Ethereum Explained
Bitcoin’s more complex but possible more valuable younger sibling
With crypto back in the news again, this time calling for the death of Bitcoin and other digital assets for the 1,000th time, I feel compelled to do an Ethereum explained post similar to my Bitcoin explained post from April.
Ethereum, although it’s the second largest cryptocurrency by market value, does not get nearly the attention and press as Bitcoin, but, I feel like that’s all about to change.
Bitcoin’s use-case and narrative are now embedded in the collective awareness. Only 21 million bitcoins will ever exist. No single organization has control over the Bitcoin network and cannot inflate, transfer, or counterfeit bitcoin (the currency). This creates an independent, decentralized monetary network where individuals can store their wealth during times of spending largesse (I use that word in jest) from governments. Ethereum, however, has an entirely different but more complex use case.
Ethereum is a programmable blockchain (meaning applications can be built on top of it) secured by its native currency (ethereum or ETH). It does not have a fixed supply but it has far more use cases for creating decentralized transfers of value. Ethereum, today, has the highest probability of becoming the foundational layer for the entire web3 decentralized internet through smart contracts.
All of the NFTs or DeFi that you’ve heard of but don’t know much about are all built on Ethereum smart contracts. So, to compare, Bitcoin is a decentralized asset to help you save and preserve your purchasing power and wealth. Ethereum is a decentralized asset that lays the foundation for permissionless transfer of value across the internet through smart contracts.
I can understand why people have trouble understanding Ethereum. What does permissionless transfer of value and smart contracts even mean?
Smart contracts are more simple so I’ll start there. Smart contracts are programmatic, self-executing contracts where the agreements between the parties are written into code. The computer code controls the execution, takes over escrow, and becomes the “trusted third party” in transactions that occur on the blockchain. This replaces the need for a toll-road third party organization that holds assets, titles, or other contract agreements in escrow and controls the execution of the contract.
Smart contracts, the technology, allows the permissionless transfer of value. In the most simple explanation permissionless transfer of value means individuals, corporations, communities, and any groups of people (that’s important) can build, collaborate, exchange, authenticate, and design applications, assets, organizations, and contracts without ever meeting one another, agreeing on terms, or needing to verify the truth. Ok, I know that’s a long sentence that is probably confusing so let’s unpack that further.
Have you ever gone to a bank to get a loan for a house? If you have, you might remember them asking you to send over reams of documents proving 1) you are who you say you are and 2) you have the income or assets to pay them back on their schedule. A bank doesn’t inherently trust you. You must prove to them that you have the ability to pay them back.
Now, let’s run that same example, getting a loan, through the lens of decentralized finance (DeFi) powered by Ethereum. You have $1 million worth of Ethereum, stable coins, or another crypto asset, and you want to get a loan to put money down for a house. So, you go to a web3 decentralized finance site like Aave.
Aave allows you to get instant loans when you post your crypto assets as collateral. Because they require you to overcollateralize your loans (meaning you cannot borrow more than a specific % of the total value of your collateral) they’re able to offer instant access to capital without the contracts, requirements of proof, or credit checks that traditional banks need. Depositing your ethereum into the protocol smart contract is all the proof the protocol needs to issue out hundreds of thousands, even millions of dollars, in a loan that’s programmatically managed by the smart contract.
This is what “trustless” finance means. The smart contract between the individual getting the loan and the organization issuing the loan guarantees compliance of the terms. If the user does not pay their interest the smart contract will, once it reaches an agreed upon “Health Factor”, liquidate your assets to pay back whatever you owe. No lawyers, judges, courts, or contracts needed. It’s all coded into the smart contract.
So, why does this matter for explaining Ethereum? Well, the same trustless exchange of value is happening across other mediums. And, the transaction fees (how users pay for the transfer of assets, deposit of assets, or swapping of assets) accrue to the Ethereum network.
And Ethereum is creating brand-new forms of finance, authentication, and organization.
There’s decentralized finance (like I mentioned above) which covers saving, lending, earning, trading, insuring, crowdfunding, investing, and more.
There’s non-fungible tokens (NFTs) which create a provable, digitally scarce asset. You can think of it like a digital signature that proves the authenticity of an asset (real world or digital). The use cases for NFTs are far bigger than art and we’re only scratching the surface of what’s possible.
There are decentralized autonomous organizations (DAOs) which create a new organizational structure that have the potential to become as common as LLCs for managing group assets, group decisions, and human capital.
These are three of the main use-cases that are live today and what drive the majority of the activity on the Ethereum blockchain. Activity is important because using the network creates the value for the underlying asset.
The use of ethereum cases create cash flows for the Ethereum network. To execute a transaction on the ethereum blockchain the user sending the transaction must add an extra fee to pay for the transaction to go through. This is called “gas”. The gas that’s spent on executing the transaction currently goes to the miners who are securing the network.
To give you an example of the cash flows that the Ethereum network currently generates, here’s a year over year comparison from James Wang of Q1 2021:
That’s $1.69 billion of fees generated in the first three months of 2021! Annualizing these fees would put Ethereum almost into the top 25 most profitable companies in all of America.
So to sum it up, the Ethereum network is a world-wide programmable monetary network that currently underpins billions of dollars of cash flow, hundreds of millions in art sales, billions of dollars in loans and liquidity, billions in asset exchange, and more.
There’s so much more to talk about regarding Ethereum, but I only wanted to include the basics here. If you’re interested to research more about why Ethereum is a behemoth in the making (and has the potential to overtake Bitcoin’s market value), here are some links you can check out:
Own the Internet - by Packy McCormick
An Open Letter to DeFi - by Tom Borgers
What is Ethereum - Ethereum Organization