A core component of the cryptocurrency marketplace is the initial coin offering (ICO), an innovative crowdfunding model that let’s blockchain start-ups bypass the traditional venture capital early seed investment phase. It wasn’t long before multitudes of different tokens with a wide range of functions and properties burst onto the scene, leaving both potential investors as well as the general public woefully behind on this topic.
Investors, start-ups, and blockchain enthusiasts would do well to keep in mind that not all ICO’s and their subsequent tokens are created equal, and the differences between the various token types is a crucial distinction that one needs to know in the 2018 blockchain ecosystem.
On a fundamental level, all digital assets can be defined as either a ‘token’ or a ‘coin.’
If the cryptocurrency operates independently of other protocols, has its own blockchain network, unique rules and governance structure, that’s categorized as a coin. The coin itself serves as an incentive mechanism to reward all the participants of the system.
However, if the cryptocurrency depends on a blockchain network or platform such as Ethereum in order to operate then it’s designated as a token. Although each transaction of said token is also a transaction on its parent platform, said platform will have its own cryptocurrency coin. There are plenty of tokens that run on the Ethereum network, but Ether is the official coin of the platform.
As for some other basic definitions, an altcoin is a cryptocurrency other than Bitcoin. Meta-coins, also known as 2nd layer cryptocurrencies¸ are coins that build upon an existing coin’s infrastructure, adding additional features without modifying its parent’s code. The distinction between tokens and coins also extends to their mineability, with most tokens and meta-coins on the market being a form of non-minable cryptocurrency. With their supply strictly limited, these tokens are often likely to rise in value simply by the laws of supply and demand – if they are successful in the first place. The price of Bitcoin, for example, can stagnate or depreciate because of new BTC that has been introduced into the market via miners.
One of the most interesting applications of blockchain smart contracts is the idea that start-ups can issue stock through initial coin offerings, much akin to an initial public offering (IPO). While the later is largely limited to wealthier companies, smaller start-ups can compete by offering their own form of shares – equity tokens – making the barrier to entry into the financial market much lower than it used to be.
Unlike most public stock’s available on traditional exchanges, these equity tokens have a big advantage in how much easier they are to purchase. Some ICO’s offer a relatively small price for their tokens, meaning that retail investors can invest small amounts of money, and if successful, they are likely to have a large return on investment.
The widespread use of these equity tokens can lead to a situation where the average retail investor has the same opportunity to seize massive growth as an established venture capital firm would.
Following the 2017 US Securities and Exchange Commission (SEC) investigation on the tokens, new regulations has arrived (at least in the United States) that confirmed equity tokens were considered a form of security if they met certain criteria. These tokenized securities, as they are also known, need to pass the Howey test, a series of questions created after the SEC v Howey case. However, some start-ups are looking to avoid classifying their offerings as equity tokens due to the somewhat restrictive regulatory status they come with.
That’s why many have instead issued a different type of token…
Most tokens are considered securities since the majority of ICO participants view these crowd sales as investment opportunities. However, if a token should fail to meet the three requirements of the Howey test, it would likely be classified as a utility token. Also called app coins or app tokens, these cryptocurrencies provide users with access to a product or service offered by the company.
In addition to buying them in an ICO, users can also acquire utility tokens by participating in the ecosystem in a number of pre-determined ways. For example, Stori is a company that serves as a decentralized data storage platform that, if users wish to access, require Stori tokens. Within the platform, these tokens are used in a variety of ways, such as payment for sharing disk space – a way to incentivize activity on the platform. Some utility tokens also give the users the right to make decisions within the platform’s ecosystem through voting rights.
By limiting their use to just access to their own platform, utility tokens are no longer financial securities and fall outside the jurisdiction of these regulations. Unlike equity tokens, the value of a utility token does come from the opportunity to trade it like an asset but is rather derived from the users and activity within the platform. Additionally, many securitized tokens come with a dividend, usually established by the ICO itself prior to the offering. In contrast, equity tokens do not come with this profit potential.
Currency tokens are actual cryptocurrencies with their purpose being to use them as a medium to buy and sell goods and services on the internet. Just like every other online currency such as Bitcoin, Ether, and Litecoin, you can store them in digital wallets as well as trade them for other tokens.
Their appeal comes from their decentralized nature, using a peer-to-peer system to validate transactions with no middleman institution, such as a bank or credit-card company, interfering in the process. This also makes them very secure, as blockchain technology makes these currencies impossible to forge or falsify.
While an equity token allows the user to own an actual share of a start-up similar to common stocks in the financial markets, asset-backed tokens represent ownership of an actual, physical asset. Through a process called tokenization, tangible assets (and even some non-tangible assets in some cases) can be fractionalized and converted into digital tokens that represent partial ownership of said asset class. These tokens offer retail investors another opportunity to participate in markets that would usually be closed off to them either because of larger capital requirements, as in the case of real-estate, or hampered through legal paperwork, a problem prevalent in the old days of commodity investing.
While a creative way of using blockchain technology, they are not the most popular type of token simply because their value is linked to traditional physical assets, and as such, don’t have the same upside potential for investors as other tokens have. However, the asset-backed token market is poised to grow substantially over the coming years if major players in the commodities markets end up utilizing this technology.
A less popular token type among investors, reward tokens, also called reputation tokens, are used to symbolize a users standing within a platform’s ecosystem. They’re usually earned over time as their use positively participates in the platform, accruing a “reputation,” if you will, that gets represented in the form of these tokens.
As such, they are largely ignored from an investment perspective, being too difficult to evaluate the value of these tokens and are usually left as a sign of achievement and trust within the network. However, some reward tokens, such as Steem, are the exception to the rule.
A user on the blockchain social media platform Steemit can earn reputation tokens called Steem Dollars (SBD). By contributing content that is positively received by the community of others as well as participating/upvoting other users content, these reward tokens are earned. Similar to how most forums have a reward or points system for active members to contribute, Steem Dollars works in a similar fashion, incentivizing activity on the platform. The catch is that Steem Dollars can be turned into Steem (STEEM), the social media platforms native cryptocurrencies, which can be traded on most exchanges.
Although still capturing a small portion of investors attention, certain types of reward tokens certainly stand out in the marketplace.
These five basic token types each have their own role to play in the larger blockchain ecosystem. As the marketplace continues to grow in 2018 with professional investors growing increasingly comfortable with the idea of ICO’s, potential start-ups should keep these differences in mind regarding their own tokens as they seek out their target audiences.
Also published on Medium.