How does Ethereum work?

How does Ethereum work

Ethereum, the first dedicated blockchain for smart contracts and decentralized applications (dapps), launched in 2015. Ethereum has become the main platform for the DeFi industry, most ICO and decentralized applications, including enterprise applications. In this article, we’ll talk about how does Ethereum work.

How did Ethereum appear?

In December 2013, Vitalik Buterin created a team to develop a new type of blockchain because the scripting language in the Bitcoin blockchain is severely limited in its ability to create applications. Most of the co-founders eventually left the project. In 2014, Buterin’s team raised 31,591 BTC (about $18.5 million) to develop the project. The blockchain was launched in July 2015, with investors in the first blockchain receiving 60 million ETH. The first version 1.0 was called Frontier.

How does Ethereum work

The Ethereum version 1.x blockchain runs on the Proof of Work consensus with the Ethash hashing algorithm. Mining is possible using GPUs and ASICs, but the superiority of specialized chips is much lower than in other algorithms. Ethereum differs from Bitcoin in the way commissions are calculated: users pay commissions in gas, which are automatically converted from ETH. Commissions are calculated based on two parameters:

  • Gas Limit – the maximum amount of gas a user is willing to pay to a miner for the execution of a transaction;
  • Gas Price – the cost per unit of gas in gwei (0.000000000001 ETH). Miners process transactions with more expensive gas first.

All transactions with tokens and smart contracts must have ETH in the wallet balance to be paid. The fees for creating and operating smart contracts are significantly higher than for simple ETH transactions.

Unlike classic cryptocurrency wallets, where all addresses are equal, in Ethereum there are so-called “contract” addresses that store the code for smart contracts. Transactions to them trigger the activation and execution of a smart contract. The response is determined by the contract code, in most cases by generating and/or sending tokens. Token sales (ICO/STO/IEO) and most DeFi platforms are based on this mechanism.

Due to weak blockchain bandwidth (up to 15 transactions per second on average), Ethereum 1.x regularly faces multiple fee increases with high network load: they were as high as $15. This problem was known from the beginning, so the developers of Ethereum had been planning to move the project to the Proof-of-Stake (PoS) consensus since 2016. A new version of the sharding-based Casper protocol will increase blockchain throughput many times over and reduce fees. The phased launch of Ethereum 2.0 has already begun.

Decentralized finance, DeFi, began its meteoric rise in 2020. Most DeFi platforms use the Ethereum blockchain to run smart contracts and issue control tokens. Practice has shown that the DeFi industry is also not completely safe from hacking and fraud.

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