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Making Sense of Crypto Token Types
For those new to cryptocurrency, it can be tempting to oversimplify digital assets. It’s easy to think of all cryptocurrencies as digital cash for facilitating transactions between people. However, that’s not the case. The reality is much more complex.
Underneath the hood in the cryptocurrency ecosystem, there are many different types of coins and tokens. Sure, some do function as digital currencies for making payments. However, there are entire classes of tokens that have other uses, like paying for specific services, voting on proposals, acquiring equity in a company, or even proving identity.
Each of these use cases leads to very different outcomes for the value, usefulness, and overall economics of a given token. If you’re an investor, it’s critical that you understand the distinctions between token types in order to make better judgments about valuation. If you’re considering launching an ICO, you’ll want to carefully consider your options for token types to make sure you select the right kind for your application. Furthermore, exchange operators and other market-makers need to understand the implications that various token types have on trading and transaction volume and prepare to support various types of currencies accordingly.
In this comprehensive guide, we’ll get you up to speed on all the possible token types. We’ll look in-depth at how each works and some common examples in the cryptocurrency market. Ultimately, this article is intended to show that the cryptocurrency community is diverse, and its various assets derive their value differently. Cryptocurrency is not a monolith, and there’s no one way to describe everything that’s going on. Instead, there are hundreds of unique tokens, each offering a different value proposition and potential.
Before we get too deep into the specifics of token types, architecture, and economics, it’s useful to lay a foundation of how blockchain tokens work generally.
The first thing to make clear is that tokens don’t actually exist, either physically or in code. There is no real-world version of a token. You also can’t look through the code for Bitcoin or any other blockchain and find a line of code that is your coin. Instead, a blockchain token only exists as a series of receipts.
As such, when you receive a Bitcoin (or most other tokens), you aren’t storing an asset in your wallet. Instead, you’re storing a receipt of the transaction where someone sent you a Bitcoin. These receipts are called unspent transaction outputs (UTXOs). It basically says, “someone sent me a Bitcoin and I can prove I haven’t spent that Bitcoin yet.”
UTXOs are different from typical currency in that where your money came from matters. Every Bitcoin only exists as a chain of receipts leading back to the valid block where that Bitcoin was originally mined and awarded as part of the block reward. As a result, I could look up the entire history of any coin in existence, seeing what public addresses have held that coin before it reaches me.
The architecture of how a token actually works and exists is important because it impacts things like privacy, fungibility, and how a wallet actually operates to keep track of a user’s funds. For some tokens that are privacy-focused, like Monero for instance, anonymity and untraceability is ensured by using stealth addresses to obscure the users in the UTXO records and grouping transactions together to hide the amounts. Other privacy coins, like Zcash, get rid of UTXOs in favor of zero-knowledge proofs, a more private but also less verifiable form of transaction confirmation.
The implications extend to wallet software, too. When your wallet shows you how many Bitcoins you control, it isn’t counting up a pile of Bitcoins in some account. Instead, it’s scanning the blockchain for UTXOs with your address as the recipient. Your wallet doesn’t actually exist and doesn’t hold anything in it. Wallet is actually a misnomer. The software is scanning the blockchain for your UTXOs, and it doesn’t hold anything inside it.
So, as a cryptocurrency user, ICO creator, or exchange operator, what does all this mean for you? Knowing the basic framework of a UTXO, we can imagine a lot of different uses for tokens. They’re not confined to being currency. They just need to represent something that needs to live on a secure blockchain. We can then use a wallet to scan for those assets later, whether they’re certificates, permissions, currency, or credits.
2. Fungible Tokens
Broadly, crypto tokens break down into two-subcategories: fungible and non-fungible tokens.
Fungibility refers to where a given coin falls on a scale from unique to indistinguishable. In order for a token to be useful as a currency, credit, or exchange of value, it needs to be fairly indistinguishable from the other tokens in its ecosystem. For example, a Bitcoin is a Bitcoin. Certain Bitcoins aren’t more valuable or more rare than others. If they were, it would disrupt the entire economic system of Bitcoin because you couldn’t exchange Bitcoins freely.
Fiat currencies are also fungible. A euro is a euro, no matter where the coin was minted, who owned that coin before you, or what country in the EU you’re in. A euro has consistent value and can be exchanged freely without thought. Fungibility is what makes a currency useful. If each euro were unique and had a different value on the market, transactions would take much longer since the shopkeeper would have to verify the history and current value of the euro you just handed him. Because euros are highly fungible, however, the shopkeeper doesn’t blink twice when you hand him a coin, and you don’t have to think about it when he hands you back your change.
Fungible tokens work the same way. Each token is the same and no token has a special value. As such, fungible tokens form the basis of all crypto payment methods, credit systems, and tradable assets.
When you think of cryptocurrency, the first type of token you likely imagine is a fungible payment token. Bitcoin is the prime example of a payment token. It’s meant to be used for transactions between parties in place of or alongside traditional fiat currencies.
Other examples of payment tokens include Litecoin, Dash, and Bitcoin Cash. These tokens all have the simple goal of allowing you to pay for things in the real world using digital currency. Monero and Zcash are also payment tokens, though they have privacy features that make them more complicated than unobscured UTXO blockchains..
Payment tokens derive their value from the amount of people that want to use them and the number of merchants who accept them. Because they’re meant to be spent on real-world items, they’re clearly not investment vehicles. However, they do have greater scarcity than fiat currencies and they behave as a good store of value. Bitcoin has drawn similarities to gold over the years as a scarce store of value that’s an alternative to fiat which loses value over time due to inflation.
The next most common fungible token type is a utility token. Utility tokens work the same way credits do at an arcade. You need the credits in order to play the games and ride the rides. In the same way, utility tokens power a platform, and you can use the tokens to get value from the platform.
Ether, Ethereum’s token, is the most famous utility token. You can use ETH to pay for smart contract execution on the Ethereum network. While you can make payments in Ether, and many people do, its primary purpose is to power the contracts, dapps, and DAOs that run on Ethereum.
Countless platforms have introduced utility tokens for their services. During 2018’s ICO craze, nearly every coin offering declared their token a utility token in the hopes that doing so would dissuade regulators from declaring their token to be an investment vehicle.
For investors, and for those considering launching an ICO, the key distinction is, “Does this project need its own token?” In many cases, a platform could have just accepted ETH or BTC as payment. There was no need to create a new token. The token only served as a fundraising mechanism for the project and a speculatory endeavor for those who bought the token. True, utility tokens, on the other hand have a clear reason for existence that can’t be served effectively by current payment methods.
In the wake of regulatory scrutiny over utility tokens, many ICOs have decided to openly declare what they’re doing: raising money by offering a tradable security.
Traditionally, we think of tradable securities as stocks. Ordinary investors can buy shares in a company. If that company’s value increases, so too does the value of the shares and investors make money. However, this kind of equity ownership doesn’t apply in cryptocurrency. Yes, most crypto investors expect the value of the currency to increase. But they don’t own any stake in the overall company. You don’t own anything, in fact, when you invest in a token. It’s only worth what the market will pay for it and could drop to zero value.
The standard for determining if a token is a security or utility token in the United States is called the Howey Test. Other regulators around the world follow a similar rule. If a transaction involves money invested in a common enterprise, the investor expects to profit from the investment, and the investor won’t do any of the work in generating that profit, then it’s an investment security.
As a token creator, declaring your token a security brings along with it a host of regulations. You need to file paperwork, track investor identity, and report on compliance for every country where your ICO is offered. You also must make it clear to your investors that they are speculating on the value of a tradable security, and there is inherent risk in the investment.
Polymath is perhaps the best-known platform for security token issuance. While you could issue a security token on any platform, Polymath handles the difficult work of building compliance directly into your token’s protocols and smart contracts. This simplifies reporting when it comes time to send your information to regulators.
The other broad category of tokens are non-fungible tokens. Non-fungible implies that each token is unique. Therefore, there’s no standard value for a token and you can’t necessarily exchange one token for another equally. Instead, each token represents unique, distinct ownership information. You can still exchange non-fungible tokens via UTXOs, but you’d usually do so in exchange for payment via a fungible payment token.
Non-fungible tokens are well-suited anywhere we need to prove ownership or identity. They fall under a completely different protocol and structure for their creation than fungible tokens. In Ethereum, for instance, fungible tokens follow the protocols in ERC-20 while non-fungible tokens follow ERC-721. Even at the basis of the source code, non-fungible tokens are different from their fungible counterparts.
Perhaps the easiest way to understand how fungible tokens work and what problems they solve is to look at a few examples.
Certification is probably the biggest potential application of non-fungible tokens. We can use a token to prove the origins of a document, piece of data, or even a physical object in the real world. Because blockchain tokens can’t be duplicated or double spent, we can ensure that a token will never be counterfeited.
The anti-counterfeit nature of non-fungible tokens lends itself well to certifying the authenticity of various types of information and content. For instance, we can create a non-fungible token for a piece of art in the real world. That token then becomes the art’s official certificate of authenticity. The owner possesses both the art piece and the verifying token. When the owner wants to sell, all they have to do is put the fungible token certificate on the market and people know they’re purchasing a verified artwork that hasn’t been counterfeited.
Non-fungible tokens also form the backbone for digital collectibles like CryptoKitties on the Ethereum network. You can buy rare drawings of funny cats. When you do, you’ll have a new ERC-721 token in your wallet proving that you own that cat and preventing anyone else from copying or counterfeiting it. CryptoKitties seems like a trivial example, but it illustrates the much larger overall power of non-fungible tokens.
It’s possible to imagine a future where land records live on the blockchain and ownership is a matter of holding the token that corresponds to the land you own. When you want to sell the land, you no longer have to visit government offices to sign over the deed to the land. Instead, you can sell the ownership token on the blockchain. The $4 trillion global real estate market could theoretically exist as billions of non-fungible tokens. The same goes for car ownership, website registrations, historical artifact ownership, natural resource extraction, water rights, crop yields, and countless other industries where certified ownership is important.
3.2 Digital Identity
Another valuable application of non-fungible tokens is digital personhood. You wouldn’t be able to trade identity tokens, but you would be able to share the UTXO of their issuance with anyone who wanted to verify your identity on the blockchain.
For instance, the hospital where you were born might issue your birth certificate as a digital token to your identity address. Later, the government might issue a national ID token to your address. As you complete school, you might receive tokens for secondary and university diplomas. Your driver’s license might be another token.
Each of these tokens would exist digitally on a universal blockchain, but they’d belong distinctly to you. Some work is needed to obfuscate the identity details contained in these tokens so that only those with permission can access the information. However, theoretically your whole identity could live on a blockchain, and you could pick and choose what to share with who and when.
3.3 Identity of Things
Similar to digital personhood, objects, devices, and machines could have their own digital identity as well. This identity of things (IDoT) is a major step on the road to blockchain-based supply chains, IoT applications, and smart cities.
As an example, consider a city in the future with autonomous cars. These cars need to be able to navigate around the city and make decisions on their own, especially when there are no passengers currently in the vehicle dictating the itinerary. IDoT would enable a database and systematic optimization of cars, passengers, traffic, and parking.
In supply chains, if each product on a supply chain had a unique identity token, we could track it over time all the way back to the raw materials. For resource usage, like water and electricity, smart grids could monitor current loads at various points in the system and autonomously trigger new pumps or power plants to activate as demand surges, taking these same pumps and plants offline when they’re not needed.
Identity of things allows all of these systems to exist in a single unified ledger. Even though multiple companies, governments, and organizations contribute to a supply chain, resource grid, or transportation system, they could all access the same basic data. Each company would still have ownership over its resources thanks to tokenization and public-private keys, but it’s also much easier to gain a shared view of the entire system thanks to blockchain.
3. Different Roles in a Complex Economy
No token type is better than another. In fact, we need all these different token types (and possibly more) in the future economy. Blockchain excels as a way to share and secure data at the same time. Everyone has access to the shared ledger, but making changes is only possible if you have the right keys. Such a hybrid between security and access opens many doors for new industries and technologies while also making current systems more efficient. Far from being just a means of payment, tokens are the critical data structure that could underpin every aspect of future society.