What Investors Should Know Before Trading Ether

By Charles Bovaird for Coindesk

Given the increasing prominence of the idea blockchain tech will impact enterprise business, both retail investors and investment institutions are optimistic the market could soon develop into a vibrant new asset class.

However, to date, there have been few alternative digital assets that have offered a value proposition that differs from that of bitcoin, the oldest publicly traded blockchain-based cryptocurrency.

Today, bitcoin appeals to investors with both a high tolerance for risk and those who believe the digital currency could one day become a stable store of value and financial rail competitive in global commerce. Though often cited as volatile, bitcoin’s market remains one of the more stable among digital currencies, with a market cap today in excess of $7bn at press time.

Many alternative digital currencies, in turn, have offered a similar value proposition, and comparably more pronounced volatility.

Amid this landscape, ether, a currency transacted through the Ethereum platform, is perhaps emerging as a contender for more adventurous portfolios. Despite a recent slump in price, ether volume has seen strong growth as more global exchanges add the asset to their offerings.

Ether provides unique benefits not offered by alternative digital currencies, including bitcoin, but it also comes with its own set of risks and considerations. Interested investors can benefit from learning the basics of ethereum, as well as the key variables that influence ether’s price movements.

What is Ethereum?

A platform for decentralized applications, Ethereum was invented by Vitalik Buterin and announced in early 2014. At the time, Buterin indicated in public appearances he was keen to create an alternative blockchain-based system that would offer a superior arsenal of tools to global developers.

Launching in beta in July 2015 and in a production version this March, Ethereum’s big innovation is that it runs Turing-complete smart contracts, applications that rely on if-then scenarios to execute specific terms of an agreement.

Basically, smart contracts ensure that once a predetermined condition is met, the corresponding clause contained in the contract is fulfilled, and the Turing-complete factor has been heralded as allowing developers a new expressiveness in writing such code.

Today, smart contracts can run on the public Ethereum blockchain, a distributed ledger technology that is used to keep track of all related transactions and agreements.

The smart contracts that run on its blockchain could have widespread applications, as developers could use them to create markets, execute transactions based on agreements created long ago and keep track of pledges made by different counterparties.

Many users have already begun taking advantage of these myriad options, developing a wide range of apps that can be used to set up ridesharing applications, sports bets and even investment schemes, The New York Times has reported.

But as open-source technology, corporations are free to create their own private blockchains based on Ethereum that do not use the public Ethereum blockchain, and as such, don’t use Ethereum’s token, ether.

How ether’s market works

Unlike bitcoin, ether is not designed to function as a global digital currency. Instead, it is meant to pay for specific actions on the Ethereum network, with users receiving it for using their computing power to validate transactions and for contributing to its development

However, ether’s market is currently supported by many of the same exchanges and infrastructure that has built up around the bitcoin network. For example, users who have historically bought bitcoin and other digital currencies on venture-backed exchange platforms such as Bitfinex and Kraken can today buy ether on these websites.

But, ether’s market did not develop in the same manner as bitcoin’s market.

In bitcoin, users were once able to process transactions on the network using a home computer, and then eventually, home mining equipment. Bitcoin grew in value as the number of participants in the network expanded. Ethereum arguably developed under different circumstances.

In a bid to galvanize a global development community around its idea, Ethereum launched a pre-sale of ether tokens in 2014, raising more than $14m in what has been called a crowdfunding effort, but bears resemblance to a kind of informal initial public offering (IPO).

Donations collected for this sale were the driving factor behind the initial supply and the rate of issuance that existed after. As a result of this event, contributors of the presale received 60m ether. Another 12m went to the development fund, with the majority of this amount going to early developers and contributors. The Swizterland-based non-profit Ethereum Foundation received the remainder of this amount.

These numbers added up to an initial ether supply of 72m ETH. Following this event, Ethereum’s protocol permitted the creation of 5 ETH for every block mined. In addition, a maximum of 18m ETH were allowed to come into existence every year following this event.

In the bitcoin network, the supply rate is more consistent. Due to hard-coded rules in the software there will only ever be 21 million bitcoins (unless the rules are changed), and the rate at which new tokens are introduced is 25 BTC roughly every 10 minutes today.

Investors should note that such consistency is not guaranteed in the ether market.

The Ethereum Foundation announced at the time of launch that ether’s rules would soon change, and that starting some time in 2017, the network would follow the rules of Casper, a consensus algorithm still being developed.

As of mid-April, the total number of ether transactions stood at 3.3 million, resulting in an ether supply of 79m ETH, Etherscan figures reveal.

In addition, ether was trading at 0.0197 BTC, or about $9.25.

How does mining affect price?

As stated above, one of the biggest factors on bitcoin’s price is the steady introduction of new bitcoins through payments to the computer operators that process transactions (miners).

Mining affects price by increasing the supply, and through the decision of miners to hold or sell bitcoin. Ethereum’s current version, Homestead, leverages a proof-of-work based consensus algorithm, rewarding computers that contribute to its security in the same way.

Under this system, miners create a new block every 15-17 seconds, resulting in the creation of 5 ETH, according to figures provided by Ethereum.org. Miners that contribute to discovering a solution, but don’t get their block included, can receive two or three new ethers, which is called an uncle/aunt reward.

Once Ethereum starts using Casper, a proof-of-stake protocol, this rate is expected to change, as many anticipate Casper will provide a smaller mining subsidy. Under the new protocol, nodes will not be able to validate transactions and therefore produce blocks unless they provide a security deposit.

Should the protocol determine that a node, or “bonded validator,” has produced anything invalid, the node will lose both any deposit provided and also the ability to participate in the consensus process. Currently, bonded validators face no penalty if they produce blocks considered invalid by the protocol.

By changing incentives, it is expected that Casper will be more efficient, but the change could also mean that ether’s value is adjusted to the new realities of the network’s operation.

Security questions

With seven years of development (and few major issues), the bitcoin network is often heralded by supporters as the most secure blockchain. Even enterprise businesses have expressed a value in its strong network effects and diverse mining network.

Ethereum has faced criticism for potential security problems for several reasons, though most center on the fact that the software is in its early stages and has only been available for a few years. The network has suffered fewer attacks than bitcoin, and as a result it has undergone less testing than its older digital currency.

The differing compositions of ether and bitcoin’s mining pools are also worth noting. While bitcoin’s mining community has sometimes drawn criticism for being dominated by a small number of players, this situation seems replicated in Ethereum.

While Blockchain.info figures show five companies control about 81% of bitcoin’s hashrate distribution, five companies accounted for more than 85% of ether’s hashrate distribution by mid-April.

Further, though the largest bitcoin miner (F2Pool) accounted for 26% of the digital currency’s hashrate distribution in this 24-hour block, the biggest ether miner (dwarfpool) supplied 41.8% of this currency’s hashrate.

Going forward, developers continue to work on newer versions of Ethereum, but critics have predicted that ether will face greater security problems than bitcoin. There is only one way to find out.

Price volatility

Because of the infancy of the platform, Ether has experienced sharp price fluctuations. At the time of report, the digital currency had logged one-day, one-month and since-inception changes of 31%, 16.7% and 53.7%, respectively.

While this volatility might make the currency look less valid in the eyes of some, these gyrations provide opportunities for traders.

Market participants can buy and sell ethereum using both fiat currency and bitcoin. Such transactions are available through numerous exchanges, as several organizations have started offering these trades in recent years.

Because of the digital currency’s sharp volatility, some traders speculate on its future price movements in an attempt to turn a profit. Others use ether to hedge bitcoin, as well as alternative digital currencies.

Charles L. Bovaird II is a financial writer and consultant with strong knowledge of securities markets and investing concepts.

Follow Charles Bovaird on Twitter here.

Image via the Ethereum Facebook page

First appeared at Coindesk