Different Types of Cryptocurrency, Simply Explained
Over the last 14 years, cryptocurrency has rapidly gained popularity as a means of investment and transaction.
Also known as digital or virtual currency, cryptocurrencies are attempting to upgrade the traditional financial system. They do this by offering secure and decentralized transactions without the need for intermediaries.
There are thousands and thousands of cryptocurrencies better known as altcoins in 2023. The term “altcoin” is used to refer to any coin other than Bitcoin.
It is crucial to understand the different types of cryptocurrency to mitigate any risks associated with speculating and investing in this space.
In the current financial system, financial institutions act as guarantors of transactions and wield significant influence because money flows through them. However, in DeFi, smart contracts replace financial institutions as the guarantor of transactions.
Quick History of Cryptocurrency
Digital cryptography has a rich history, with pioneers like David Chaum proposing anonymous cryptographic electronic money in 1983.
Hashcash in 1997 and Bitgold in 1998 were two other earlier attempts at creating digital cash. Bitcoin is the first decentralized cryptocurrency by Satoshi Nakamoto. It was created following the publication of a white paper called “Bitcoin: A Peer to Peer Electronic Cash System” in 2008.
Bitcoin, based on Hashcash’s proof-of-work algorithm, is an improvement on these earlier experiments explained above.
While thousands of coins have entered the market over the past 14 years, Bitcoin (BTC) and Ethereum (ETH) are the two dominating coins in the space.
Cryptocurrency Mining
Cryptocurrency mining is the process of verifying transactions on the Bitcoin blockchain by solving complex mathematical equations.
The most common form of mining is Proof of Work (PoW), which requires significant computational power and energy consumption. Miners are rewarded with newly created coins for their efforts.
How Many Cryptocurrencies Are There?
Some of the most common types of altcoins that make up the thousands available to the retail market include store-of-value cryptocurrencies and altcoin utility tokens, stablecoins, and central bank digital currencies (CBDCs).
Store-of-value cryptocurrencies
As their name implies, store-of-value cryptocurrencies are digital assets that serve as a store of value, similar to gold or other precious metals.
Namely, these include Bitcoin (BTC) and Litecoin (LTC), which serve as a medium of exchange and operate on a proof-of-work (PoW) blockchain limited in total supply, making them inherently scarce.
Both these coins are decentralized, meaning they are not controlled by any government or financial institution. These cryptocurrencies are two of the most popular and are likely to remain a popular investment choice for investors seeking long-term value appreciation.
Utility tokens
Utility tokens hold a specific use within a blockchain network. They allow users to do things like pay for services or complete transactions on that network.
Some examples of utility tokens include:
- Decentraland (MANA) – The native currency in Decentraland is called MANA which is an in-house Crypto for the Decentraland metaverse. In the metaverse, items can be purchased only in MANA.
- Chainlink (LINK) – The utility token of the Chainlink network. Chainlink is a decentralized oracle network that connects smart contracts with real-world data and systems. LINK is the bridge facilitating the connection between smart contracts and external data sources.
- Polygon (MATIC) – The MATIC token is used to secure the Polygon network by staking it as collateral, which maintains the network’s security and stability.
Consider a utility token as a key needed to unlock a door and enter a room. In this same way, you need a utility token to access certain functionalities on a blockchain network.
The value of the token is determined by the demand for the services it unlocks.
Stablecoins
Stablecoins are designed to maintain a one-to-one value compared to a fiat currency such as the US dollar or gold making them more predictable and less risky for investors and traders.
They provide a way to minimize volatility in the cryptocurrency market and make it easier to use cryptocurrencies for day-to-day transactions. Stablecoins are a modern-day bridge between traditional finance and cryptocurrencies.
Some examples of Stablecoins include:
- Dai (DAI) – A stablecoin created by Ethereum, which is backed by a basket of cryptocurrencies and not traditional fiat currency.
- USD Coin (USDC) – A stablecoin issued by Coinbase, which is pegged to the US dollar.
- Tether (USDT) – Tether Limited, the company behind the stablecoin known as Tether (USDT), claims that it is backed by traditional currency reserves, such as the US dollars held in a bank account.
Central Bank Digital Currencies
CBDCs, short for Central Bank Digital Currencies, are digital replicas of fiat currencies issued and controlled by central banks.
CBDCs are a relatively new concept that is gaining traction among central banks worldwide. Their purpose is to combine the advantages of cryptocurrencies with the stability and regulation of traditional currencies.
CBDCs could potentially replace physical cash, making it easier for people to access financial services and participate in the global economy.
Cryptocurrency Regulations
The debate surrounding cryptocurrency regulation has been ongoing since its inception a decade ago.
Currently, crypto enthusiasts and institutional investors are collaborating with regulators to bring much-needed regulation to the crypto industry.
A decentralized protocol like Bitcoin (and its Proof of Work blockchain), deemed a commodity, breeds protection in the form of healthy lobbying and gains awareness without asking as it constantly attracts individuals organically into its network.
For example, it gains marketing awareness in many ways, such as sports teams that willingly choose to place the logo on their team jersey which actively promotes the network.
This means people, companies, politicians, and government representatives might also choose to defend the network due to personal interests they might have in the network.
Regulatory uncertainty still remains around areas such as crypto exchanges, stablecoins, security tokens, and DEFI exchanges.
The US is expected to establish the global standard for regulation, with the Securities and Exchange Commission (SEC) and Commodity Futures Trading Commission (CFTC) unofficially classifying Bitcoin as a commodity rather than a security, unlike other altcoins.
This is because it does not pass the Howey test which we will speak about in more detail below.
In Europe, the EU’s decision to vote against the banning of proof-of-work in 2022 was also seen as a positive move towards greater acceptance of cryptocurrency that uses the PoW blockchain.
Today, the big question surrounding cryptocurrency is how we must define these coins as either commodities or securities.
Security or Commodity – What is the Howey Test?
Cryptocurrency is a rapidly evolving and complex area of finance, and one of the big questions surrounding its evolution and growth is how to classify these digital assets, as either commodities or securities.
The answer has significant implications for how cryptocurrencies are regulated and traded in various jurisdictions around the world.
The Howey Test is a legal framework used to determine whether an investment contract or in this case a crypto coin is considered a security under U.S. federal securities law or not.
It is important, moving forward, that if blockchains that identify as commodities are securities, these crypto companies understand that they will need to go through certain hurdles before offering their tokens. This also implies that centralized exchanges who are offering the buying and selling of these security tokens take action and behave in line with the government law.
If not, they might be subject to regulation in the form of fines or legal action.
To understand whether cryptocurrency is a commodity or a security, it needs to answer four questions.
These four questions are identified under the Howey test as four key criteria that must be met for a crypto coin or investment contract to be classified as a security and can be defined as such:
- Did the investor put money into the investment?
- Was there an expectation of profits from the investment?
- Was the investment in a common enterprise?
- Did any expected profits come from the efforts of others, such as the promoters, sponsors, or managers of the investment?
All four questions of the Howey test must be answered with a “yes” for an investment contract to be considered a security under the U.S. federal securities law.
If even one of the questions is answered with a “no,” the investment may not be considered a security.
The Howey test is an important tool for regulators such as the SEC to determine whether a financial instrument is a security or not, and has been used to evaluate various types of investments, including cryptocurrency offerings.
Cryptocurrency Exchanges
Cryptocurrency exchanges serve as digital marketplaces allowing users the experience to buy, sell, and trade various types of cryptocurrencies, such as Bitcoin and Ethereum. These exchanges are similar to traditional stock market exchanges that facilitate the trading of digital assets or cryptocurrencies.
There are two types of cryptocurrency exchanges: centralized and decentralized.
Coinbase and Binance, are owned and operated by a company and are considered centralized exchanges.
They require the user to deposit funds into an account before trading. Where the user can then execute buying and selling orders for cryptocurrency against fiat.
Decentralized exchanges, such as Uniswap and PancakeSwap, operate on a peer-to-peer basis without the involvement of a middleman-like exchange allowing users to trade directly with one another.
Centralized exchanges offer more advanced features and greater liquidity. The problem with these exchanges is the central point of failure which can be manifested in the form of a hack.
Decentralized exchanges offer a secure trading experience eliminating the need for a central authority. The problem with these kinds of exchanges is lower liquidity makes it harder to execute larger trades.
Cryptocurrency Wallets
Cryptocurrency wallets are digital wallets that allow users to store, send, and receive cryptocurrencies. They come in many forms, including hardware, software, and paper wallets.
It is advised that once you purchase cryptocurrency on an exchange, you transfer the crypto asset to a digital wallet. The different types of wallets available include:
- A hot wallet, accessible through an app on your mobile phone, remains connected to the internet and is a software wallet.
- A cold wallet, which looks like a physical USB device, remains offline to protect your cryptocurrency from hacking attempts. A popular cold wallet option is the Ledger Nano device.
By using a digital wallet, you maintain full ownership and control of your cryptocurrency through your private key and a seed phrase consisting of 12 to 24 words.
Paper wallets are physical printouts of a user’s public and private keys and are typically used for long-term storage.
Benefits of Cryptocurrency
Cryptocurrencies offer a promising alternative to traditional financial systems, providing benefits such as decentralization, security, anonymity, accessibility, fast and low-cost transactions, and increased individual empowerment through the use of digital scarcity.
In addition, cryptocurrencies allow for fast and low-cost cross-border transactions.
This speed and affordability are made possible due to its peer-to-peer payment system. This allows for seamless operation using the internet, promoting constant access and individual freedom.
Anonymity in transactions is another benefit of cryptocurrencies, allowing users to conduct transactions without revealing their identities. This can be especially important in countries with strict financial regulations or where privacy is a concern.
Furthermore, with no central authority controlling the network, there is no single point of failure, making it more difficult for hackers to compromise the system.
Lastly, the use of encryption and digital signatures ensures that transactions are secure and cannot be tampered with.
Overall, some cryptocurrencies offer a promising alternative to traditional financial systems due to their assurance of decentralization and the fact they do not require third parties.
Risks of Cryptocurrency
One of the most notable drawbacks is the high price volatility of cryptocurrencies which makes it difficult to hold money in a crypto.
Additionally, scams and fraud are prevalent in the cryptocurrency space, leading to the risk of hacking individuals’ funds.
The technology behind cryptocurrencies can be complex and prone to errors and the lack of mainstream adoption means that many merchants do not accept cryptocurrencies as a form of payment, limiting their usefulness.
Regulation remains a significant concern in the cryptocurrency space, with many governments taking a cautious approach to the technology. This means, consumer protections are limited, and the lack of accountability for bad actors can lead to financial losses for innocent parties.
The association of cryptocurrencies with illegal activities further exacerbates the problem, making it harder to achieve widespread acceptance of the technology.
Finally, there is an ongoing debate about the environmental impact of cryptocurrencies, particularly related to the process of mining coins.
Some argue that the energy consumption required for mining is excessive and unsustainable, while others believe that renewable energy sources can mitigate these concerns.
The Future of Cryptocurrency
The future of cryptocurrency looks promising as more individuals and businesses recognize the benefits of decentralized and secure financial transactions.
On one hand, the decentralization and security offered by cryptocurrency technology may lead to more efficient, transparent, and secure systems. However, to reach this level of utility, questions to do with scalability and regulatory challenges need to be addressed.
It is widely believed that the future of cryptocurrency will be shaped by how well the technology can overcome these challenges and deliver real-world solutions that meet the needs of businesses and consumers.
Ultimately, only time will tell what the future holds for blockchain technology.
FAQ
What are the different types of cryptocurrency?
Of the thousands of cryptocurrencies available the most popular and widely traded include Bitcoin, Ethereum, Cardano, Dogecoin, and Tether, among others.
Each cryptocurrency has unique characteristics and purposes, with some focused on providing a means of exchange and others enabling the execution of complex smart contracts and decentralized applications.
How do people use cryptocurrency?
There are multiple ways cryptocurrency can be used. It can be used to purchase goods and services as well as store value. It can also be used to enter smart contracts.
Who created cryptocurrency?
Bitcoin is the first decentralized cryptocurrency by Satoshi Nakamoto. It was released following the publication of a white paper called “Bitcoin: A Peer to Peer Electronic Cash System” in 2008. Nowadays, there are many cryptocurrencies and many creators behind them.
Who can mine cryptocurrency?
Miners on the Bitcoin network compete to solve complex mathematical problems. The first miner to solve the puzzle is rewarded with Bitcoin.
Who controls cryptocurrency?
If the cryptocurrency is decentralized then it will not be controlled by a third party or an authoritative figure.
