Digital Tokens Explained
In the crypto industry, users come across the terms such as cryptocurrency, coins, and tokens often mentioned in the same sentence. Many users call assets trading on crypto exchanges “a coin,” but calling all crypto assets this way is a common misconception.
In the crypto industry, users come across the terms such as cryptocurrency, coins, and tokens often mentioned in the same sentence.
These terms are indeed used interchangeably, which makes it even harder for many newcomers to understand the difference between them. In this article, we’ll describe key attributes of tokens and explain how they relate to other types of crypto assets.
Understanding Digital Coins
Many users call assets trading on crypto exchanges “a coin,” but calling all crypto assets this way is a common misconception. You might be surprised by discovering that there are significantly fewer actual “coins” on your favorite crypto exchange.
The first and the most important feature that distinguishes a coin from a token lies in the technology itself. Coins run on their own blockchain. Bitcoin (BTC) is commonly referred to as the most “classic” example of a digital coin. It is often used as a yardstick to determine the value of other digital coins (or altcoins) and the vast majority of tokens.
If an asset runs on its own blockchain then it is a coin.
Some altcoins such as Litecoin (LTC), XRP, Monero (XMR), Dash (DASH), and Stellar (XLM) are in the track of Bitcoin and are designed to serve as a medium of exchange.
However, there is another class of digital coins like Ethereum (ETH), Tron (TRX), Cardano (ADA), Neo (NEO), and Solana (SOL). The difference is in the ability to run smart contracts on their blockchain and use them not only as a medium of exchange but also as “gas” to fuel smart contracts.
This brings us to the point where the token thing begins.
What Differs Tokens From Coins
The smart contract function allows anyone to create a token of their own, based on an existing blockchain. Thanks to the flexibility of smart contracts and unique features of the underlying blockchains, such tokens can represent almost anything — from a disk space on a cloud storage to an artwork or certificate of authenticity.
For a long time, the Ethereum blockchain with ERC20 tokens remained the most popular tokenization platform. Today, the market may offer a significantly wider choice of platforms for the same purpose, such as Cardano, Tron, Binance Smart Chain, and more.
Unlike coins that operate on the blockchain of their own, the transaction fees for tokens are paid in the native coins of the used blockchain ecosystem. This means that when transferring ERC20 tokens from one address to another, users would have to pay in ETH (even if the transaction cost is represented in USDT).
If the asset requires to pay fees in another currency then it’s a token.
Types of tokens
Depending on tokens’ purpose, they are divided into several categories. Understanding fundamental differences between them is crucial in terms of risk management and decision making in the volatile crypto market.
Back in 2017, the original idea behind issuing utility tokens was to get a quick injection of funds without trading the company’s independence in exchange. Utility tokens are released by a certain project and intended to provide benefits to their holders. This may be either a service or a promise of profit in the future.
An additional use case is to stimulate the audience to use the platform. For example, the privacy-focused Brave browser rewards users with Basic Attention Token (BAT) for watching ads. Among other examples are Filecoin (FIL) that offers cloud storage space to all token holders, and Civic (CVC) that promises seamless identity validation service.
One of the most successful examples of utility tokens is BNB, the native token of the Binance crypto exchange. It was first introduced as an ERC-20 token based on the Ethereum blockchain, in 2017.
After gaining increasing momentum, it has moved to the new blockchain and evolved into a native cryptocurrency of the Binance Smart Chain. Today it is widely used not only for paying transaction fees, but also for travel bookings, entertainment, online services, and more.
Utility tokens had been existing long before blockchain technology emerged. You may find some real-life examples in the most common places like public transport (bus tickets) or your local grocery store (discount vouchers).
Raising capital through utility tokens means that new companies could circumvent restrictions, costs, and liabilities of institutional finance. The volatile nature of the crypto market, however, can hardly provide stable conditions for running a company with an economy backed solely by tokens.
To remain solvent, and to secure at least part of the raised funds, many companies instantly cashed out tokens right after they were listed. Such actions damaged the reputation of the ICO market, which had already been crowded with dubious projects, nonviable ideas, or out-and-out scams.
Unlike utility tokens, they act like a tokenized form of property and in many ways are similar to bonds or stocks. They provide holders with the right to vote shares and receive dividends from the issuing company.
Depending on their purpose, security tokens are divided into several categories:
- Debt tokens represent debt instruments such as real estate mortgages or corporate bonds;
- Equity tokens represent equity position in an underlying asset;
- Derivative tokens derive their value from an underlying asset;
Such tokens are classified as investments and issuing companies must provide detailed reporting and comply with a set of strict regulatory requirements. This brings the process of emission and distribution during security token offerings (STOs) closer to IPOs and represents a more secure investment alternative to ICOs.
Security tokens have kept gaining increased traction from institutional investors. Among key reasons are high fragmentation potential, round-a-clock trading, and fast payment processing. For traditional exchanges, this means getting access to the whole new class of assets.
Governance tokens gained momentum in 2020 during the DeFi boom. These tokens represent the right to influence the development of a particular project. The holders of governance tokens can determine the future of the protocol, without relying on developers’ favor or, on the contrary, demanding their involvement.
Token holders can use them to delegate their right to vote to other users, experts, or even applications. For example, offer new assets or change the lending interest rate of a DeFi platform.
Such proposals can be represented in the form of direct injection of a digital code and implemented automatically when backed by the majority of token holders.
Governance tokens are sometimes offered as a reward for staking and can be used for validation of transactions. In some systems, they coexist with other types of tokens and can be exchanged at a favorable rate. For example, Zilliqa protocol can pay interest in both standard ZIL and governance gZIL tokens.
The most famous governance tokens are the UNI token of the UniSwap decentralized exchange and the Compound’s COMP token, the world's largest algorithmic money market protocol on the Ethereum blockchain.
Asset-Backed, or commodity tokens, are tied to a real readily obtainable asset. In some way, they shaped the blockchain economy as we know it today.
While the conventional stablecoins like USDT, BUSD, USDC, and many others are tied to a value of the US dollar or other fiat currencies, some of them look far more exotic, representing non-financial assets.
Among them are El Petro, pegged to 1 barrel of Venezuelan oil, or CaskCoin, backed by barrels of Scotch whiskey.
Digital currencies themselves can be tokenized for using in other blockchains, for example, WBTC (Wrapped BTC) - bitcoin tokenized according to the ERC20 standard on the Ethereum network.
Non-Fungible Tokens (NFTs)
Non-Fungible Tokens, or NFTs, represent the right of ownership for certain unique items and put it on a blockchain. NFTs allow tokenizing almost anything: from paintings and collectibles, to tweets, songs, and even real estate. The record of ownership is locked in a smart-contract and cannot be modified or duplicated.
“Non-fungible” in the word NFT means that each token on the blockchain is not interchangeable and cannot be replaced by another, due to its unique properties. You can exchange a USDT token to another cryptocurrency and back at any time, because they share the same properties, like value to US dollar, but you will hardly find two equal NFTs.
There are many kinds of tokens and their use cases. You can earn money on tokens in different ways — from simple investment purchases based on an increase in demand and price, or trading with tokens, to more complex schemes such as staking, yield farming by providing liquidity, and many others.
You can buy almost any tokens for these purposes on centralized and decentralized exchanges, as well as on a number of non-custodial platforms, for example, crypto wallets.