Ethereum Explained: Smart Contracts, Gas Fees, Staking and Ether
Ethereum is the second-largest crypto network, but it works very differently from bitcoin. This guide explains what smart contracts do, how gas fees are calculated, how proof of stake and staking work, what drives the supply of ether, and the risks and tax rules US investors should understand.
Bitcoin was designed to do one thing: move a scarce digital currency between people without a bank. Ethereum, launched in 2015, set out to do something broader. It is a blockchain that can run programs, which means developers can build lending markets, exchanges, stablecoins and other applications directly on top of it. Its native currency, ether (ETH), is what users spend to run those programs and what validators lock up to secure the network.
That design makes Ethereum more flexible than bitcoin, and more complicated. Here is how the main pieces fit together, and what they mean for anyone considering ether as an investment.
Smart contracts: programs that run on a blockchain
A smart contract is code stored on the Ethereum blockchain that runs exactly as written when someone interacts with it. Nobody can quietly change the rules once it is deployed, unless the code itself allows upgrades.
In practice, smart contracts power most of what happens on Ethereum:
- Tokens. Many cryptocurrencies, including widely used dollar stablecoins, exist as tokens on Ethereum following a shared standard called ERC-20.
- Decentralized finance (DeFi). Lending and borrowing protocols, and decentralized exchanges where users trade tokens with a contract instead of a company.
- NFTs. Unique tokens that record ownership of a digital item.
- Other applications, from prediction markets to on-chain identity tools.
The upside is openness: anyone can build or use these applications without permission. The downside is that a bug in the code can be exploited, and there is usually no customer service desk to reverse a mistake.
Gas: how Ethereum fees work
Every action on Ethereum, from sending ether to swapping tokens, consumes computing work measured in units of gas. The fee you pay is roughly the gas used multiplied by the price per unit of gas, and that price is quoted in gwei, a tiny fraction of one ether (one billionth).
Since an upgrade in 2021, each transaction fee has two parts:
- Base fee: set automatically by the protocol. It rises when recent blocks are full and falls when they are not. The base fee is burned, meaning it is permanently removed from circulation rather than paid to anyone.
- Priority fee (tip): an optional extra paid to the validator to include your transaction sooner.
Two practical consequences follow. Fees vary with demand, so the same transfer can cost very different amounts at different times. And complex transactions cost more than simple ones, because they consume more gas. Wallets estimate the fee before you confirm.
Proof of stake and how staking works
Ethereum originally used proof of work, the same energy-intensive mining system as bitcoin. In September 2022, an upgrade known as the Merge switched it to proof of stake, which cut the network's energy use dramatically.
Under proof of stake, validators rather than miners propose and confirm blocks. To run a validator independently, a participant locks up 32 ETH as collateral. Validators earn rewards in ether for doing the job properly and can lose part of their stake, a penalty called slashing, for certain rule violations.
Most individuals do not run their own validator. Common routes include:
| Route | How it works | Main trade-offs |
|---|---|---|
| Solo staking | Run your own validator with 32 ETH | Full control; requires technical skill, reliable hardware and uptime |
| Exchange staking | A crypto exchange stakes on your behalf | Simple; you rely on the exchange as custodian and it takes a cut |
| Staking pools and liquid staking | Pool funds with others; often receive a token representing your staked ether | Lower minimums; adds smart-contract and provider risk |
Staking rewards are not a fixed interest rate. They vary with network activity and the total amount staked, and they are paid in ether, so their dollar value moves with the price.
Ether's supply: no fixed cap
Bitcoin's supply is capped at 21 million coins, as our guide to how bitcoin works explains. Ether has no hard cap. Instead, its supply changes through two opposing forces:
- Issuance: new ether is created to reward validators.
- Burning: the base fee on every transaction is destroyed.
When network activity is high, more ether is burned and the supply can shrink. When activity is low, issuance outweighs burning and the supply grows. That makes ether's monetary policy more dynamic, and harder to summarize in a single number, than bitcoin's.
Layer 2: scaling Ethereum
The main Ethereum network, often called "layer 1," can only process a limited number of transactions at a time. To expand capacity, developers built layer-2 networks, known as rollups, that bundle many transactions together and settle them on Ethereum. Arbitrum, Optimism and Base are well-known examples.
For users, layer 2 typically means far lower fees and faster confirmation. The trade-offs are added complexity, the need to move funds between networks using "bridges," and extra risk if a bridge or rollup has a flaw. Bridges have been a frequent target for hackers.
Ways US investors get exposure
Americans generally get exposure to ether in one of three ways:
- Buying ether directly on a crypto exchange or app, and either leaving it with the platform or moving it to a self-custody wallet. Our guide to crypto wallets and custody covers the choices.
- Spot ether exchange-traded funds, which began trading in the US in 2024 after SEC approval. They hold ether and trade in ordinary brokerage accounts and IRAs, with an annual expense ratio.
- Other products, such as futures-based funds or shares of companies with crypto exposure, which behave differently from the asset itself.
Direct ownership allows staking and using applications; an ETF offers simplicity and familiar account statements. Neither removes ether's price volatility.
The risks to weigh
- Volatility. Ether's price has historically swung far more than stocks, including drawdowns of well over half its value.
- Smart-contract and hack risk. DeFi applications, bridges and staking providers can fail or be exploited.
- Irreversible mistakes. Sending to the wrong address, or approving a malicious contract, usually cannot be undone.
- Scams. Fake tokens, phishing sites and "airdrop" lures are common. The SEC and FTC regularly warn about crypto investment fraud.
- Regulatory change. How US rules apply to tokens, staking and DeFi continues to evolve.
Taxes in brief
The IRS treats digital assets as property. Selling, swapping or spending ether can trigger a capital gain or loss, and staking rewards are generally taxed as ordinary income when you receive control of them, under IRS Revenue Ruling 2023-14. Gas fees can affect your cost basis or proceeds. Brokers are now subject to digital asset reporting rules; check the IRS digital assets page for current forms.
The short version
Ethereum is less a digital currency than a shared computer whose fuel is ether. Its value case rests on whether people keep building and using applications on it, which shows up in fees, burning and staking. Anyone considering it should understand gas, custody and staking trade-offs first, size any position for large swings, and keep good records for tax time.
Frequently asked questions
What is the difference between Ethereum and ether?
Ethereum is the network: a blockchain that runs programs called smart contracts. Ether, ticker ETH, is the network's native currency, used to pay transaction fees and to stake. People often say they are buying 'Ethereum' when they mean ether.
Why are Ethereum gas fees sometimes high?
Gas fees rise when many people want to use the network at the same time, because block space is limited and the protocol raises the base fee when blocks are full. Complex transactions, such as swaps on decentralized exchanges, also use more gas than a simple transfer. Layer-2 networks were built largely to make transactions cheaper.
Are Ethereum staking rewards taxable in the US?
The IRS has said staking rewards are generally taxable as ordinary income when you gain control over them, valued at their fair market value at that time. Selling the ether later can then create a capital gain or loss. Rules and reporting forms continue to evolve, so check IRS guidance or a tax professional.
