Ethereum and altcoins explained: smart contracts, staking, gas fees and the risks

Ethereum is a public blockchain that, unlike Bitcoin, was built to run general-purpose programs called smart contracts. Its native coin, ether (ETH), pays the fees for every transaction and program run on the network. Since the Merge in September 2022, Ethereum has been secured by proof of stake rather than mining. "Altcoins" is the umbrella term for every crypto-asset other than bitcoin, from large smart-contract platforms to tokens created last week with no track record at all.

This guide explains what smart contracts do, how proof of stake works, what gas fees are and why they change, and the specific risks of altcoins: thin liquidity, concentrated ownership, token unlocks and code failures. If the basics of blockchains and keys are new to you, read what is cryptocurrency first.

Risk first. Ether and other altcoins are highly volatile, and smaller tokens can lose almost all of their value in hours. Smart contracts can be hacked. You can lose all of the money you put in, and leveraged products such as CFDs magnify losses. Most retail CFD accounts lose money.

What Ethereum is

Ethereum was proposed by Vitalik Buterin in a white paper in late 2013 and launched in July 2015. Bitcoin's ledger records mainly who owns which coins. Ethereum's ledger also stores programs and their data, and every node runs those programs in exactly the same way, so everyone agrees on the result.

That design lets developers build applications that hold and move money according to fixed rules, without a company in the middle. Examples include:

• Tokens. Most crypto tokens, including the largest dollar stablecoins, exist as smart contracts on Ethereum or similar chains. See stablecoins explained.
• Decentralised exchanges. Programs that let users swap one token for another from pools of liquidity rather than a traditional order book.
• Lending protocols. Programs that let users borrow against crypto collateral and automatically liquidate positions if the collateral falls in value.
• NFTs. Unique tokens recording ownership of a digital item.

Collectively these are often called DeFi (decentralised finance). They operate largely outside the investor protections that apply to regulated financial firms.

Smart contracts: what "code is law" means in practice

A smart contract does exactly what its code says, not what its authors intended. If the code has a bug, an attacker can exploit it and the network will process the theft as a valid transaction. The best-known early case was The DAO in 2016, an investment fund run by a smart contract that was drained through a flaw in its code. The Ethereum community chose to reverse the effects with a change to the chain's history, a hard fork. Those who rejected the change kept the original chain running, which survives as Ethereum Classic. Exploits of smart contracts and the bridges that connect blockchains have continued since, and stolen funds are rarely recovered.

Proof of stake and the Merge

Ethereum originally used proof of work, like Bitcoin. On 15 September 2022 an upgrade known as the Merge switched it to proof of stake. The Ethereum Foundation estimates this reduced the network's energy consumption by about 99.95%.

How proof of stake works

• Validators lock up ether as a stake. Running a full validator requires 32 ETH.
• Time is divided into slots of 12 seconds. In each slot a validator is chosen to propose a block, and committees of other validators vote, or attest, that it is valid.
• Validators earn rewards for proposing and attesting correctly. If they go offline they miss rewards; if they act dishonestly, for example by signing two conflicting blocks, part of their stake can be destroyed. This penalty is called slashing.
• Withdrawals of staked ether were enabled in April 2023, before which staked coins were locked.

Staking for ordinary holders

Most people who stake do not run their own validator. They stake through an exchange, a staking pool or a liquid staking token that represents staked ether. Each adds risk on top of ether's price risk: the platform may fail or freeze withdrawals, the staking token may trade below the value of the ether behind it, and the smart contracts involved can be exploited. Staking rewards are not interest from a bank; they come from the network's issuance and fees and vary over time. Be wary of anyone advertising high, fixed staking returns.

Supply: no fixed cap

Unlike bitcoin, ether has no hard limit on supply. New ether is issued to validators as rewards. Since an upgrade in August 2021 (EIP-1559, part of the London upgrade), a portion of every transaction fee, called the base fee, is destroyed, or "burned", rather than paid out. Whether total supply rises or falls over a given period therefore depends on how busy the network is: when activity is high, more ether is burned; when it is low, issuance can outpace the burn.

You will hear arguments that this makes ether "ultra-sound money" or, conversely, that it is inflationary. Both are claims about a supply mechanism that has changed several times and can change again through future upgrades. Neither tells you what the price will do.

Gas fees: paying for block space

Every action on Ethereum, from a simple transfer to a complex DeFi trade, uses computational work measured in units of gas. A plain ether transfer uses 21,000 gas; interacting with a smart contract uses more. You pay for gas in ether, usually quoted in gwei, where one gwei is one-billionth of an ether.

The fee per unit of gas has two parts:

• the base fee, set automatically by the network according to how full recent blocks were, and burned;
• a priority fee, or tip, which goes to the validator and helps your transaction get included sooner.

When demand for block space surges, for example during a sharp market sell-off, a popular token launch or a wave of liquidations, the base fee rises quickly and fees can jump many times over within minutes.

Worked example: the cost of a transfer

Illustrative numbers only. You send ether when the base fee is 20 gwei and you add a 2 gwei tip.

• Fee per unit of gas: 20 + 2 = 22 gwei.
• Total: 21,000 gas times 22 gwei = 462,000 gwei, which is 0.000462 ETH.
• If ether were priced at 3,000 dollars, that would be about 1.39 dollars.
• If congestion pushed the base fee to 200 gwei, the same transfer would cost about 0.0042 ETH, or roughly 12.70 dollars at the same price. A complex smart-contract interaction using 200,000 gas would cost about ten times more again.

Fees are paid whether or not your transaction does what you hoped, and a failed transaction still costs gas.

Layer 2 networks

To reduce costs, many users now transact on "layer 2" networks, often called rollups, which bundle many transactions together and post a compressed record to Ethereum. Fees are usually far lower, but you take on extra risks: the rollup's own software, the operators who sequence transactions, and the bridges used to move funds between networks.

What counts as an altcoin

"Altcoin" simply means any crypto-asset other than bitcoin. The label covers very different things:

• Smart-contract platforms that compete with Ethereum, each with its own coin and its own trade-offs between speed, cost and decentralisation.
• Payment and settlement coins aimed at moving value quickly between parties.
• Exchange tokens issued by trading platforms, whose fortunes are tied to the issuing company.
• Governance and project tokens that give holders votes on a protocol's settings, usually with no claim on its revenue or assets.
• Memecoins with no stated purpose beyond attention and speculation.
• Stablecoins, designed to track a currency rather than float freely.

Thousands of tokens exist, and a large share of those launched in past cycles are now illiquid or worthless. A token being listed on a large exchange, or offered as a CFD by a broker, does not mean anyone has vetted it as sound.

Liquidity and concentration risks

These are the risks that most separate small altcoins from bitcoin and ether. They apply whether you buy the token or trade a CFD on it.

Thin order books

For smaller tokens, there may be only modest amounts bid and offered near the current price. A large order "walks the book", filling at progressively worse prices. Spreads widen sharply in volatile moments, and on CFDs this can trigger stops at prices well away from where the market looked a moment earlier. See slippage explained.

Illustrative example. Suppose a small token's order book shows buyers for 2,000 dollars' worth at 1.00, another 3,000 dollars at 0.97 and 5,000 dollars at 0.92. Selling 10,000 dollars' worth at market would fill across all three levels at an average price of roughly 0.95, about 5% below the quoted price, before fees. In a fast market, those bids can disappear before your order arrives.

Concentrated ownership

Many tokens are held mainly by a handful of wallets: founders, early backers, the project's treasury or an exchange. If one of them sells, the price can fall heavily. Blockchain data lets you see large holders, but not always who they are.

Token unlocks and insider allocations

Projects often allocate a large share of tokens to founders and investors, released on a schedule. When a big batch "unlocks", supply that could be sold rises suddenly. Check whether only a small fraction of the total supply is circulating; a low price per token with a large unreleased supply can be misleading.

Market cap is not money in the market

A token's market capitalisation is its price multiplied by its circulating supply. It does not mean that amount of money was invested, or could be taken out. If holders tried to sell, the price would fall long before the headline figure was reached.

Delistings and failure

Exchanges remove tokens for regulatory or commercial reasons, sometimes with little notice, leaving holders with a shrinking set of places to sell. Some projects are abandoned or turn out to be "rug pulls", where the creators withdraw liquidity and disappear. See crypto scams and regulation.

Correlation

In sharp sell-offs, altcoins have tended to fall together with bitcoin, often by more. Holding several altcoins can give less diversification than it appears. Our guide to currency correlation explains why correlations shift when you need them most.

Trading ether and altcoins through CFDs

EU-regulated brokers offer CFDs on ether and usually a limited list of other large coins. Under ESMA rules retail leverage on all crypto CFDs is capped at 2:1, regardless of the coin; in the UK, crypto derivatives cannot be sold to retail clients. Spreads on smaller coins are typically much wider than on bitcoin or ether, and overnight financing applies to every day a position is held. Our guide to crypto CFDs vs buying crypto compares the two routes, and why spreads widen explains when quoted costs jump.

Before any trade, work out how much you lose if your stop is hit, using the position size calculator, and check the result with the profit and loss calculator. Then ask whether you could live with a gap well beyond the stop. Our guide to crypto volatility and risk goes into sizing for markets this volatile.

Common mistakes

• Judging a token by its unit price. A coin at a fraction of a cent is not "cheap"; what matters is supply, liquidity and whether anyone will buy it from you.
• Ignoring gas when moving funds. Fees during busy periods can be large relative to small balances, and failed transactions still cost gas.
• Sending tokens on the wrong network. The same token can exist on several chains; sending it to an address on the wrong one can lose it.
• Approving unknown smart contracts. Signing an "approval" can let a malicious contract spend your tokens later.
• Chasing staking or yield offers. High advertised returns usually mean high hidden risk, or a scam.
• Assuming a listing is a stamp of quality. Exchanges and brokers list what customers want to trade.

Our glossary explains terms such as liquidity, spread and slippage.

Frequently asked questions

What is the difference between Ethereum and ether?

Ethereum is the network: the blockchain and the software that runs smart contracts. Ether (ETH) is its native coin, used to pay transaction fees and staked by validators to secure the network. People often use the names interchangeably.

What was the Merge?

The upgrade that switched Ethereum from proof of work to proof of stake on 15 September 2022. Mining ended, validators who stake ether took over block production, and the Ethereum Foundation estimates energy use fell by about 99.95%.

Why are Ethereum gas fees sometimes so high?

Block space is limited, and the base fee rises automatically when blocks are full. During busy periods such as market sell-offs or popular launches, many users compete to get transactions included, and fees can rise many times over in minutes.

Is staking ether a safe source of income?

No. Staking rewards vary, staked ether still carries ether's full price risk, and staking through a platform or token adds the risk of that platform failing or its smart contracts being exploited. Validators can also lose part of their stake through penalties.

What is an altcoin?

Any crypto-asset other than bitcoin. The term covers large smart-contract platforms, exchange tokens, governance tokens, stablecoins and memecoins. Many altcoins have low liquidity and concentrated ownership, and many from earlier cycles are now worthless.

Does ether have a maximum supply?

No. Unlike bitcoin's 21 million cap, ether has no fixed limit. New ether is issued to validators and part of every fee is burned, so supply can rise or fall depending on network activity and on future upgrades.