To have heard about Ethereum and to fully appreciate what the Ethereum blockchain is capable of are two very different things. In this blog post (1 of 2 in the series), I'll attempt to explain (as a test of my own understanding) how to Ethereum ecosystem works using the helpful diagram below as a guide. Let's dive in!
I'll refer to the diagram above throughout this post, so it may be helpful to go through each layer of the stack, section-by-section, starting at the bottom.
Ethereum is often described as the 'World's Computer' which, technical implementation aside, is designed to take away and redistribute the power increasingly concentrated in today's internet with just a few companies (all discovery happens via Google, communication via Facebook, web hosting via Amazon, etc.).
The most basic layer of the Ethereum ecosystem consists of two (commonly confused) components:
- The Ethereum blockchain - the global ledger of transactions made on the Ethereum network
- Ether (aka ETH) - the underlying 'currency' that powers the network (often called 'gas') . Technically, ether spans both the settlement AND asset layers due to the role it plays in settling transactions.
These two concepts are important to understand as they underpin every transaction, application, and derivative use of the Etheruem network. More on this later. We call this layer of the stack the settlement layer because it maintains both the undeniable record of transactions made (in the form of a gloablly distributed ledger) and the security required to prevent unwarranted modification of that ledger.
Put simply, ether acts as the incentive for nodes/validators on the Ethereum blockchain to record a particular transaction and make it an irreversible part of the Ethereum ledger.
What happens when you purchase an NFT on Opensea, for example? You pay a gas fee to the network, in the form of ether, for nodes to recognize your purchase and append a transfer of ownership as part of the blockchain. Your gas fees are rewarded to nodes that make that update and the transaction is made final. Your are officially the owner of that NFT, as recognized by the ledger.
In slight contrast to bitcoin, the 'currency' of the Bitcoin blockchain, it'll become quickly apparent that ether has far more utility than bitcoin due to its versatile programmability.
While bitcoin has the utility of being digital store of value, its utility beyond sending and receiving bitcoin between wallets is limited. In contrast, ether is infinitely programmable (think: 'if - then' statements) to execute smart contracts with varying levels of complexity. Ether can be transferred, loaned, borrowed, etc. conditionally because of ether's programmability through smart contracts while also acting as a store of value on the Ethereum network. This leads us to the second layer of the stack!
This layer of the Ethereum stack is perhaps easiest to wrap our heads around since this is where all cryptocurrencies seem to exist. To understand this layer of the stack, it's important to understand what an asset is... and luckily, this is quite simple!
An asset is anything that has underlying value to it. Even the most rudimentary dictionaries agree with this definition. Whether it's a unit of fiat currency (e.g. 1 USD), a piece of gold, a residential home, or a business, all of these qualify as assets due to the underlying value they hold.
But let's take it a step further. Here, I find Robert Greer's super asset classes to be a helpful framework follow. The framework simplified:
- Capital Assets - produce yield over time (e.g. stocks, rental properties)
- Store of Value Assets - scarce in nature and preserve value over time (e.g. gold, silver, real estate)
- Consumable/Tranformable Assets - can be consumed to derive utility (e.g. wheat, corn, crude oil)
So where does ether fit? Well... that's the magic! Ether is a rare triple-point asset that spans across all three asset classes:
- Ether is a Capital Asset - it can be loaned out for yield, staked, put into liquidity pools all in an effort to earn cashflows from the asset
- Ether is a Store of Value Asset - it appreciates in value (mostly) over time and can be used as collateral for other assets
- Ether is a Consumable / Transformable Asset - it can be used as gas to secure and execute transactions on the Ethereum network
Why is this important? Well, it underpins why ether and the thousands of token built on Ethereum are assets. Each token fits at least one of these asset classes and comprise the second layer of the stack: the asset layer.
You may have heard of ERC-20 and ERC-721 tokens (ERC simply stands for 'Ethereum Request for Comment'). Despite the complicated sounding nomenclature, these are just two 'types' of Ethereum-backed tokens that all have some form of underlying value on the Ethereum network.
While ERC-20 tokens are more commonly akin to an 'investment' in a particular protocol on the Ethereum network (kind of like, but not identical to stocks/securities), ERC-721 tokens are more famously used for NFTs (non-fungible tokens) dilineating 'uniqueness' of an asset. More on this in a future post.
Let is suffice to say that both ERC-20 tokens and ERC-721 token meet our definition of assets. While ERC-20 tokens are not 'unique' relative to other tokens of the same type (two USDT tokens are the same.... they are 'fungible'), ERC-721 tokens tend to be one-of-a-kind in form an function (two CryptoPunks NFTs are sufficiently unique from one another... they are 'non-fungible').
The asset layer provides the foundation for invention and innovation in the Etherum network. Protocols can be invested in and grow over time. They create value in the ecosystem and create an incentive for participation in the network through protocols. In short, they create a means of transferring utility within the network.
I know breaking down only two layers of the Ethereum network seems long and complicated. But a thorough understanding of these foundations lay the groundwork for understanding the drove of diverse (and exciting!) innovation happening on the network.
With a means of recording, securing, and executing transactions in a decentralized manner paired with an asset layer to capture and transmit value in place, we now get to dive into all the use-cases this innovation brings. Stay tuned for part 2 in this series where we'll get into the thick of it.
As always, I'd love your feedback. Was this helpful? More confusing than it was useful? Drop me a line on Twitter to let me know!
🙏🏾As always, thanks for reading