary spiral, causing the crypto to soar.
Is Ethereum a good investment?
Ethereum has grown significantly over the past few years, so those who bought and held years ago have done well. But rather than looking at yesterday’s price movements and being afraid to miss out, it’s important to understand what you’re investing in. And based on that, those who buy Ethereum are buying a cryptocurrency that is not backed by any assets or cash flows. .
It may sound trivial, but this is the main difference between stocks and cryptocurrency. A share is fractional ownership in a business, so its performance over time is due to the continued success of that business. If the company increases its profits, its stock is likely to follow that growth over time. Shareholders have a legal interest in the assets and cash flows of this business.
In contrast, Ethereum – and most other popular cryptocurrencies – aren’t backed by anything at all. The only thing holding the price up is the optimism of other investors, who all think they will be able to sell the cryptocurrency for more money later on to someone else – so called the “biggest fool theory” of investing. Speculation is the only thing that pushes Ethereum and other cryptos higher.
For this and other reason, investment legend Warren Buffett will not touch cryptocurrency and has even publicly stated that she calls it “squared rat poison.” Buffett’s approach is a good clue to the sustainable value available in cryptocurrencies.
Should you buy or mine Ethereum?
If you are looking to speculate on Ethereum, it is easy to buy and trade the cryptocurrency on a popular trading platform such as Robinhood or Binance.US. You can access the market around the clock and you will have good liquidity, which means you will be able to trade without changing the price too much. Calculating profit is also simple: you earn when you sell coins for more than what you paid for.
If you are planning to mine Ethereum, you have to think like a business owner. You will have to invest large sums in mining rigs in order to be able to produce the cryptocurrency, and then you will have to spend expensive electricity while you mine it. You will need to analyze the numbers to see if it makes financial sense for you to make the initial investment and keep your operation going. That is, you want to earn coins that are worth more than what you paid to mine them. With the change in Ethereum’s validation system, potential miners need to be sure that the profit is still there.
In the end, it’s easier to buy Ethereum than to mine and requires less effort. There may be the potential for profit in mining cryptocurrency, but you’ll have to see if the numbers work.
At the end of the line
Speculators can invest directly in cryptocurrencies such as Ethereum, but they can also invest in companies that could benefit from a move towards digital currencies.
Whether you are trading Ethereum, Bitcoin, or any other cryptocurrency company, understanding the risks, including the potential loss of your entire investment, is essential. Investors should take a measured approach with cryptocurrency, given its volatility and many risks. Those looking to get a taste of the action shouldn’t invest more than they can afford to lose.
Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making an investment decision. In addition, investors are advised that past performance of investment products is not a guarantee of future price appreciation.