Let me start by saying I am not a CFA or a registered investment advisor, nor am I a bitcoin maximalist or a crypto evangelist. However, I have spent much of the last decade researching and participating in the traditional financial system and the cryptocurrency ecosystem, and the differences between the two are considerable. Many people are working on the bridge between, but those who are less acquainted with the crypto economy ought to mind the gap.
Those on the traditional side of the spectrum must understand that the innovation behind cryptocurrencies is technical first, financial second. The most innovative aspects — novel network architectures and decentralized application infrastructure — are inherently technical. The foundation of the cryptocurrency ecosystem is not banks, brokerages, or cash flow statements. It is computer code running on hundreds of thousands of machines around the world. These new ecosystems may support familiar financial functions like lending and borrowing, but they do so in a fundamentally different way.
Armed with financial knowledge alone, you will be disappointed if you try to figure out what is so valuable about Bitcoin, Ethereum, or blockchain. DCF models are not easily applied to digital assets or the internet collectives behind them. A deeper understanding of what’s going on under the hood of these ecosystems is essential for realizing their immediate value and long-term potential.
This realization led me to look at cryptocurrencies through a different, technical lens. However, the aim of this article is to…
- give an overview of the Ethereum ecosystem in the least technical way possible
- explain why Ether, the native token in the Ethereum ecosystem, is valuable
In the spirit of transparency, I do own Ether so you should take my opinion with a grain of salt.
The term “Ethereum” refers to the blockchain at the heart of the ecosystem. The Ethereum blockchain does two things:
- it maintains a single source of truth for all actors in the ecosystem
- it provides a platform for applications, also known as smart contracts
The Bitcoin blockchain was designed to support a singular application: a peer-to-peer virtual currency. To function, Bitcoin only needed a single source of truth. The Ethereum blockchain is different. The Ethereum blockchain still maintains a single source of truth, but it also functions as a general-purpose platform for a variety of applications.
To use an analogy, the earliest computers functioned as calculators. They couldn’t do much more than math. However, when general-purpose computers were introduced, they could do far more than just add or subtract numbers. The same sort of functional leap applies to Bitcoin and Ethereum.
Single Source of Truth
The Ethereum blockchain establishes a single source of truth for the ecosystem by maintaining a public transaction database. This shared database captures all transactions that occur between users and applications. Unique virtual addresses identify actors, and each transaction captures participating addresses. These addresses do not reveal any personal information, allowing users to remain anonymous. Transactions are batched together into blocks and validated by thousands of computers — or “nodes” — before joining the public ledger.
Once posted, no one can remove or alter transactions. Because records are sealed, bad actors cannot revert a transaction after the fact or tamper with the public record. Balances are known and transactions are settled in real-time, so the entire ecosystem is on the same page. This append-only approach assures users and applications that the current state of the blockchain is final and trustworthy.
Platform for Applications
In addition to providing a shared source of truth, the Ethereum blockchain provides a platform for applications. The ability to store and power these applications sets the Ethereum blockchain apart from the Bitcoin blockchain.
Before diving deeper, it is important to understand a few things about applications in general. Every application (blockchain-based or not) requires computational resources to run. A laptop provides the resources that a word processor requires to run. A desktop provides the resources that a video game requires to run. A server provides the resources that a large relational database requires to run.
Computers provide fundamental resources for an application in the same way that the electric grid provides energy for an office. They contribute critical resources required by core functions.
As internet technology evolved, firms found a way to pool computational resources and sell them as a service over the web. This model simplified the process of managing applications by managing many machines behind the scenes and offering their collective resources to customers as web services.
Just like physical computers, web services provide infrastructure for applications, which is why they are marketed as platforms to build applications on. These web services are also known as the cloud or virtual machines. For a point of reference, cloud infrastructure and virtualization markets exceeded $130 billion in 2020. Big tech players like Amazon, Microsoft, and Google control the vast majority of market share in these industries. The role they play in sustaining today’s digital economy cannot be understated.
Now, back to Ethereum
The Ethereum blockchain provides critical application infrastructure similar to web services. Thousands of nodes that maintain the single source of truth also supply resources like storage, processing power, and bandwidth. Because people run these nodes all over the globe, Ethereum is referred to as the “world computer” because the collective resources function as a single machine.
Ethereum is different from centralized web services in that transaction data and applications are distributed across thousands of nodes, rather than a few data centers controlled by a corporation. This feature, known as decentralization, leads to a highly redundant and resilient ecosystem that cannot be controlled or censored by a single entity.
The code for these applications lives on the blockchain just like the transactions created by users and other applications. As a result, applications deployed on Ethereum are open and auditable. These apps are also designed to interoperate with other apps in the ecosystem (a stark departure from the traditional “black box” approach for software). Once applications are deployed to Ethereum, they operate autonomously, meaning that they will execute the programs they are designed to run without manual intervention. They are controlled by code, not by individuals or companies. For this reason, applications are referred to as smart contracts.
A common analogy for smart contracts is vending machines. Vending machines are programmed to automatically deliver specific items based on specific inputs. Users punch in a code and receive the corresponding item. Likewise, smart contracts receive inputs from users, execute their programmed code, and produce an output. For example, a user can interact with the Uniswap smart contract and use ETH to buy DPI, an index product composed of 15 underlying tokens.
What this means for Decentralized Finance (DeFi)
Because the most fundamental data recorded on the Ethereum blockchain is accounts, balances, and transactions, it makes sense to build financial applications on top of Ethereum. Users and other applications can freely interact with these financial applications because they are public and permissionless by default.
Simple financial services like lending and borrowing can be programmed and deployed on the blockchain as applications, allowing users (and other applications) to earn interest on digital assets or take out loans. Order book exchanges can autonomously pair buyers and sellers at no charge. Automated market makers can minimize spreads by creating liquidity pools that automatically rebalance according to predefined logic. Derivatives can be deployed on the blockchain so that contract terms are known and the underlying assets are priced in real-time. As a matter of fact, all of these capabilities exist on Ethereum today.
- Compound enables users to earn interest on digital assets and take out over-collateralized loans
- Uniswap coordinates liquidity pools for dozens of digital assets to support its exchange and other exchanges that need liquidity
- UMA gives users the ability to create, collateralize, and trade derivatives tied to underlying assets on Ethereum
What’s truly unique about Ethereum is that applications deployed to the blockchain are designed to be interoperable. Consider Compound. Users can interact with Compound through the website, but other applications can also interact with the protocol programmatically. Exchanges like Binance have integrated Compound into their platform, enabling users to earn interest on assets held with the exchange. Personal wallets like Argent and institutional services like Coinbase Custody also leverage Compound to generate yield on idle assets.
Applications like these are often referred to as “money legos” because the interoperability is intentional — they are meant to be pieced together with other protocols and products. This feature is best known as composability. Projects can plug in the components they need and capitalize on the collective innovation created on Ethereum. The ultimate result? An open financial stack, universally accessible for anyone with an Ethereum address and an internet connection.
What we’ve covered so far:
- the Ethereum ecosystem revolves around a synchronized, single source of truth embedded in the blockchain
- the Ethereum blockchain also acts as a platform for building applications
- These applications, or smart contracts, are designed to be open and interoperable with each other
The nodes who maintain the Ethereum blockchain don’t do it for free. There are costs associated with supplying resources to the ecosystem, so there must be an incentive to outweigh these costs. This is where Ether — abbreviated as ETH — comes in. Ether incentivizes actors to process transactions and maintain the blockchain for the ecosystem.
Whenever users or applications initiate a transaction, they pay a small fee in Ether. This fee — which is referred to as “gas” — applies to any transaction that sends, receives, or swaps a digital asset on Ethereum. Deploying applications to the blockchain also costs gas. This fee compensates the nodes who spend their resources batching transactions into blocks.
Nodes also earn block rewards each time they propose a new block of transactions that is added to the chain. The Ethereum protocol is programmed to mint new Ether each time a new block is added to the chain, which increases the circulating supply of Ether at a predictable rate. If a node proposes a new block and that block is confirmed by the majority of the network, the proposing node receives 2 ETH as a reward.
For a real-world example, the node that proposed block #12006099 received: 1.487 ETH in gas fees + 2 ETH in block rewards = 3.487 ETH. At current prices, 3.487 ETH amounts to $8,138. On average, the Ethereum blockchain grows by 6,400 blocks a day, so if we apply a similar payout per block, that’s over $52 million worth of incentives daily. Rewards of this size motivate individuals and organizations to run nodes, process transactions and maintain the blockchain. These rewards also enhance the security and stability of the ecosystem by drawing in more node operators and creating greater decentralization.
In addition to fueling the world computer, Ether is the default currency for the ecosystem. When users want to purchase a different token or buy a piece of digital art, ETH is the easiest medium of exchange to use because it is native to Ethereum. It is worth noting that Ether is not the only medium of exchange in the ecosystem (though it is the most popular). Non-native cryptocurrencies, like Bitcoin, have been imported to Ethereum and can act as mediums of exchange. Tokens pegged to fiat currencies and issued on Ethereum, like USDC, can also function as mediums of exchange. These alternatives still require Ether for transaction fees, so even if a user within the ecosystem is paying with Bitcoin, they must pay the gas bill with ETH.
There are other ways to use Ether — as a store-of-value, an inflationary hedge, or an interest-bearing asset — but the virtuous circles created by the open application environment and the incentivized support structure demonstrate the demand for Ether.
When user activity across the network increases, gas fees attached to transactions also increase. Higher gas fees incentivize node operators, old and new, to maintain the blockchain. As node operators join the network, decentralization increases. Improved decentralization strengthens the security and stability of the ecosystem. Greater security and stability attract new users, who then generate more transactions.
More users also attract new applications, which require Ether to run. Existing applications can leverage the capabilities introduced by new applications due to composability. The result is new and improved applications that enhance user experience (UX) and attract more users. The larger the user base, the more applications it attracts. And the cycles continue.
For Ethereum, financial applications are only the beginning. Because Ethereum is a general-purpose blockchain, almost anything can be digitized and distributed on Ethereum. The blockchain at the heart of the system makes it easy to establish ownership and facilitate peer-to-peer interaction. Collectors of digital trading cards can back up their bragging. Artists and content creators can monetize their work without middlemen. Owners of real assets can access liquidity. Social media users can own their data and sell it at their discretion. Ethereum is the engine for the next generation of internet commerce, and Ether is the fuel.
- “The cloud infrastructure market hit $129B in 2020”; Tech Crunch
- “Global Virtual Machine Market Segmentation by Type”; Market Data Forecast
- “About Uniswap”; Uniswap.org
- “DeFi Pulse Index (DPI)”; Index Coop
- “Compound Protocol”; compound.finance
- “UMA”; umaproject.org
- “Decentralized Finance (DeFi)”; ethereum.org
- “Block #12006099”; etherscan.io
- “What is Wrapped Bitcoin (wBTC) and Why it’s So Important”; Securities.io
- “Introducing USD Coin (USDC) — Stablecoin by Coinbase”; Coinbase.com
About the Author
Allan Gulley is a Certified Blockchain Solutions Architect and a Certified Blockchain Security Professional. He holds a BSBA in Accountancy from Auburn University, where he formally researched and led early-stage blockchain projects for multiple Fortune 100 companies. Allan has also been a HODLer, Staker, and Node Operator in a variety of crypto ecosystems since 2014.
By day, Allan is a Senior Designer and Technical Architect at People Rocket, a management design firm based in San Francisco, where he advises companies on enterprise blockchain and other emerging technologies.