What are Crypto Tokens, How do they Work?
Cryptoforce|What Are Crypto Tokens?
A crypto token is a representation of an asset or interest that has been tokenized on an existing cryptocurrency's blockchain. Crypto tokens and cryptocurrencies share many similarities, but cryptocurrencies are the native asset of a blockchain.
Crypto tokens are often used to raise funds for projects and are usually created, distributed, sold, and circulated through an initial coin offering (ICO) process, which involves a crowdfunding round.
History of Crypto Tokens
Although there were cryptocurrencies that forked from Bitcoin and Ethereum previous to the 2017 ICO boom, the first recognized ICO and token was Mastercoin. Mastercoin was created by J.R. Willet and announced in January 2012 via Bitcoin Forum. He titled his whitepaper "The Second Bitcoin Whitepaper."
Mastercoin was one of the first projects to describe using layers to enhance a cryptocurrency's functionality. The project linked the value of Mastercoin to Bitcoin's value and explained how the project would use the funds to pay developers to create a way for users to make new coins from their Mastercoins.
The ICO Boom
Between 2012 and 2016, crypto token creation and ICO increased until 2017—token offerings skyrocketed as investors seemed to become aware of them and the possible increase in value they promised. Developers, businesses, and scammers began creating tokens rapidly in attempts to take advantage of the fund-raising boom—so much so that regulatory agencies began issuing alerts to investors warning them about the risks of ICOs
After the Bubble
The ICO bubble burst in 2018—shortly after, initial exchange offerings (IEO) emerged, where exchanges began facilitating token offerings. Exchanges claimed to have vetted the token offerings, reducing the risks to investors; however, scammers used the exchanges to promote their scams.
Regulatory agencies issued alerts to investors about the risks involved in participating in an IEO; they also alerted exchanges that they were required to register with the authorities if they were facilitating these fund-raising efforts. The logic was that the exchanges might be acting as alternative trading systems or brokers/dealers, which by law are required to register.
Crypto tokens are still being created and used to raise funds for projects through ICOs. Whitepapers read like pitchbooks, outlining the token's purpose, how it will be sold, how the funds will be used, and how investors will benefit.
Concerns About Crypto Tokens
The single most important concern about crypto tokens is that because they are used to raise funds, they can be and have been used by scammers to steal money from investors.
However, it can be difficult to distinguish between a scam token and one representing an actual business endeavor.
Here are some factors to look for when you're looking at a crypto token:
- Based on jurisdiction, it might need to be registered. In the United States, the SEC considers tokens securities and requires them to be registered unless they qualify for an exemption.
- Look at the team behind the ICO and their backgrounds. Determine if they are a legitimate business by checking the address and phone numbers and visiting the website of the Secretary of State for the state they claim to be registered in and search for them. If you can't find information about it other than in a white paper and custom website, it might be a scam.
- ICOs from outside of the U.S. might be difficult to research. One such token was BananaCoin, issued as a fundraiser for banana plantations in Laos. Investors were told they could exchange their tokens for an equal value of bananas or funds after launch.
- Many crypto tokens are listed on non-regulated exchanges outside of the United States. If it isn't listed on a regulated exchange, the odds of it being a scam are much higher.
- Even crypto tokens listed on a registered exchange can be scams.
How Crypto Tokens Work
Crypto or cryptography refers to the various encryption algorithms and cryptographic techniques that safeguard crypto tokens and currencies, such as elliptical curve encryption, public-private key pairs, and hashing functions. Cryptocurrencies, on the other hand, are virtual currencies on a blockchain. These systems allow for secure online payments and the storing of value.
Crypto tokens are transactional units created on top of existing blockchains by blockchain companies or projects. They are created using standard templates like that of the Ethereum network. Such blockchains work on the concept of smart contracts or decentralized applications, wherein the programmable, self-executing code is used to process and manage the various transactions that occur.
A smart contract is a self-executing program that automates transactions. Two parties agree on terms. Then a code is written to execute the transaction once the agreed upon terms are met.
For example, you might receive a crypto token representing a certain number of customer loyalty points on a blockchain that manages such details for a retail chain. Another crypto token might give the token holder the entitlement to view 10 hours of streaming content on a video-sharing blockchain. A token can even represent other cryptocurrencies, such as a crypto token equaling 15 bitcoins on a particular blockchain. Such crypto tokens are tradable and transferrable among the various participants of the blockchain
Investors can use crypto tokens for any number of reasons. They can hold onto them to represent a stake in the cryptocurrency company or for an economic reason—to trade or make purchases of goods and services. As a practical example, decentralized storage provider Bluzelle allows you to stake your tokens to help secure its network while earning transaction fees and rewards.
The Financial Industry Regulatory Authority (FINRA) continues to issue alerts about cryptocurrency and token fraud, so be sure you research before investing in any cryptocurrency—the same way you would with any stock.
Crypto Tokens vs Cryptocurrencies
The term crypto token is often erroneously used interchangeably with "cryptocurrency." However, these terms are distinct from one another.
A cryptocurrency is used for making or receiving payments using a blockchain, with the most popular cryptocurrency being Bitcoin (BTCUSD). Altcoins are alternative cryptocurrencies that were launched after the massive success achieved by Bitcoin. The term means alternative coins—that is—cryptocurrency other than Bitcoin. They were launched as enhanced Bitcoin substitutes that have claimed to overcome some of Bitcoin's pain points. Litecoin (LTCUSD), Bitcoin Cash (BCHUSD), Namecoin, and Dogecoin (DOGEUSD) are typical examples of altcoins. Though each has tasted varying levels of success, none have managed to gain popularity akin to Bitcoin's.
While cryptocurrencies have their own blockchain and are its native asset, crypto tokens are built on an existing blockchain, which acts as a medium for the creation and execution of decentralized apps and smart contracts. The tokens are used to facilitate transactions on the blockchain. In many cases, tokens go through an ICO and then transition to this stage after the ICO is completed.
What Is the Purpose of Tokens?
Crypto tokens generally facilitate transactions on a blockchain but can represent an investor's stake in a company or serve an economic purpose, similar to legal tender. However, tokens are not legal tender. This means token holders can use them to make purchases or trades just like other securities to make a profit.
Is Bitcoin a Token or a Coin?
Bitcoin is a coin also known as a cryptocurrency. It can be used to trade, store value, or make purchases.
What Is the Difference Between a Crypto Coin and a Crypto Token?
The main difference is that crypto coins have their own independent blockchain, whereas tokens are built on an existing blockchain. Crypto coins are designed to be used as currency, while crypto tokens are intended to represent an interest in an asset and facilitate transactions on a blockchain.
What Are Some of the Different Types of Tokens That Reside on Blockchains?
Blockchain tokens include reward, utility, security, governance, and asset tokens.
Conclusion
Crypto tokens are digital assets built on existing blockchains and serve various functions, such as facilitating transactions or representing ownership. Unlike cryptocurrencies, which have their own blockchains, tokens rely on platforms like Ethereum.
Tokens are often used to raise funds through ICOs, but they can also be prone to scams. Investors should conduct thorough research to ensure the legitimacy of the project and its regulatory compliance.
While tokens offer opportunities, understanding their differences from cryptocurrencies and the types (e.g., utility, governance, security) is essential to navigating the risks and rewards of the crypto space.
Disclaimer
The information provided on this blog is for educational and informational purposes only. It is not intended to be a substitute for professional financial advice, investment recommendations, or individualized guidance. We encourage readers to conduct their own research and consult with qualified financial advisors before making any investment or financial decisions. The author and publisher are not responsible for any financial losses, risks, or damages incurred because of the information presented here. Investing and financial decisions involve risk, and past performance does not guarantee future results.