Crypto Currencies

Ether Explained - Chapter 3: How Ethereum works

26/07/2019 | 5 min read

Vontobel now offers investors access to the crypto currency «Ether». But what is Ether? And why has the second best-known crypto currency gained so much popularity in such a short time? In eight chapters, we want to give you high-quality knowledge about the exciting topic of «Ether».

Ethereum broadens Bitcoin's concept with a variety of other applications in the blockchain, striving to become the foundation of other blockchain projects. Ethereum not only represents a significant change in the status quo, but also enables the rapid development and deployment of new applications. The majority of blockchain projects do not have their own blockchain, but use Ethereum's blockchain as a basis. In addition, the Ethereum project has its own crypto currency called Ether (ETH). Ether as a crypto currency is therefore linked to Ethereum - the platform that created it.

Ethereum is a decentralized platform for "dapps" (decentralized applications), which is based on a blockchain technology, as already known from Bitcoin. Distributed nodes execute smart contracts, which in turn ensure the integrity of the goods and payment in Ether. Decentralization thus makes Ethereum a counter-model to central servers that currently dominate the Internet infrastructure. Although Ethereum provides a blockchain-based means of payment with Ether, it serves for more than that. Rather, the platform intends to give developers the opportunity manage the distribution of their apps by themselves and to provide more security.

Vitalik Buterin has launched Ethereum

The foundations of Ethereum were laid in 2013 by the Toronto-based programmer Vitalik Buterin. He published a white paper on Ethereum's basic functions. His vision was to use a blockchain not only for a crypto currency, but also to accommodate many other programs. At that time, Buterin was only 19 years old, so he was celebrated worldwide as a prodigy. In 2014, he managed to collect USD 18 million through a crowdsale to start the Ethereum project. In 2015, Ethereum went into operation.

The Ether is a token used for transactions within the Ethereum network. As it is a very volatile currency, the price is permanently subject to large intraday fluctuations. In June 2017, there was an enormous drop in the exchange rate due to a false report about the alleged death of Buterin. ETH must be distinguished from Ethereum Classic (ETC). After content-related disputes among programmers, ETH split off from ETC in 2016. Like Bitcoin, Ether exists as part of a peer-to-peer financial system, free from government supervision and intervention. And like Bitcoin, Ether has experienced an enormous increase in value in a short period of time. Ethereum has also experienced an enormous influx of supporters and users.

Ethereum blockchain is no longer a list of transactions

Ethereum’s functionality can be explained by comparing it to Bitcoin. Bitcoin's blockchain is a cryptographically linked list of transactions. This is the basic structure of any crypto currency. However, the Ethereum blockchain, contains additional dynamic elements, the so-called «Smart Contracts». These are protocols and algorithms that are executed as DApps by a virtual environment, the Ethereum Virtual Machine (EVM). The blockchain is therefore no longer just a list of transactions. Put simply, DApps and Smart Contracts function like machines that are triggered by an event, such as a transfer in Ether, to execute pre-defined agreements. Ether is needed to run applications on the Ethereum network. At the same time, developers use it to create their applications and smart contracts. The application diversity of this concept is enormous and currently not really manageable.

Ethereum wants to be a software platform that operates as a decentralized Internet and App Store. This platform needs the currency Ether to pay for the computing resources needed to run an application or program. Ether does not require a third party to process the payment and transfers take place anonymously. Ether not only functions as a digital currency, but also as a «fuel» for the DApps within the network. For example, if a user wants to change something in an Ethereum app, he must pay a transaction fee so that the network can process the change.

Ether mining: transaction validation and ether generation

Like Bitcoin, Ether uses a common digital ledger in which all Ether transactions are recorded. It is publicly accessible, completely transparent and very difficult to change retroactively. The transactions are bundled into «blocks», each block being concatenated with its previous blocks. However, before the transaction can be added to the general ledger, it must be validated by a process called mining. In mining, a group of so-called «nodes» apply their computing power to performing a «proof of work» task, which is basically a mathematical puzzle. The more powerful the computer, the faster it can solve the puzzle. An answer to this puzzle is proof of the work and guarantees the validity of a block. Many miners around the world compete with each other to create and validate a block. Every time a miner provides proof of a block, new Ether tokens are generated and the respective miner earns 2 ETH as a reward. These 2 ETH currently have a value of approximately (USD 222.40 x ETH) = USD 444.80 (as of 25 July 2019). However, these 2 Ether shares could be reduced as the crypto currency scales further. The miners are the backbone of the Ethereum network, as they not only validate transactions and other operations within the network, but also generate new Ethers. Without these miners, the distributed network would collapse.

Ethereum: A decentralised approach

Ethereum is a decentralized system, i.e. it is completely autonomous and not controlled by anyone. The majority of online services and companies are based on a centralized system, although history has shown that this concept has flaws. Apps and online servers that use a centralized approach are extremely vulnerable to hacker attacks and electrical power outages. In addition, most social networks and online services require their users to provide personal information that is then stored on their servers. From there, this information can easily be stolen by the company itself, its employees or hackers. There is no central point of failure at Ethereum as it is operated by thousands of volunteer computers around the world. This means that Ethereum can never go offline. The entire Ethereum system is supported by a global system of nodes. These are volunteers who download the entire Ethereum blockchain to their desktops and fully enforce all the consensus rules of the system, ensuring that the network meets these standards and receives rewards for doing so.

Smart Contracts ensure a secure, fast and cost-effective system

Smart Contracts are an essential part of the Ethereum infrastructure. These are contracts that are automatically executed and accepted as soon as the desired sum of ETH has been transferred. A buyer therefore transfers a required sum of ETH to the seller. The corresponding Smart Contract recognizes the transaction and then ensures that the customer is recorded in the blockchain and can make use of the service. The manipulation-resistant blockchain itself guarantees security. Agreements are automatically executed as soon as the predefined conditions are met, eliminating the time and effort required to manually execute a transaction. A further advantage is the renunciation of an intermediary, such as a bank employee or, in the case of software such as Apple, Google and Microsoft, their App Stores. Each transaction is stored within the entire blockchain, i.e. on all devices connected to the network. This results in enormous security advantages: Attackers can manipulate the data on centralized servers. However, the decentralized concept of the blockchain permanently checks the integrity of the entire database. If manipulation attempts are detected, the blockchain corrects this automatically. Smart Contracts can also be used in much more complex cases and their potential is infinite. They are already used in projects in the areas of insurance, real estate, financial services, law, crowdfunding, political elections, logistics, healthcare, Internet of Things, and many more.


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