What is Ethereum? What to know before investing

• Ethereum is a general-purpose decentralized computing platform that uses blockchain technology.
• Ether (ETH) is Ethereum's native currency, and it is currently the second-largest cryptocurrency by volume.
• Despite its popularity and wide applications, Ethereum remains a highly speculative investment.

Ethereum and Bitcoin have nearly become household names. However, while they're often mentioned in tandem, they're far from the same.

Bitcoin was created as an alternative, decentralized currency. Ethereum draws inspiration from Bitcoin, but has bigger aspirations: To create a software platform that not only supports cryptocurrencies, but any kind of decentralized application that can run without the need of a third party, thus giving people more control over their data.

What is Ethereum?

Ethereum is an open-source, decentralized computing platform network. The Ethereum network works like the Bitcoin network in that it's built on blockchain technology, essentially a digital public ledger where financial agreements can be verified and stored entirely by software - without intervention of a third party.

The easiest way to think of the Ethereum network is as a secure database that's accessible to anyone. When new "blocks" of data get added, they're cryptographically "chained" to a parent block, effectively making an uneditable record of the previous changes.

Ethereum is considered one of the largest cryptocurrencies (next to Bitcoin), because ether is the second largest crypto next to bitcoin by market capitalization.

Note: The process of mining cryptocurrency is known as proof of work. However, Ethereum developers have plans to adopt an alternative method, called proof of stake, which requires less energy and makes mining more accessible.

But what makes Ethereum so exciting to users and enthusiasts is the network's potential to do more than just handle financial transactions. Ethereum takes the Bitcoin blockchain further by allowing developers to run programs (known as "smart contracts") that can host any kind of decentralized application (known as "dApps").

"Bitcoin was the pioneer of blockchain technology, used to create a peer-to-peer payment system," says Jacob Wade, a financial coach and president of iHeartBudgets. "Ethereum uses similar blockchain technology, but added the ability to create decentralized applications on top of its platform."

People have already created and launched a variety of dApps on Ethereum, including games, marketplaces for digital art, and decentralized finance (DeFi) apps.

How does Ethereum work?

Ethereum works by using computing power to power the network. In practice, this means people and organizations are using their computers to run specific software, or nodes. Anyone can set up their computer to run a node.

"Ethereum relies on node operators to process transactions on the Ethereum network," says Wade. "These operators collect a fee for running the hardware and software necessary to facilitate these transactions."

The fees are called gas fees because they keep the network running. And they're paid in ether (ETH).

Consider the many ways that you could use a large network of computers. Similar to Bitcoin, Ethereum uses it to power peer-to-peer transactions and track who owns the ether cryptocurrency. Additionally, developers can create and run dApps on the network.

The dApps connect to the Ethereum blockchain with "smart contracts," which are more like computer programs than contracts in the traditional sense of the word.

"Smart contracts are small programs stored on the Ethereum blockchain that can self-execute when certain conditions are met," says Robert Farrington, founder of The College Investor. "A good way to think about it is that the dapp is the front-end of the program, and the smart contract is the backend of the program."

Also, dApps rely on the decentralized and open-source Ethereum network and can't be controlled by a single entity. In fact, once a dApp is added to the Ethereum platform, it can't be taken down - even if the original creator wants to remove it or disbands entirely.

The decentralized system can lead to more anonymity for users, who may be able to pseudonymously use dApps. And it can also result in less control and censorship from third parties, including corporations and governments.

Is ether the same as Ethereum?

Ethereum and ether work in tandem, but they're not the same. "Ethereum is the technology, and ether is the actual cryptocurrency," explains Farrington. "You can think of ether as the actual 'cash' or fuel that powers the Ethereum network."

If you want to invest in Ethereum, you can buy ether on a cryptocurrency exchange. You may also be able to use ether to buy other products or services, similar to how you can use bitcoins and other currencies. Ether could also potentially act as a "store of value," similar to how you may want to buy and hold gold.

A brief history of Ethereum

Ethereum was originally conceived of by Vitalik Buterin, who published an introductory white paper on the idea in 2013. The basic idea was to build on the blockchain technology that Bitcoin uses to create a decentralized and programmable platform.

Here are a few key moments in Ethereum's history beyond its original inception:

• 2014: Ether goes on sale for the first time and people could initially buy 2,000 ether for one bitcoin. The Ethereum blockchain publicly launched the next year.
• 2016: The decentralized autonomous organization (DAO) hack leads to a disagreement about whether people should get back the money they lost. The resulting DAO fork leads to the creation of Ethereum Classic - a continuation of the original blockchain - and Ethereum.
• 2017: Popular dApps launch, including the CryptoKitties game. The price of ETH increased from around $8 to over $700 during 2017.
• 2021: The London hard fork makes several important changes, including EIP-1559, which makes network fees more predictable and reduces the supply of ether.

Forks of Ethereum

Ethereum has also changed since it was first launched. "When blockchain technology changes (or upgrades), a fork can occur - just like a fork in the road," says Farrington. "When this happens, it can be a soft fork or hard fork."

In general, there are what's known as soft forks and hard forks in ethereum:

• Soft forks can be minor changes that are backward compatible. Node operators can stay connected to the blockchain, but they're incentives to upgrade to the latest version if they want to continue earning ether.
• Hard forks are major upgrades that can significantly change the system and aren't backward compatible. Node operators need to switch to the latest version to keep the blockchain going. Or, if there's a disagreement, a split could result in two competing blockchains.

Often, changes are proposed and discussed in an attempt to form consensus before making a change. For example, there's a multiple-step upgrade to Ethereum 2.0, which may be completed in late 2021 or early 2022. The update will make significant changes to how Ethereum works, and may help make it more scalable and ecologically sustainable.

Ethereum vs. Bitcoin

Ether and bitcoin are both popular cryptocurrencies that rely on blockchain technology, but they're far from identical.

"Ethereum is also a technology platform that enables smart contracts - which is very different from Bitcoin, which is essentially just a store of value," says Farrington. "This aspect of smart contracts on Ethereum unlocks a lot of potential use cases that you can't do with Bitcoin."

Is Ethereum a good investment?

It depends. There's no one right answer for anyone looking to invest in Ethereum. The major thing to know that like any investment - it's risky and should be considered as such before adding it to any portfolio.

Ether is becoming more widely available and there's a lot of noise in the news about it's rising value - but it's always important not to get sucked into the speculation too much.

"It may serve some purpose in a portfolio, but it should be a very small amount and be viewed as highly speculative," says Farrington. "It's also important to note that it's still very early - so while the technology is promising, it's unknown which technology may win in the long run."

In the news: Ethereum network changes could make cryptocurrency staking a $40 billion industry within a few years.

The financial takeaway

Ethereum uses blockchain technology to create a decentralized platform. The ether cryptocurrency is the "fuel" that powers the network, and you can invest in the Ethereum network by buying ether. "As with any cryptocurrency, buying Ether is a speculative investment," warns Wade. "Always do your research before investing into any digital currency, and don't risk more than you are willing to lose."

If you're interested in cryptocurrencies more broadly, you could also look for ways to invest in companies that participate in the space rather than buying a single cryptocurrency.