In September, CFA Society Toronto hosted the second webinar in their Crypto Series, titled “Ethereum & AAVE – Blockchain Technologies Powering Decentralized Finance.” Guest speakers James Wang, Head of Tokens at Amun, and Ajit Tripathi, CFA, Head of Institutional Business at Aave, addressed a wide range of topics, including what Ethereum is and why the technology behind Ethereum gives intrinsic value to the cryptocurrency.

Defining blockchain and cryptocurrency

It is useful to distinguish between a blockchain and a cryptocurrency. A blockchain is a database or decentralized ledger of transactions that can be verified on a peer-to-peer basis without the need for an intermediary. On the other hand, a cryptocurrency is a digital asset, and its transactions are processed by a blockchain. There are different blockchain technologies and different cryptocurrencies.

So, what is Ethereum then?

Ethereum is a blockchain. It helps to think of Ethereum, and its utility, in cloud computing terms. The benefit of cloud computing is that an organization doesn’t need to own servers or other such infrastructure. Instead, they can rent these capabilities from a company such as Amazon Web Services and deploy many of their applications to the cloud. Ethereum has a similar function, enabling users to deploy applications to the Ethereum blockchain like they would to a cloud computing space. However, with Ethereum, there is no centralized entity that owns the computing space or infrastructure. Rather, it is a decentralized network distributed across many computers, called nodes. This is a huge advantage because when a company owns the infrastructure, both parties need to contract to certain terms and conditions. With Ethereum, no permission or contract is needed, and anyone can access the blockchain. This property is not unique to the Ethereum blockchain. The Bitcoin blockchain also has a decentralized ledger and protects access in a similar manner. However, the difference is that Ethereum allows users to run much more complex programs than Bitcoin.

Then there is Ether (ETH), which is a cryptocurrency. ETH is unique to Ethereum and is the native asset of this blockchain, which users of the Ethereum blockchain use to pay for transactions. Put simply, Ethereum is the blockchain and ETH is the cryptocurrency.

To process a transaction on the Ethereum blockchain, users must pay “gas” (in the form of ETH) to the miners who process and validate the transaction. Transactions vary in form and range from transferring funds between two wallets to more complicated settling of smart contracts. The more complex the transaction, the more “gas” (ETH) is needed. As a result, ETH has some intrinsic value and utility, unlike some other cryptocurrencies, such as Bitcoin. The more transactions occur on Ethereum, the more gas will be needed, and the more value ETH holds.

One drawback of Ethereum is that it often takes a lot of “gas” to perform a transaction, which can make it an expensive platform. This is because in its current form, known as Layer 1, there is little capacity or bandwidth—Ethereum can perform around sixteen transactions per second. Although this is faster than the Bitcoin blockchain, which processes around seven transactions per second, it is much slower than existing centralized payment systems. Developers are currently working on improving the processing capacity of Ethereum, and a move to the so-called Layer 2 is underway. This will allow more transactions to be bundled together, which should speed up performance dramatically and push transactions per second into the thousands. That should make Ethereum a cheaper platform for transactions, increase volumes, and eventually match existing centralized payment systems in processing speed.

Exploring other blockchains and cryptocurrencies

There are many blockchains—including Bitcoin, Solana, and Cardano, to name a few—many of which have their own token or cryptocurrency. Given that cryptocurrency and blockchain technology is still in early-stage development, it is not clear which blockchain(s), will emerge as dominant. If blockchains follow a similar path as the early stages of computing and network development, it is likely that 80 percent of the market could end up being controlled by just one or a handful of blockchains. For now, this space is developing at a breakneck speed and changes occur daily.

Although their current market share is still minute, proponents of cryptocurrencies, blockchain, and decentralized finance (DeFi) believe that technologies such as Ethereum and other platforms will take a greater market share from traditional finance. One example of such a protocol is Aave, which aims to facilitate transactions in digital assets such as cryptocurrencies on blockchains without choosing a clear favourite. Aave is a decentralized finance protocol (or set of rules) that allows a person to deposit and borrow cryptocurrency at a certain interest rate without having to go through a centralized intermediary. This protocol effectively provides pools of liquidity in a long list of cryptocurrencies to participants who wish to transact. In this way, Aave protocol serves to bypass traditional intermediaries in the financial system. That said, while it may be possible to buy some goods and services in cryptocurrencies, it is unlikely that traditional banks will exchange cryptocurrencies for fiat currencies, such as ETH for Canadian dollars, at this stage. However, there are crypto exchanges that would exchange cryptocurrencies for currencies such as USD, EUR, or CAD and that thereby serve as a bridge between DeFi and traditional finance.

Because DeFi is still in its infancy, there is a lot of development that needs to be done before it becomes mainstream. At this point, DeFi in general lacks reputation and trust, which is essential for any financial system or institution. DeFi also needs to provide users with a greater sense of security that assets will be safe. Traditional finance, for example, provides insurance on deposits in some cases, which DeFi doesn’t do. As a result, because of its decentralized nature, DeFi also provides little recourse to an individual or company if something goes wrong, such as funds being transferred in error to the wrong account. But even in these early stages, there seems to be general acknowledgement that even if DeFi is successful and becomes more mainstream, it is unlikely to replace traditional finance. Rather, DeFi is likely to co-exist alongside traditional finance.

Regulating crypto

Lastly, regulation of cryptocurrencies remains a thorny issue in many countries. Although one aim of DeFi is to reduce costs and increase transparency, there will always be people who wish to misappropriate the technology for their own gain—this has happened with other financial developments in the past and is likely to happen again in the future. Since DeFi is developing at an incredibly fast pace, regulation tends to be reactive rather than proactive. The DeFi community will have to work more closely with regulators on these issues, just like DeFi and traditional finance will work together in the future. What seems clear from the insights of Wang and Tripathi is that blockchain, cryptocurrencies, and DeFi are here to stay and are likely to play a larger role in our society as the technology evolves.