If you are reading this article, you may have asked the question, “what is a cryptocurrency?” Bitcoin, Ethereum, Ripple, and any digital asset you are likely to have encountered are cryptocurrencies. Cryptocurrency refers to tokens, which can be used inside a blockchain, much like a currency can be used inside an issuing country.
What are Cryptocurrency Tokens?
I remember my first time trying to explain cryptocurrency to a relative. While they were financially literate and no stranger to investment vehicles, they were stuck on the comparison of cryptocurrencies to everyday, government-issued fiat currency and struggled to see the value proposition of cryptocurrencies stating, “I won’t be interested until I can use cryptocurrency at the corner store.” While this comparison is not flawed, and some idealists would like cryptocurrency to replace the USD, I believe this is misleading as to the intent of many cryptocurrencies.
While USD, and other fiat currencies, have value everywhere, its intended purpose is to be used inside the United States. The USD will never replace the Euro inside Europe. Similarly, while a cryptocurrency like Ethereum may have widely accepted value and may one day be accepted by many corner stores, its intended purpose, or “use case,” is not to replace the USD but to be used inside the Ethereum blockchain. A better comparison to introduce cryptocurrencies is by comparing cryptocurrencies to gift cards as opposed to fiat currencies.
Gift Cards: A Better Comparison for Cryptocurrencies
A company issues a gift card for use inside their stores. While a gift card may be resold or traded, its intended use case is to purchase goods from the company’s stores. While most stores accept standard government currency, imagine that this store accepted only gift cards to buy their goods. This scenario would create a stronger use case and increased demand for gift cards, but the value would still be equal to the gift card’s face value. Now lastly, imagine that this same store placed a limit on the number of gift cards in circulation, and you were only able to buy one if there was one available to sell. If this store sold high-demand goods that could only be purchased with these limited gift cards, someone could conceivably pay a larger sum of money to buy a gift card than the face value, creating a more volatile asset with fluctuations in resale value according to demand. If you have followed this example, you already have a better idea of what a cryptocurrency is and why it may be valuable.
A program built on a decentralised, public blockchain is not tied to any one country or company. To transact using the program, instead of using any number of regional fiat currencies, the program may use its own “cryptocurrency” token, similar to a gift card, that can be used inside the program. If the program offers a high-demand service, there may be high demand for their token. This comparison better demonstrates that cryptocurrencies have a value derived from limitations on their circulating supply and demand for the programs running on distributed blockchain technology.
How Different Cryptocurrencies are Used
Though definitions vary widely, we have identified several broad categories that may help to understand the many different applications cryptocurrencies can be used for to help applications realise the advantages of blockchain technology.
While fiat may not be the best example for all cryptocurrencies, some tokens are intended to be used similarly to fiat currency. The objective of these tokens is to act as a general form of payment and, as a result, a store of value. The token that fits this description is Bitcoin, which aims to provide an alternative store of wealth. You may have heard stories about early investors buying pizza with bitcoin or about Elon Musk offering to sell Tesla cars for bitcoin. This type of use reflecting its usefulness as a transactional token.
While some tokens can be used for general transactions, others are intended to be used for particular purposes or solve a specific problem. Although these tokens have an exchange value, they differ from tokens like bitcoin because they have an inherent function inside a given ecosystem. For example, Basic Attention Token (BAT) is a cryptocurrency token intended to be used in a closed system to reward users for viewing ads who intern can sell it to advertisers to pay for more ad views. This demonstrates a clear utility for this token in a specific system.
The recent boom in decentralised finance, or “DEFI,” has created a new use for tokens as security. Some DEFI protocols mint tokens that represent deposits in their protocol. These tokens represent right or “security” to the underlying deposits. Examples include tokens like YUSDC: which represent “USDC” deposited inside the Yearn Finance protocol and entitles the holder to an underlying amount of USDC plus interest. This representation of underlying rights in a token demonstrates the usefulness of tokens as security.
Governance is an important component of decentralisation. Many blockchains use a democratic system of governance where anyone holding a token is entitled to participate in the governance of the protocol. This may vary from a simple vote to more complex structures. Early cryptocurrencies served duel functions, while some projects have minted tokens specific to governance. Some are intended to convey governance rights also entitle the holder to a share of profits generated by the protocol. Yearn finance, for example, has minted YFI tokens which give users both the right to vote on how Yearn Finance is managed and entitles the holder to a percentage of profits.
Stablecoins intend to minimize volatility by directly linking the value of the token to an underlying asset. Stable coins are often linked to the USD but can be linked to any currency or commodities such as gold. Stable coins operate by using deposited value to purchase underlying assets in exchange for tokens. For example, to create USDC, the USDC protocol purchases USD and stores them in a bank account. Some projects undergo audits to provide assurance to users that there is sufficient value in these underlying accounts to match the tokens in circulations.
All the examples discussed so far can be classified as fungible tokens. Fungible tokens have two key characteristics: they are interchangeable and divisible. Fungible tokens can be traded easily on exchanges because all the tokens in circulation hold the same value and because they can be both divided and multiplied.
Non-fungible tokens are the opposite. Non-fungible tokens are not interchangeable and not divisible; instead, they are specific and represent a single whole asset. Non-fungible tokens of the same type are not necessarily equal in value and may have different characteristics. My favourite way to think about non-fungible tokens is by comparing them to airline tickets. An airline may issue hundreds of tickets on a single flight, but each ticket represents one unique and specific seat. You cannot divide your ticket into half tickets, and the value of one ticket may not be equal to that of another.
Non-fungible Tokens are currently undergoing a surge in popularity as they are being used to represent digital artwork on blockchains. Digital artwork is being codified and stored in the blockchain, with the value of digital artworks reaching unprecedented highs.
Cryptocurrency tokens are used to transact with other users on a blockchain or even with a blockchain directly. While some tokens help users access goods and services, others provide users with rights to underlying assets or future profits. Most cryptocurrencies are fungible, meaning they are both divisible and of equal value. However, recent interest in non-fungible tokens, or NFTs, has created new ways for users to leverage blockchain to share unique goods like digital artwork.
Whether you are a seasoned investor, a passionate user, or completely new to the blockchain space, cryptocurrencies are revolutionizing the way people interact and how value is stored, transferred, and created.