Tokens are used in a variety of places. For example, at the arcade, you use tokens to play your favorite video games. At the fair, you use tokens for food and drinks. At the carwash, you use tokens to wash, dry, and vacuum your car. However, as crypto continues to rise in popularity, the term token takes on a whole new meaning.
In the world of cryptocurrency, a token is a digital asset residing on top of a blockchain. But what is a token? And what are tokens used for? We’ll answer these questions, discuss the types of tokens, and talk about how they work with decentralized finance.
What is a token?
Tokens are often referred to as digital coins, which isn't entirely accurate. A token is an item given a unit of value issued by an organization. To make the transition to the crypto market, you'll have to add that it's accepted by a community and supported by a blockchain.
An example of a token can be found on the Ethereum (ETH) network. These digital assets are ERC-20 tokens. There are other types of tokens in the crypto world, but the most common are ones created on the Ethereum blockchain. Anyone has the ability to create their own crypto tokens on a blockchain network that supports it.
Think of tokens as a subset of cryptocurrencies. There are several different types of tokens, but we'll discuss those further in a bit. For now, know that tokens are a way for projects in the crypto market to incentivize and reward users.
Difference between coins and tokens and why it matters
We briefly touched on one of the main differences between cryptocurrencies and tokens, but there are a few more. The three key disparities between the two are:
- Tokens are developed and reside on existing blockchains, whereas digital coins are part of the native blockchain.
- Tokens are ideal for a wide variety of purposes, whereas digital coins are typically used for payment processing.
- Tokens can be easily developed on top of already existing blockchain networks, like Etheruem and Binance, whereas digital coins are more of a challenge to create.
So, why does it matter that not all cryptos are tokens but all tokens are cryptos? First, if you're an investor, this is a critical piece of information to have. That's because it provides an important measuring tool for determining the project's potential.
For example, a new, independent cryptocurrency that already has projects on its blockchain is probably a reliable product. This increases the earning potential of the cryptocurrency. The more applications developed for the blockchain, the better its chances of success.
Conversely, if an investor is considering the value of a newly developed token-based project, it's helpful if it was built on top of a well-known, highly respected blockchain like Ethereum or Binance.
Types of Tokens
There are two main types of tokens in the world of cryptocurrency: utility tokens and security tokens. What are the differences between these two token types, and what function do they perform?
Utility Tokens
Utility tokens are regularly given out during an ICO, or initial coin offering. These types of tokens are a coupon given by a startup that promises access to services and products in the future. Utility tokens disbursed to investors often come with additional benefits and features of a platform.
Keep in mind that the token holders should use utility tokens for the products or services of the company that offered them. For example, Binance uses its native token, BNB, to give users discounts on transactions that occur on its platform.
While you might be able to trade BNB on other exchanges, you're not going to get the same discount Binance offers for using its token. If a user wants to use a different token on a different platform, they'll probably have to trade it against a fiat currency or a popular cryptocurrency like Ethereum or Bitcoin (BTC).
Security Tokens
Security tokens get their value from external assets, like a stock. That means that an investor who purchases a digital version of a security token will gain the same rights as someone purchasing a traditional stock. Typically, this includes profit shares and voting rights. The difference here is that a security token comes in a digital form, with legal ownership confirmed via blockchain technology.
Think of security tokens as investments. Dividends are distributed anytime the company experiences a profit. Typically, this is done in the form of more digital assets. So as you can see, the main thing that sets security tokens apart from utility tokens is that security tokens live under the same regulatory oversight as other investment services and products.
What role do tokens play in decentralized finance?
Tokens play a significant role in the world of decentralized finance (DeFi). One of the biggest players in DeFi is Ethereum, which has many tokens developed on top of the Ethereum network. Let's take a look at how some of these tokens impact the decentralized market.
Transactional
When it comes to decentralized finance, transactional tokens have three purposes: a unit of account, a means of payment, and a store of value. Stablecoins, including Dai (DAI) and Tether (USDT), are examples of transactional tokens, as are wrapped tokens like wrapped Bitcoin (wBTC).
Liquidity
Due to the significant amount of liquidity found in the DeFi industry, liquidity provider (LP) tokens have risen to prominence. These crypto-assets represent the number of shares a liquidity provider has in a pool. Investors automatically earn fees based on their share of the liquidity pool. As a result, liquidity tokens serve an important role in decentralized finance as they enable liquidity to move throughout the ecosystem.
Governance
A governance token gives communities the ability to use their ownership to support the direction of the project that issued it. For example, the Compound platform uses its COMP token. Holders of the token use blockchain-based voting to participate in collective decisions regarding the organization.
In-App Utility
In-app utility tokens behave much the same way local fiat currencies do. However, they are only good within a specific ecosystem. Just like U.S. dollars may not be accepted in another country, certain in-app tokens can't be used outside of a specific environment or platform. BAT, for example, allows users to tip content creators on the Brave browser with Basic Attention Tokens. However, you're not going to be able to use your BAT for the same purposes on any other browser.
NFTs
NFTS, or non-fungible tokens, are a new and emerging form of collateral in the DeFi market. These tokens are indivisible and unique and represent a specific physical or digital item. However, NFTs typically use the ERC-721 standard rather than the usual ERC-20 standard most decentralized tokens use. Just like any other token, NFTs can be traded and transferred on the open market.
Rise of Speculative Tokens
Decentralized finance has become a hot-button topic for investors both within and outside the blockchain community for a couple of reasons. First, there is a massive amount of crypto locked into these tokens, and second, because there is a continuous stream of new projects being released.
So, how does this impact the DeFi market? Just like any other new or nascent investment, there are advantages and disadvantages to the rise of speculative tokens in the DeFi industry. For example, DeFi lending tokens remove barriers that currently exist in traditional finance. The current process to procure a loan through traditional means is exclusionary and simply isn't an option for a large part of the population. DeFi aims to remove these types of problems.
Additionally, as more tokens enter the market, the potential for congestion and bottlenecks rises. Placing an extra burden on a single blockchain results in slower transactions, which in turn causes higher transaction fees. However, these concerns are being slowly alleviated as projects move off the Ethereum blockchain and over to other networks like Binance or Algorand.
Lastly, for many tokens, there simply isn't a use case that justifies owning them. There are now more than 6,000 different cryptocurrencies and tokens available in the market. It would be ridiculous to suggest that every single one is useful. There are legitimate tokens and projects in the DeFi marketplace aiming to provide safe financial services that don't require the use of traditional finance.
Using Tokens to Your Advantage
As you can see, there are a wide variety of tokens in the crypto market. These tokens have various purposes and use cases, so you should have no trouble finding a project to invest in. Additionally, there are many ways you can put DeFi tokens to work for you. One example previously mentioned is through a liquidity pool.
You can also use your tokens for yield farming. Plenty of platforms let you deposit your funds and automatically find the best returns for you. An example being Unagii, which supports several decentralized tokens and stablecoins. All you have to do is deposit a token to start earning.
