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Ethereum, explained: why Bitcoin's stranger cousin is now worth $1 billion

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Bitcoin has struggled to live up to the hype that surrounded its emergence into the mainstream three years ago. Despite more than a billion dollars of venture capital funding, Bitcoin startups have failed to develop applications that appeal to mainstream customers. And over the past year, the Bitcoin community has become paralyzed by a bitter feud over how — and whether — to expand the network's capacity.

The result: For the first time since its creation, Bitcoin is in danger of losing its status as the world's leading cryptocurrency. The new challenger is a Bitcoin-like technology called Ethereum that has seen a surge of interest from users, developers, and the corporate world. The network's currency, called ether, is now worth more than $1 billion — that compares to Bitcoin's total market value of nearly $7 billion. Last week, a leading Bitcoin startup called Coinbase announced it was adding support for Ethereum to its popular currency trading platform.

The growing excitement about Ethereum reflects the fact that it's a lot more than just a Bitcoin clone. People can use the Ethereum network to make payments, just as they can with Bitcoin. But the network can do a lot more than that.

Ethereum is a new kind of virtual computing platform. Its most exciting feature is its ability to create binding financial agreements that can be enforced entirely by software — no involvement by courts or other human mediators required. That, in turn, has made possible virtual organizations that exist only on the internet. One such organization, called the DAO, has raised more than $150 million in virtual currency to fund further work on Ethereum-based technologies.

Like Bitcoin, Ethereum represents a technological breakthrough, allowing people to do things purely in software that weren't possible before. But the big question about Ethereum is whether it has practical applications. Ethereum has gotten techies excited, but so far no one has created an application for Ethereum — or Bitcoin, for that matter — that has appealed to mainstream consumers.

Ethereum is like Bitcoin, but for making commitments

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Bitcoin is a global payment network like Visa or MasterCard, but with an essential difference: There's no company with ownership or control over the network. Instead, computers all over the world cooperate to maintain a shared record of transactions called a blockchain.

The key innovation that made this work was a clever scheme for rewarding computers that help build this shared ledger. Computers that participate are rewarded with freshly created bitcoins worth thousands of dollars every hour. As a result, there's no shortage of volunteers to contribute computing power to helping process Bitcoin transactions.

The Bitcoin network is custom-designed to verify and record payments. In 2014, a 20-year-old programmer named Vitalik Buterin realized that he could create a Bitcoin-like network that could perform a much broader range of computational tasks. If Bitcoin is a distributed version of Visa or MasterCard, Ethereum is a bit like a distributed version of cloud computing platforms run by companies like Amazon and Microsoft.

Not only can you use Ethereum to make ether-denominated electronic payments, you can also spend ether to run programs on the Ethereum network itself.

Ethereum is a very unusual cloud computing network. Every calculation is performed simultaneously by thousands of computers around the world, making it thousands of times less efficient than a conventional online server. And because the results of these calculations are stored on the Ethereum blockchain, all data is public. So Ethereum would be a terrible choice for conventional applications like running a web server.

But Ethereum's distributed structure also gives it a unique advantage: Once a program starts running, no one has the power to modify or stop it. That means you can use Ethereum to make binding, long-term commitments — which is why Ethereum programs are known as "smart contracts."

The early Ethereum applications may involve illegal activity

A good way to illustrate Ethereum's capabilities is with an example. One of the biggest challenges of Bitcoin has been the currency's volatility; Ethereum offers a potential solution for this problem: a smart contract that hedges against currency fluctuations.

Two users might each submit $1,000 worth of ether to a smart contract. After a month, the smart contract would look up the current dollar/ether exchange rate, paying one user $1,000 worth of ether at the new exchange rate (which might be more or less ether than originally submitted) and sending the rest of the ether to the second user.

This works the same as a conventional hedging contract, with one important difference: The contract is enforced by a computer program running on the Ethereum network instead of by the courts. Once submitted, the program can't be modified by either party, so neither party has to trust the other.

Of course, the obvious question is why you'd want to use such a convoluted technique to execute an ordinary financial contract. Modern financial markets make it cheap and easy to hedge against a wide variety of price fluctuations, and it's not obvious people are clamoring for a weird, internet-based alternative to these products.

As with Bitcoin, some of the early uses of Ethereum are likely to involve illegal activity. You can use ordinary financial networks to hedge against changes in the price of wheat or crude oil, but if you want to hedge against changes in the street price of cocaine, a smart contract might be your only option.

Ethereum could become a platform for online betting. Bitcoin already supports simple gaming applications, but more complex Bitcoin-based gaming requires players to trust the company running the game not to cheat. Smart contracts could allow the creation of complex, provably fair online games. Ethereum could also allow people to bet on events (like elections) in countries (like the United States) where such gambling is restricted by law.

Ethereum could also prove particularly useful in countries with dysfunctional legal systems. The ability to make binding legal commitments may not be so useful in countries like the United States where legal institutions work fairly well. But in countries where the courts are corrupt, incompetent, or nonexistent, the ability to make and enforce contracts online could be attractive.

As with Bitcoin, legally dubious applications come to mind quickly because Ethereum's decentralized structure makes it hard for governments to control. But the hope is that the same characteristics of decentralization and flexibility will allow people to build entirely new classes of applications that can't be built on top of conventional financial and legal infrastructure. So far, that hope has mostly not panned out for Bitcoin, but it still could happen — and people are just getting started exploring Ethereum's capabilities.

Ethereum allows a totally new type of organization

There are a lot of different ways to use Ethereum contracts, but the application that has attracted the most interest is virtual organizations. At a fundamental level, an organization is just a bundle of agreements between groups of people — shareholders, employees, creditors, and so forth. In most organizations, these are conventional contracts enforced by the court system. Ethereum allows the creation of decentralized autonomous organizations, whose contracts and bylaws are enforced by Ethereum smart contracts instead.

This is not just a theoretical possibility. A virtual organization called the DAO has raised more than $150 million over the past few weeks. Technically speaking, the DAO is just a specific Ethereum address controlled by a computer program running on the Ethereum blockchain. People send ether to this address and get back shares in the organization.

Once the fundraising phase is complete, these shareholders will be able to vote on what to do with the money. The idea is that the DAO will act as a kind of venture capital fund for the Ethereum community. Programmers and companies will submit detailed project proposals to the DAO. DAO shareholders will then vote on which proposals to fund.

It's important to take that $150 million figure with a grain of salt. For one thing, the DAO's funds are in the form of ether, and media hype about the DAO has pushed up ether's value, so once things settle down the DAO might not actually have $150 million at its disposal. Also, the DAO has a mechanism for shareholders to request refunds, so again, the full $150 million might not ultimately get spent.

And the DAO — and DAOs in general — are going to face significant challenges.

One challenge relates to governance. The structure of conventional organizations developed over many decades, shaped by hard-won experience. They have boards of directors, CEOs, auditors, and well-defined management hierarchies to ensure that the organization behaves in a coordinated fashion and is accountable to shareholders.

The DAO is essentially starting with a clean slate, with most decisions made by majority rule. It's as if Apple asked its shareholders to vote on which products to develop. That could lead to erratic and unpredictable decisions, making third parties reluctant to enter into long-term relationships.

At the same time, the fact that the company's basic bylaws are hard-coded into the Ethereum blockchain means that a bug in the DAO's software could have disastrous consequences. If a design flaw causes the organization's operating software to behave in an unexpected and undesirable way, there might be no way to fix the problem other than to liquidate the organization and start over. There's no DAO board of directors with the power to make technical, commonsense changes to the bylaws the way they could in a conventional company.

Blockchain-based organizations face challenges from regulators

The DAO may also encounter unwanted attention from securities regulators. In the United States, the Securities and Exchange Commission has detailed regulations that companies must follow when they offer investments to the general public, and most other countries have similar rules.

The DAO's creators don't appear to have followed any of these regulations. And indeed, it's not clear that it's even possible for a purely blockchain-based organization to comply with SEC rules, whose authors probably never considered the possibility that a company could be an autonomous computer program running on a blockchain.

In some ways, DAOs are in a similar position with respect to SEC regulations that Bitcoin was in with respect to regulations governing money-transmitting services. Bitcoin seemed to meet the commonsense definition of a money-transmitting service, and arguably should have complied with consumer protection and money laundering laws.

But Bitcoin's decentralized structure meant that there was no specific person whom regulatory authorities could fine or prosecute for flouting the law. And so regulators contented themselves with regulating Bitcoin exchanges — companies that convert bitcoins to dollars, and vice versa — and allowed Bitcoin itself to operate free of regulation.

The big question is whether the SEC (and regulators elsewhere in the world) will take the same laissez-faire attitude toward the DAO. They might decide that it's too difficult to try to force DAOs to comply with securities law, or they might choose to interpret securities laws in ways that exclude virtual, blockchain-based organizations.

But securities regulators might also take a more aggressive posture. No one directly controls the DAO, but 10 prominent members of the Ethereum community — including Ethereum creator Vitalik Buterin — serve an oversight role as "curators" for the DAO. They could conceivably face unwelcome attention from investment regulators.

It's possible that the DAO and other virtual organizations will find ways to navigate these tricky legal waters. For example, a conventional organization called DAO.LINK was recently created to provide conventional services — like invoicing and tax compliance — to blockchain-based organizations. Conceivably, organizations like this could provide legal services to DAOs and help them navigate the tricky regulatory issues they raise.