Learn Ethereum in 2024. #6. Ether and the cryptocurrencies.
The first blockchain in the modern sense, Bitcoin, was created with the primary objective of facilitating a decentralized digital currency. The term “cryptocurrency” stems from the fact that blockchains leverage various cryptographic techniques, including hash functions and asymmetric cryptography, to ensure the security and integrity of the network. While blockchain technology has evolved to serve a wider range of applications, its most renowned and widely adopted use case remains cryptocurrencies. Although the term cryptocurrency is ubiquitous today, few people truly understand how it works.
Mining
We have already established that Bitcoin comprises a ledger that records transactions of its native currency, bitcoin. However, it’s crucial to understand how these currencies come into existence. For an individual to transfer a cryptocurrency to another person, they must first possess that currency, meaning it has been transferred to them by someone else. To resolve the conundrum akin to the chicken and egg dilemma, we introduce the concept of mining.
Bitcoin’s consensus mechanism relies on the concept of proof of work, where participants engage in a computational puzzle-solving process. The participant who successfully solves the problem first earns the right to append the next block to the blockchain. When this occurs, the algorithm mandates the inclusion of a special transaction within the block, transferring a specific amount of bitcoins to the individual who typically won the computational challenge. Essentially, with each block, bitcoins are generated “out of nowhere” and awarded to an individual. This process is commonly referred to as mining, which is why those who successfully complete the computational challenge and add blocks to the chain are known as miners. The bitcoins earned through this process constitute the miner’s reward.
The number of bitcoins mined per block is not constant. It commenced with 50 bitcoins in 2009 and undergoes a halving process approximately every four years. In 2012, the reward decreased from 50 bitcoins per block to 25 bitcoins, and as of 2024, it will further decrease to 3,125 bitcoins. This halving progression ultimately leads to Bitcoin having a total cap, meaning only 21 million bitcoins will ever be issued.
In addition to the fixed reward of bitcoins per block mined, miners also receive another type of reward, which is variable. When users submit a transaction on the network, they typically attach a tip in bitcoins for the miners. This is because there are usually more transactions waiting to be processed than can fit into a block. Therefore, miners prioritize transactions with higher tips, ensuring that these transactions are included in blocks first. However, it’s important to note that this process only redistributes existing bitcoins and does not create new ones.
Block rewards
Ethereum initially followed a trajectory similar to Bitcoin, employing a proof-of-work mechanism and relying on miners to secure the network. Miners in Ethereum were initially rewarded with 5 ether (ETH) for each block they successfully mined, in addition to receiving transaction fees known as gas fees. While gas fees might seem analogous to the tips in Bitcoin transactions, they serve a distinct purpose within the Ethereum ecosystem. We’ll delve deeper into gas fees in a future article. If you examine Ethereum’s block number 1 on etherscan, accessible at https://etherscan.io/block/1, you’ll find a block reward worth 5 ETH listed under “Block Reward.”
Ethereum does not employ a halving mechanism, but the block reward can be adjusted through community consensus. Currently, the reward is no longer fixed at 5 ETH, and its distribution is more intricate. This complexity arises from Ethereum’s shift away from the proof-of-work consensus mechanism. However, even in the new consensus mechanism, new ethers are still generated with each block. These ethers are distributed as rewards to validators, who actively participate in the consensus mechanism by validating and proposing blocks.
The London upgrade
In 2021, Ethereum underwent a significant upgrade known as London, which had a profound impact on its economy. As previously mentioned, executing transactions on Ethereum requires the payment of a gas fee, in ether. Prior to the London update, this fee was entirely allocated to the miner; however, following the upgrade, only a portion of this fee began to be rewarded to the miner (and currently to the validators). The remainder of the fee is now destroyed, a process referred to as burning. Consequently, with every block, new ethers are created to reward validators, while some existing ethers are burned. This mechanism has the potential to transform ether into a deflationary currency, wherein its circulating supply decreases instead of increasing. This contrasts with Bitcoin, which will continue to increase in supply until it reaches its predetermined total cap.
You can track the total ETH supply on several websites, such as https://ycharts.com/indicators/ethereum\_supply. This chart shows that at some point in 2021, the increase in Ethereum supply ceased being linear, and more recently, it has become nearly stable. The reason for this behavior can be attributed to the changes introduced by the London upgrade and, more recently, the transition to proof of stake. As of now, there are around 120 million ETH in circulation.
Tokens
One of the primary use cases for Ethereum is the creation of new tokens through smart contracts. Beginners often confuse tokens created on Ethereum with its native currency, ETH. While both can be categorized as cryptocurrencies, there are fundamental distinctions between them. As previously mentioned, ether serves at least two purposes on the Ethereum network: it is utilized to pay the gas fee for transactions and allows its holder to participate in the consensus mechanism as a validator. On the other hand, tokens, in essence, are merely data stored within a smart contract.
The economy of ether (ETH) is governed by the entire network collectively, regulated through its protocol, and can only be altered by the consensus of the majority of the network. Conversely, the economy of a token is controlled by its corresponding smart contract, which is immutable and subject to the decisions made by its creators. It is common for individuals without technical expertise to perceive tokens as tangible assets or to attribute special properties to them within the Ethereum ecosystem. However, it’s important to clarify that a token is simply code and information stored within a smart contract account. Fundamentally, a token does not inherently have any relationship with Ethereum’s native currency, ether.
We often refer to ether as Ethereum’s native token in an attempt to distinguish it from tokens generated by smart contracts. While there isn’t a universally defined terminology for this distinction, it’s crucial to comprehend the disparity between the two. Typically, every blockchain possesses its own native token. For instance, on the Binance Smart Chain, the native token is BNB, and on Polygon, it is MATIC. Similar to ether, these currencies are utilized to pay fees for their respective networks and/or engage in their consensus mechanisms.
Another common misconception about tokens is the belief that it’s possible to directly buy or sell them. While such transactions are indeed feasible, they don’t occur directly within the Ethereum network. Ethereum itself has no concept of fiat money. The primary method of obtaining ether is either by participating in the network as a validator and receiving newly created tokens as a reward, or by having another network user transfer their ethers to you. Naturally, this transfer can be made in exchange for fiat money, as facilitated by centralized exchanges. In the early days of Bitcoin, when Bitcoin exchanges were not yet established, individuals could propose to send bitcoins to others in exchange for goods or services, such as… pizza.
Ethereum units
Finally, let’s discuss ether denominations. The smallest unit of ether is called wei, named after computer engineer Wei Dai, and it is equivalent to 10^(-18), or 0.000000000000000001 ethers. Seen another way, 1 ether equals 10¹⁸ wei, or 1000000000000000000 wei. Another commonly used unit of ether is the Gwei (giga wei), also known as Shannon, in honor of the eminent scientist Claude Shannon. One Gwei is equivalent to 10⁹ wei or 1000000000 wei. Gwei is extensively employed for documenting gas fee values, which typically fall within this order of magnitude. Besides these, there exist other units of measurement, such as Mwei and Kwei, but they are less frequently used in practical applications. For convenient conversions between wei, Gwei, and ether, you can utilize the website https://eth-converter.com/.
Understanding these denominations is crucial because when interacting with Ethereum, transactions and balances are typically expressed in wei. For instance, when transferring 1 ether to another individual, we must specify the transfer as 10¹⁸ wei. Similarly, when checking the balance of an Ethereum account, the balance is presented in wei.
