The Three Basic Types of Cryptocurrencies Explained
Cryptocurrencies refer to virtual forms of currencies that are basically taken as alternatives to fiat currencies. The other names would be digital currencies, virtual currencies or cryptocoins or digital coins. As such, Bitcoin, which was initiated back in 1998, is the first cryptocurrencies and is spent today as a store of value, unit of account and a medium of exchange.
Cryptocurrencies are a type of crypto assets, which refer to any digital assets built on top of blockchain and utilizing cryptography. Cryptography is an encryption technique that is utilized to secure and verify transfer of transactions. You can check this article for basics of blockchain and cryptography and how they work but basically, a blockchain comprises of a distributed network of nodes that will validate a transaction once it is requested and broadcast by someone on the network. A transaction is verified and combined with others to create a new block of data that is immutably stored on ledger. As would be expected, cryptocurrencies are a subset of digital currency: there are other versions that unlike Bitcoin do not use blockchain and have mediators like the bank.
Although virtual forms of fiat for different countries existed prior to Bitcoin, the creation of Bitcoin led to other coins especially Ethereum as the second cryptocurrency or coin. This plus other Bitcoin forks were created (or are still being created) in an attempt to solve the challenges and shortcomings of Bitcoin. Altcoins is a name that refers to other coins and tokens created after Bitcoin since they are taken as alternatives to Bitcoin.
Ethereum, as one among the first altcoin, added the ability to create what is now referred to as tokens. Although cryptocurrencies/coins and tokens are all regarded as cryptocurrencies, tokens refer to representations of particular assets or utilities and are issued on top of another blockchain.
80 percent of projects known as cryptocurrencies are tokens issued on three or four main blockchains. The main difference between tokens and altcoins is in their structure: while altcoins are separate currencies running on their own blockchain, tokens are created and issued on top of another blockchain and do not have their separate blockchain. For more information on the differences between coins and tokens, check this article.
Bitcoin is known as the mother of all cryptocurrencies and the first decentralized digital currency invented by an unknown Satoshi Nakamoto in 2009, who posted a link to the creation paper to a cryptography mailing list on 31 October 2008. The decentralized electronic or digital form of currency does not have a central bank or single administrator and works on a peer-to-peer method without the need for intermediaries.
Today, Bitcoin is used in peer-to-peer transactions, worldwide payments with low processing fees. Compared to other altcoins, it is the largest cryptocurrency by value and dominates transaction volume by over 52 percent currently. The coins, like in the case of many altcoins, are created in the process of mining and can be exchanged for fiat or other crypto and altcoins. Each Bitcoin can be subdivided into smaller units known as Satoshis up to eight decimal places and so the smallest fraction is 0.00000001 Bitcoin.
Transactions on the Bitcoin blockchain network are verified by everyone on the network (comprising of individuals located in any part of the world and hooked to the network) before they are validated and sent through, hence the idea of decentralization.
Altcoins, as the name suggests, are alternative coins to Bitcoins and like Bitcoin, each runs on a different or separate blockchain, miners, and wallets from the others. After the creation of Bitcoin, most of the projects running their own blockchains wanted to improve the shortcomings or challenges of Bitcoin. Majority of altcoin projects use the peer-to-peer proof of work standards utilized or supported on Bitcoin cryptocurrency while a few are using proof of stake standards.
The first altcoin was named Namecoin and came up in 2011 with Litecoin appearing in October 2011, but we now have more than a thousand options. Although most of them utilize the same building block with Bitcoin, altcoins can differ from Bitcoin in a range of ways. For instance, they may have a different economic or coin-distribution method, or as said, utilize proof of stake.
Others may have a larger block size, better anonymity, better scalability, more hash power or use a different hashing technique (some use SHA 256, scrypt algorithm, others X11, X13, X15, NIST5 or 100% POS), and like Ethereum, many of them allow for the building of applications on top of them. Like tokens, not all altcoins have monetary use cases: some have non-monetary use cases like domain name registry or data storage pointers.
To understand the case of altcoins, altcoins came to improve or offer alternatives on a number of issues experienced on the Bitcoin network. For instance, new coins are produced after every 10 minutes on the Bitcoin network. Additionally, Bitcoin uses proof of work mining algorithm which is energy intensive, and it has other scalability, privacy/anonymity issues.
As explained, tokens represent a particular fungible and tradable asset or utility such as commodities and loyalty points or other cryptocurrencies. Tokens are issued on top of another blockchain such as Neo, Ethereum, Counterparty, Omni, Ripple and Waves and are very easy to create because they do not require modification of code or blockchain from scratch. The creator will follow given standards, smart contracts and a template supported on the blockchain in creating these types of decentralized applications. A popular word in the area of tokens is tokenization because tokens are also employed in the tokenizing of real world and or digital assets.
Once they are created the person or entity then issues or distributes them to the public through Initial Coin Offerings (ICOs), which is a form of crowdfunding comparable to an Initial Public Offering (IPO) for stocks. When issued on the same blockchain, the template provides a standard interface for interoperability between tokens.
Currently, Ethereum is the most popular platform for creating tokens, which span thousands of projects currently.
There is also categorization of token projects as either utility tokens or security tokens. Most of the tokens are utility tokens and are spent to purchase services within the platforms issuing them. Tokens can be used to buy a service or product at an accelerated speed and with the added element of privacy as well.
A good example of utility tokens is those used in many gaming platforms. A user can buy them using Bitcoin or some fiat or earn them by winning the game etc and then spend the token in buying game assets. Of course, a user can also send the tokens to other users, spend them to buy services and goods outside that gaming platform, exchange them for some other services or other types of tokens, or even convert them back to fiat or crypto.
Security tokens are spent in the same manner as utility tokens but they are created for the clear purpose of making money for investors and therefore are required to meet certain standards and rules of a security (an asset with monetary value).
In other words, a security token represents a legally binding investment contract between the person or entity issuing it and the investor in the token. They are preferred because there is some certainty about and legal business responsibility on the part of the creator to investors and are verifiable and legal same to other securities such as stocks, bonds, etc.
Other types of tokens include currency, asset, reputation and reward tokens.
There is also an article on the Diviproject blog about the differences between altcoins, Bitcoins and tokens.