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What is Ethereum, and how does it work?

Ethereum, founded in 2015 and a relative latecomer to the crypto world, is the second most popular cryptocurrency (opens in new tab) after Bitcoin. And because of how Ethereum works, it will likely continue to dominate the crypto market for the foreseeable future.

If you are considering investing in Ethereum, it’s important to understand the mechanics of this cryptocurrency so you can make the best possible decisions for your investment. Here’s what you need to know:

What is Ethereum?

Ethereum is a platform for exchanging digital currency that has no physical counterpart. The currency unit on the Ethereum platform is called an ether (ETH).

Ethereum operates on the blockchain, which is a decentralized ledger that records all crypto transactions. It’s helpful to imagine the blockchain as a never-ending receipt. While new transactions can always be added to the blockchain “receipt,” older transactions remain on the blockchain and are virtually impossible to change.

One of the appealing features of Ethereum (or other cryptocurrencies on a blockchain) is the fact that there is no individual, company, or government in charge of the blockchain. 

This makes ether a decentralized currency that requires no central intermediary (such as a bank or currency exchange) to use. It additionally makes it possible for transactions to be anonymous, since the blockchain only records transaction details and no personal information of the buyers and sellers.

What’s the difference between ether and Ethereum?

Ethereum is the platform's name, while ether is the currency unit on that platform. But it's helpful to understand exactly what you can do with ether or on Ethereum, since the platform offers users more than just access to the currency.

To start, there are several potential ways to use ether:

  • As a digital currency: You can handle financial transactions where both buyer and seller accept ether as a valid currency.
  • As a store of value: If you believe that ether will maintain its value in the future (i.e., it will retain the same buying power over the years despite inflation reducing the buying power of the dollar), you can purchase ether now as a store of value.
  • As an investment: If you believe that ether will increase in value, you can purchase ether now to resell at a later date for a profit.

But there is more to Ethereum than just ether. The platform also allows users to store data and run applications. Ethereum's decentralized network means the users have complete control of their information and applications and don't have to follow the rules and guidelines of a server owned and operated by a central authority.

NFTs, or non-fungible tokens (opens in new tab), are one of the most popular ways that Ethereum users take advantage of this aspect of the platform.

Another Ethereum innovation is the self-executing or "smart" contract, where the two parties agree to the details of delivering goods or services in the future when certain conditions are met. 

The agreement is coded into the Ethereum blockchain, and the contract self-executes when those conditions are met.

How does Ethereum work?

Instead of a single centralized server (or even a network of connected servers that are maintained by a central authority), Ethereum is housed on thousands of computers, known as “nodes.” This widespread network maintains a single “computer” that Ethereum calls the “Ethereum Virtual Machine” (EVM).

Each node holds a copy of the EVM, and every interaction on Ethereum is verified so that nodes can update their copy of the EVM.

Ethereum currently uses a consensus mechanism called “proof of work” to verify blocks of data with new interactions. Proof of work requires miners to validate blocks before adding them to the blockchain.

Miners are rewarded with ether coins in exchange for doing the proof of work validation. However, mining requires a great deal of computer power and can be both financially and environmentally costly. 

What is Ethereum 2.0?

Sometime in late 2022, Ethereum will shift from proof of work to a proof of stake consensus mechanism in a move the platform calls Ethereum 2.0.

With proof of work, anyone can mine data to validate blocks of information before adding it to the blockchain. Proof of stake, on the other hand, uses randomly chosen validators to ensure that the new data is reliable before adding it to the blockchain. 

To have the chance of becoming a validator, users must have committed to purchasing and locking up a certain amount of ether coins. In other words, by having a stake in the cryptocurrency, users may have the chance to be chosen as a validator, and rewarded with tokens for doing the validation work.

Ethereum calculates that the shift to proof of stake under Ethereum 2.0 will reduce the platform’s energy usage by 99.95% (opens in new tab).

Can ether be converted to cash?

Like any other currency, ether can be exchanged or converted to a different currency. The easiest way to do this is through a crypto exchange platform. 

On such a platform, you can sell your ether against your preferred currency, such as U.S. dollars. You will simply need to connect an existing bank account to cash out the sale.

Be cautious about choosing a reputable crypto exchange platform, and be aware of the fees or other costs associated with cashing out your ether.

Benefits and drawbacks of Ethereum

Make sure you are aware of both advantages and disadvantages of Ethereum before jumping in.

Benefits

  • Liquidity: Despite being a digital-only asset, ether is easily exchanged for cash or other currencies because of the popularity and ubiquity of the Ethereum platform.
  • Inflation protection: Ethereum has several strategies in place (opens in new tab) for hedging ether against inflation, including the implementation of Ethereum 2.0. 
  • Anonymity: Users can feel confident that their transactions, apps, data, and other interactions on Ethereum are anonymous.
  • Decentralization: Users who wish to handle transactions, operate applications, and store data outside of any central authority can do all three on Ethereum.
  • Additional usage beyond cryptocurrency: Ethereum is more than just the ether coin. You can also build applications, create self-executing contracts, and create and trade NFTs. 

Drawbacks

  • Volatility: Like all cryptocurrency, ether is not backed by any asset, nor does it have any intrinsic value. That means its value depends on the enthusiasm and whims of other investors.
  • Scalability issues: Since Ethereum handles more than just its ether currency, it is more complex than a currency-only platform like Bitcoin. This opens it up to possible breakdowns, computer bugs, hacking, and other problems.
  • Not beginner friendly: The complexity of the platform also means newbies to Ethereum who wish to take part in the Ethereum Virtual Machine or create an app on the platform may find it difficult to get started.
  • Regulations: One of crypto’s appeals is that it is decentralized and beholden to no particular government, which is slowly changing. The United States is working to apply additional laws and regulations (opens in new tab) to cryptocurrency transactions. This may help users in some ways (by providing a legal framework for handling disputes). Still, it may also reduce some of the benefits of anonymity and other advantages of crypto.

Is it worth it to invest in Ethereum?

Whether Ethereum is a healthy part of your investment portfolio depends on several factors. First, you need to make sure you completely understand what you are investing in and how it works. Since Ethereum isn't backed by any other asset and does not have intrinsic value, casual investors should be cautious before putting up their cold, hard cash.

Additionally, you need to consider your risk tolerance and the amount of money you intend to invest. If rapid fluctuations in value make you queasy and you can't afford a rapid decline, then Ethereum will not be the right investment for you.

On the other hand, if you only invest what you can afford to lose and enter into your Ethereum purchase with your eyes wide open, then this investment could be an exciting addition to your portfolio.

Just remember that there's no such thing as a sure thing. Not even when the investment is an amazing new innovation.

Emily Guy Birken
Personal finance writer

Emily Guy Birken is a former educator, lifelong money nerd, and a Plutus Award-winning freelance writer who specializes in the scientific research behind irrational money behaviors. Her background in education allows her to make complex financial topics relatable and easily understood by the layperson. Her work has appeared on The Huffington Post, Business Insider, Kiplinger's, MSN Money, and The Washington Post online. She is the author of several books, including The 5 Years Before You Retire, End Financial Stress Now, and the brand new book Stacked: Your Super Serious Guide to Modern Money Management, written with Joe Saul-Sehy.


Emily lives in Milwaukee with her family.