What Is Ethereum and How Does It Work?

Value of ethereum technology

Ethereum is a decentralized platform that's built with blockchain technology. The Ethereum platform supports and relies on Ether (also called ETH), which is its native cryptocurrency and one of the most well-known cryptocurrencies in the world next to Bitcoin. However, Ethereum is also a programmable platform that supports a wide range of applications, not just cryptocurrencies.

How Does Ethereum Work?

Ethereum uses a public blockchain network to power its platform. It's sometimes referred to as a global supercomputer, which can be a helpful way to think about the platform. The technology allows computers from all over the world to work together to power Ethereum.

Bitcoin and other cryptocurrencies use the same decentralized blockchain technology. However, Bitcoin's blockchain is mostly used to track transactions and account balances, which it does with a digital ledger. Ethereum builds on this idea and lets people create and run programs on its network.

Here are a few key terms and concepts that are important for understanding how Ethereum works:

  • Ethereum miners: Ethereum is powered by "miners" who set up their computers to perform complex math that powers and secures the network. The miners receive Ether for the use of their computer's processing power.
  • Gas costs: Gas refers to how much you have to pay a miner to add information to the Ethereum blockchain. Paying more can result in your transaction being processed faster.
  • Ether: Ether is Ethereum's primary and native cryptocurrency. There are other cryptocurrencies built on the Ethereum platform, but miners are paid in Ether.
  • Decentralized apps: The apps that are built on the Ethereum network are called decentralized apps (dapps) because they aren't run by a single entity.
  • Smart contracts: A smart contract isn't necessarily a contract in the legal sense. Instead, it's the name for programs that are stored and run on the Ethereum blockchain. People can create and upload new smart contracts to Ethereum or build new dapps using existing smart contracts.
  • Ethereum Virtual Machine: The Ethereum Virtual Machine (EVM) is the environment that stores and executes smart contracts.

Ethereum is also undergoing an upgrade to Ethereum 2.0, or Eth2. The new system will attempt to address concerns about the current platform's slow network speeds, high gas fees and energy usage.

Ethereum vs. Bitcoin: What's the Difference?

Ether and Bitcoin share similarities as they're both cryptocurrencies that you can use to purchase goods or services. Or, you may want to hold on to a cryptocurrency in the hope that it will increase in value. However, the Ethereum and Bitcoin systems differ greatly in many respects.

Bitcoin was created as an alternative to fiat currency—money minted and controlled by governments—while Ethereum is a platform.

Consider the headline-grabbing non-fungible tokens (NFTs). An NFT is a unique token that represents ownership of a digital asset, such as a digital image or video. You never take physical possession of something purchased as an NFT, but that's not stopping people from paying astronomical prices for them. (In March, an NFT sold at auction for nearly $70 million.)

Many NFTs are created and stored on the Ethereum blockchain. And, you can use Ethereum dapps to easily buy, sell and trade NFTs. Miners might receive Ether to help keep the decentralized network running and secure, but Ethereum is the entire ecosystem.

Should I Buy Ether?

You may be interested in buying Ether as an investment or out of curiosity. However, as with other cryptocurrencies, Ether has experienced dramatic price swings in the past few years. While you might make a lot of money if the cost of Ether increases, an ill-timed sale could cost you.

If you can stomach the volatility and are interested in buying Ether, make sure you don't get caught in a scam. Also, be aware that you may have to pay taxes on the earnings if your cryptocurrencies increase in value before you use or sell them.

How to Buy Ether

As the second-largest cryptocurrency by market cap (behind Bitcoin), Ether can be purchased on many major cryptocurrency exchanges. Popular options include Binance.us, Coinbase and Gemini.

To purchase and possess Ether, you'll first need to set up a digital wallet. The safest option is to use a "cold" wallet that isn't connected to the internet, such as a thumb drive with your Ethereum account information. Some exchanges offer wallets or can store your cryptocurrencies for you. This is a more convenient option, but it puts your cryptocurrencies at risk if the exchange gets hacked or goes under.

Generally, the cheapest way to buy cryptocurrencies on an exchange is to transfer funds from your bank account or use a debit card. Some exchanges accept credit cards, but you may have to pay additional fees to both your card issuer and the exchange.

Alternatives Ways to Invest

The volatility of cryptocurrencies make them attractive to investors looking to cash in on fluctuating prices. However, many investors only hold a small portion of their investments in cryptocurrencies. Whether you're just starting or you're an experienced investor, diversifying your investments can help limit your risk.

Consider the many ways you can invest your money beyond cryptocurrencies:

  • Stocks: When you invest in company stocks, you're purchasing a portion of the business. As a partial owner, you can then benefit financially when the company's value increases. Some public companies also share their revenue with stockholders by issuing dividends.
  • Bonds: A bond is a loan taken out by a corporation or government. When you purchase bonds, you're lending money and will then get repaid with interest. There are different types of bonds, and your return and risk can depend on the risk that the borrower won't be able to repay you.
  • Mutual funds and exchange-traded funds (ETFs): Mutual funds and ETFs can hold or track multiple investments, letting you quickly invest in different areas with a single purchase. For example, you could buy a fund that tracks the entire stock market or a fund that focuses on sustainable businesses. There are even funds that focus on cryptocurrencies and blockchain companies available to investors.
  • Retirement accounts: Retirement accounts, such as IRAs and 401(k)s, can offer tax advantages to investors. An IRA or 401(k) isn't an investment in and of itself, but you can move money into one of these accounts and then invest the funds.

No matter the investment, there's always a risk that you'll lose money. High-yield savings accounts and certificates of deposit (CDs) can offer nearly risk-free ways to make money, but you'll usually need to take on more risk if you want higher returns.

Will Buying Ether Impact Your Credit?

Buying and owning Ether won't directly impact your credit. Your credit reports don't contain any information about your savings, investments, income or net worth. And credit score calculations are based entirely on the information in one of your credit reports.

However, buying Ether could indirectly cause a credit score impact if the purchase affects your finances in other ways. Perhaps you invest a lot of money in Ether hoping it will quickly rise in value, or because you believe in the long-term value of Ethereum as a platform. But then you're faced with an emergency expense and don't have enough cash on hand to cover it.

If the price of Ether has dropped, you might not want to sell right away. However, the alternative might be to miss bills—which could lead to fees and late payments that hurt your credit. Or, you might use a credit card. Even if you pay your credit card bills on time, the higher balance could accrue interest and hurt your credit scores by increasing your credit utilization ratio.

You can manage some of this risk by building up your emergency fund before making any investments. Also, look for ways to protect and build your credit while you're saving and investing. You can get a free copy of your Experian credit report, a free FICO® Score and personalized recommendations for improving your credit for free with an Experian account.