Introduction

Blockchain, an innovative concept predating Bitcoin, originated in 1982 when David Chaum introduced a blockchain-like protocol. This laid the groundwork for decentralized systems redefining trust and security in digital environments.

In 2009, Bitcoin, a pioneer in cryptocurrencies, launched, revolutionizing finance with its global, decentralized digital currency. It avoids central institutions, ensuring censorship resistance.

Ethereum, introduced in 2014, builds upon Bitcoin's foundation. It aims to address limitations, enable Decentralized Autonomous Organizations (DAOs), and support decentralized application (DApp) development. Ethereum's smart contracts open new possibilities.

To understand Ethereum, let's delve into Bitcoin's technology and principles, highlighting why Ethereum was introduced and its internal workings.

Bitcoin

Introduction to Bitcoin

In 2009, blockchain technology emerged with Satoshi Nakamoto's whitepaper introducing decentralized blockchain for digital trust, giving birth to Bitcoin and its journey into a prominent blockchain.

Bitcoin, a decentralized digital currency using blockchain, enables peer-to-peer transactions, value storage, and global financial participation, reducing reliance on traditional banks. Its decentralized, limited supply and secure features innovate finance and technology.

Bitcoin employs public-key cryptography and a "proof-of-work" consensus algorithm to manage ownership and validate blocks. This algorithm resolves key blockchain challenges: network-wide agreement on block validation through miners solving puzzles and ensuring fair consensus participation, promoting decentralization and security.

How Bitcoin works internally

State Transition System

State transition in the context of Bitcoin refers to the process by which the Bitcoin blockchain moves from one state to another, primarily involving the creation and transfer of bitcoins (BTC) between different addresses.

The State of the Bitcoin is just a collection of coins or UTXOs(unspent transaction outputs) that have been minted and not yet spent but there is no list of owners and balances. These UTXOs will say who their owner is and how much BTC they contain.

Let's dive into a simplified exploration of the Bitcoin state transition, avoiding complex technical details. To grasp the concept, let's use an analogy involving two individuals: Person A and Person B.

Imagine that Person A wishes to send 2 BTC to Person B while holding 2.4 BTC. It's essential to recognize that Person A had previously received 1.2 BTC each from two other individuals, Person 1 and Person 2. This prior state, where Person A has 2.4 BTC in total, serves as a recorded or existing state.

Now, let's examine how a transaction unfolds between Person A and Person B:

1. Initialization: Person A initiates a transaction, creating an agreement or contract to transfer 2 BTC to Person B.

2. Outputs: The transaction comprises two outputs. First, 2.0 BTC is transferred from Person A to Person B (Person A -> Person B). Then, the remaining 0.4 BTC is returned to Person A as "change."

3. Updating the State: This new state, reflecting the updated account balances of Person A and Person B, is added to the existing state of transactions. Consequently, a fresh state is generated, showing the new distribution of BTC among the involved parties.

In essence, this process exemplifies how transactions operate within the Bitcoin blockchain, with the blockchain maintaining a continuous ledger of state changes resulting from these transactions.

Mining

Recording transactions in a centralized system involves storing them on a server, while Bitcoin relies on decentralization. To achieve this, a consensus mechanism ensures agreement among network nodes on transaction history. In Bitcoin, this relies on generating new "blocks" about every 10 minutes. Each block consists of a timestamp, a nonce (a unique number), and a reference to the previous block, forming a chain.

Validating blocks in Bitcoin follows a strict algorithm:

1. Verify the reference hash (previous block's hash).

2. Check the timestamp's sequence and time limits.

3. Confirm the block's Proof of Work (PoW).

4. Inspect transaction validity within the block.

Bitcoin blocks track transaction validity, not states. The entire state is reconstructed from the genesis block to the current one, with the transaction order being crucial. PoW assigns a hash value to a block, adjusting consensus difficulty. It employs the double-SHA256 algorithm to produce a hash with leading zeros. For instance, a block with a valid hash (e.g., 0000000000000000057fcc708cf0130d95e27c5819203e9f967ac56e4df598ee) can join the blockchain.

The Bitcoin network adjusts a dynamic target every 2016 blocks to maintain a 10-minute block creation time, ensuring network resilience and efficiency.

Merkle Tree

A Merkle tree, or Merkle root, is a key structure in Bitcoin for storing all transactions, enhancing security and scalability. Named after Ralph Merkle, this tree simplifies transaction confirmation and boosts security.

The Merkle tree is a binary tree with many bottom nodes representing unique transaction IDs, paired and hashed together to form a root node, representing all top-level transactions. This root is added to the block header for all nodes' access. It safeguards against malicious changes to lower transactions.

The Merkle tree is crucial for Bitcoin's long-term viability. By April 2014, full nodes had grown to 15GB and continued to expand at 1GB per month.

To meet network demands, the "Simplified Payment Verification" (SPV) protocol introduced light nodes by 2023. Light nodes download block headers, verify proof-of-work, and fetch relevant transaction data, providing secure, efficient access without the entire blockchain download. This shift revolutionizes how Bitcoin transactions are accessed and validated.

Scripting

Bitcoin facilitates a weak version of the concept of "smart contracts". A smart contract contains a set of instructions and terms on which one or more parties agree to make a successful transaction. A transaction made using a smart contract must be verified by a smart contract itself. In Bitcoin, we can do things like Multisig (multiple parties agreeing to pass) or decentralized cross-cryptocurrencies exchange.

However, there are limitations to what these scripts (smart contracts) can do in Bitcoin. They are:-

1. Lack of Turing Completeness: The Bitcoin scripts can handle a large subset of computation but not everything. It is not able to handle an infinite loop during transaction verification; theoretically, it can be handled but it leads to a very space-inefficient script.

2. Value Blindness: In UTXOs, you can spend the entire amount stored in UTXO or none of it. There is no way you can specify how much you want to withdraw.

   Imagine a scenario where two parties, A and B, have contributed $1000 worth of Bitcoin each to a smart contract, and after 30 days, they want the script to automatically send $1000 worth of Bitcoin back to A and the remainder to B. To make this work, you would need an oracle, which is a trusted data source that can provide external information.

   The problem is that in a UTXO system, you can't specify the exact amount to be sent to A and B.

3. Lack of state: UTXO is either spent or unspent. It cannot handle the multi-stage contract/scripts which keeps an internal state. UTXO cannot keep the track of the state of the transaction it does.

4. Blockchain Blindness: UTXO cannot read the blockchain data like the nonce, the timestamp and the previous block hash. This severely limits the applications like decentralized organizations and several other categories of use cases.

All the limitations listed above can be overcome in 3 ways. Building a new Blockchain, writing scripts on Bitcoin Blockchain or building a meta-coin on top of Bitcoin. But each has its drawbacks.

Introducing Ethereum! Ethereum is an alternative Framework that allows easier development as well as stronger light client properties, while at the same time allowing applications to share an economic environment and blockchain security.

Let's look at Ethereum in detail.

Ethereum

Introduction to Ethereum

Ethereum is designed to be a new way to create decentralized applications. It offers benefits like fast development, security for small apps, and efficient interactions between different apps. It does this by using a blockchain with a built-in programming language (Solidity), allowing people to create smart contracts and decentralized apps with their own rules for ownership and transactions. This makes it easy to build various applications, including currencies and reputation systems. Smart contracts in Ethereum are like digital boxes that hold value and only open under specific conditions, offering more flexibility and power compared to Bitcoin's scripting.

How does Ethereum work internally?

Accounts

In Ethereum, the accounts are made up of objects that contain a 20-byte address (eg. 0xa9179193EB2852CE462244bfD966da7Dne37R1Ec) and state transition. The accounts contain four things:

1. Nonce

2. Current Ether balance

3. Contract Code, if any

4. Storage, empty by default

Ether is the crypto-fuel on which the Ethereum blockchain works. It is used to pay transaction fees. There are two types of accounts in Ethereum. They are:-

1. Externally Owned Accounts: These accounts are also called user-controlled accounts. They do not contain any code. They are used to send messages to other accounts by creating and signing transactions by private key, used for managing Ether and interacting with smart contracts.

2. Contract Accounts: These accounts are associated with smart contracts and are controlled by a self-executing contract code. They can perform various functions and transactions when the conditions are met. These accounts hold Ether and are managed by code associated with smart contracts.

Transactions

'Transaction' in Ethereum is used to refer to the signed data packages that store a message and send it to an externally owned account. A transaction contains the following things:

1. Receiver's message

2. Signature of the sender

3. Amount of ether to transfer from sender to receiver

4. An optional data field

5. STARTGAS value represents the maximum computational steps a transaction takes to be successful.

6. GAS PRICE value represents the fees paid by the sender per computational step.

The above three fields are similar to that of cryptocurrency transactions. data field sometimes contains the data that is required by a contract. A contract can access the data using an opcode available in the EVM (Ethereum Virtual Machine).

StartGas and GAS PRICE both are very crucial to Ethereum's anti-denial of service model. To prevent any hostile infinite loops or other computational wastage, each transaction that occurs requires to set limit of the computational power it can use to execute code. The fundamental unit of computation is called "gas".

The above image shows the transaction details. Here, the GAS PRICE is 2.76754326 Gwei, Gas limit & Usage by Txn aka STARTGAS is 59,497 and besides that 45,826 is the used "gas" to complete the transaction.

There are three types of units used in Ethereum WEI, GWEI and Ether.
1 Gwei = 10⁹ Wei
1 Ether = 10⁹ Gwei = 10¹⁸ Wei

Here is the link for the converter. Click Here

Messages

A 'Message' is a special type of transaction that is used to interact with smart contracts. Message is a virtual object and is internal to EVMs which do not create a new transaction. It contains the following fields:-

1. The address of the sender of the message

2. The address of the receiver.

3. The amount of Ether to be transferred

4. An optional data field

5. A STARTGAS value

A Message is used specifically between contracts or to interact with contracts to invoke a function, update some data or execute some specific logic. A Gas limit has to be provided by the sender to handle the computation for executing the code. This limit is the maximum amount of gas that can be consumed by the execution of the contract code.

Ethereum State Transition

State Transition refers to the process by which EVM goes from one state to another as a result of executing the transactions or messages on the Ethereum Blockchain. Here is how the state transition in Ethereum takes place.

1. It checks whether the transaction is correctly formed or not. A transaction should contain the signature of the sender, the nonce that matches the nonce of the account.

2. It calculates the transaction fees GAS PRICE * STARTGAS then determines the sender's account and tries to subtract the fees, if the account does not contain enough balance it returns an error.

3. At first, the Gas is set to STARTGAS as an initial value and then it assigns a gas cost to each byte of data transaction and calculates the total gas cost.

4. It subtracts the Ethereum from the sender's account and transfers it to the receiver's account. If the receiver's account does not yet exist, it creates an account. If the receiver is a contract, then either run the code until completion or until the execution runs out of gas.

5. If the execution somehow fails due to not having enough funds in the sender's account or the execution runs out of gas, it reverts all the state and the gas cost is transferred to the miner's account because some execution took place and the resources were used.

6. If there is some gas cost left, it returns that amount to the sender's account.

Let's take an example of Contract execution. Consider an analogy that there is a decentralized bank and A wants to deposit some ETH into his/her bank's account. That bank contains a deposit contract that executes some code.

Let's say A wants to deposit 10 ETH in the bank. For a transaction, the STARTGAS is 2000 and GAS PRICE is 0.001. Also, some data containing the information of A which is 64 bytes.

1. First, it checks that the information that the transaction contains is perfect.

2. The maximum gas is going to be 2000 * 0.001 = 2 ETH. This determines that the A's account should contain at least 2 ETH.

3. The initial gas will be set to 2000. Let's say that this transaction takes 170 bytes to get executed and the gas per byte price is 5. So, the total gas used for the transaction will be 170 * 5 = 850 gas (the remaining gas will be 2000 - 850 = 1150).

4. Now, the 10 ETH will be subtracted from the A's account and transferred to the contract account.

5. Run the deposit code to deposit into the bank. This code execution requires the data that is sent with the transaction, utilizing it and execution requires an additional 180 gas, so the total Gas cost becomes 850 + 180 = 1030 gas (the remaining gas will be 1150 - 180 = 970).

6. The remaining gas, i.e., 970 gas (970 * 0.001 = 0.97 ETH) will be added to A's account. The total amount of Ether added to the bank account after transaction fees will be 8.97 ETH (10 ETH - 1030 * 0.001 = 10 ETH - 1.03 ETH = 8.97 ETH).

Note:

The whole 10 ETH was not transferred but the transaction fee was deducted from the transferred amount.

Code Execution

The code in Ethereum is written in a low-level language, stack-based bytecode language, also known as 'EVM code'. The contract code has access to information and storage present in EVM. They are:-

1. The stack (last-in-first-out), is a container to which values can be added or popped.

2. Memory is an infinite byte array.

3. The contract storage key/value store. It stores the values for the long term whereas stack and memory get reset after the computation is completed.

4. The code can also access the value, sender and data of the incoming message, as well as block header data, and the code can also return a byte array of data as an output.

This is what a bytecode of a contract looks like.

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The computational state of the EVM is defined by a tuple containing several elements: block_state, transaction, message, code, memory, stack, pc (program counter), and gas. These elements collectively represent the EVM's state and provide the information needed to execute the EVM code.

block_state refers to the global state, which includes all accounts, their balances, and storage data. It represents the overall state of the Ethereum blockchain.

The execution of each instruction is based on its specific definition, and these instructions are responsible for modifying the elements of the tuple to reflect the changes in the EVM's state.

For developers, Solidity is the language used to write smart contracts in Ethereum. It then converts the whole code into bytecode which can then be deployed on the EVM.

Mining

The Ethereum blockchain is similar to Bitcoin's in many ways, but there are some key differences. One significant difference is how blocks are structured and validated. In Ethereum, a block contains not only a list of transactions but also the most recent state. This means it includes the current state of all accounts and balances. It also stores the block number and difficulty. Here's how Ethereum's basic block validation works:

1. First, it checks if the previous block mentioned in the current block exists and is valid.

2. It verifies that the timestamp of the current block is later than the timestamp of the referenced previous block but not more than 15 minutes into the future.

3. It checks the block number, difficulty, transaction details, uncle details (uncle blocks are a mechanism to reward the miners who almost completed the puzzle but were not able to), and gas limit to ensure they are valid.

4. It verifies the proof-of-work, which is a way to secure the block.

5. It maintains a state, which is like a snapshot of all account balances, at the end of the previous block. Then, it applies each transaction in the current block to this state. If any transaction produces an error, or if the total gas used in the block exceeds a certain limit, the block is considered invalid.

6. It calculates the final state, including the rewards paid to the miner.

7. Finally, it checks if the final state is correctly represented in the block header. If it is, the block is considered valid; otherwise, it's not.

Note:

Ethereum 2.0 uses another consensus mechanism to validate a block called Proof-of-Stake

You might wonder why Ethereum needs to store the entire state with each block, as this seems inefficient. However, Ethereum uses a clever structure known as a Patricia tree that allows it to store and reference data efficiently. This way, only the parts of the state that change need to be updated between blocks, saving space and resources. This strategy means Ethereum doesn't need to store the entire history of the blockchain, which can save a significant amount of storage space compared to Bitcoin.

As for where contract code is executed, it's an integral part of Ethereum's state transition function, which is part of the block validation process. This means that when a transaction is added to a block, the code execution it triggers is executed by all nodes (computers) that download and validate that block, both now and in the future. This ensures consistency and security across the network.

Applications of Ethereum

Ethereum is a versatile blockchain platform that has a wide range of applications. It enables the creation of decentralized applications (DApps) and smart contracts, which can be used in various domains. Here are some key applications of Ethereum:

1. Decentralized Finance (DeFi):

   Ethereum is a fundamental platform for DeFi, allowing the creation of decentralized lending and borrowing platforms, decentralized exchanges, stablecoins, yield farming, and more. DeFi applications aim to replicate traditional financial services without the need for traditional intermediaries like banks.

2. Smart Contracts:

   Ethereum's primary use case is smart contracts. These self-executing contracts with the terms of the agreement directly written into code can automate various processes, such as insurance, legal agreements, and supply chain management.

3. Non-Fungible Tokens (NFTs):

   Ethereum's ERC-721 and ERC-1155 token standards have enabled the creation of NFTs. NFTs represent ownership of unique digital or physical assets, such as art, music, collectibles, virtual real estate, and in-game items.

4. Tokenization of Assets:

   Ethereum allows the tokenization of real-world assets, such as real estate, stocks, and commodities. These tokenized assets can be traded on blockchain-based platforms, providing increased liquidity and accessibility.

5. Decentralized Applications (DApps):

   Developers can create decentralized applications on Ethereum. These applications run on the blockchain and can provide services in a trustless and censorship-resistant manner. DApps can be developed for various purposes, including social media, gaming, and governance.

6. Supply Chain Management:

   Ethereum's transparent and tamper-resistant nature is useful for tracking and verifying the origins and journey of products within a supply chain. This can help improve transparency and reduce fraud in supply chain management.

7. Identity Verification:

   Ethereum can be used to create secure and portable digital identities. Users have control over their data and can choose when and how it's shared with various services, enhancing privacy and security.

8. Voting and Governance:

   Ethereum-based applications can be used for decentralized voting and governance systems. This enables transparent and tamper-proof voting processes for elections, referendums, and corporate governance.

9. Gaming and Virtual Worlds:

   Ethereum can power blockchain-based games and virtual worlds where in-game assets are tokenized, and players have true ownership of items and characters. This opens up opportunities for creating unique gaming experiences and economies.

10. Content Distribution and Publishing:

    Ethereum can be used to create content-sharing platforms that reward content creators and consumers. Smart contracts can automatically distribute payments based on content views, likes, or shares.

11. Healthcare:

    Ethereum can facilitate secure and interoperable healthcare data management. Patients can control their health records, and medical institutions can securely access and update this data as needed.

12. Decentralized Autonomous Organizations (DAOs):

    Ethereum is used to create DAOs, which are organizations governed by code and smart contracts. Members can vote on decisions, allocate funds, and manage resources in a decentralized and transparent manner.

13. Energy Trading and Grid Management:

    Ethereum can be used to build platforms for peer-to-peer energy trading, enabling individuals and businesses to buy and sell renewable energy directly, while ensuring transparent and efficient grid management.

Conclusion

The Ethereum whitepaper laid the foundation for Ethereum's development and the broader blockchain ecosystem. It introduced groundbreaking concepts that have since evolved and expanded, leading to the development of numerous decentralized applications and the growth of the Ethereum platform. Ethereum continues to be a major player in the blockchain and cryptocurrency space, fostering further innovation and decentralized solutions.

I have tried to explain the Ethereum whitepaper as simply and kept it as detailed as possible.

Thank you.