In early 2009, an anonymous developer (or group) launched the cryptocurrency known as Bitcoin.
This developer went by the name Satoshi Nakamoto. In the years since, the technology that makes Bitcoin possible has taken on a life of its own, and numerous other cryptocurrencies have sprung up to compete with it. To an outside observer, today's cryptocurrency market might appear to be little more than a group of similar offerings all competing for the attention of investors.
Major types of cryptocurrency
There's quite a bit of variance between today's cryptocurrencies. They rely on different versions of the original blockchain technology that powers Bitcoin, and not all of them are designed to function like fiat currencies. Making sense of it all requires careful study and a fairly extensive understanding of how cryptocurrencies work under the hood.
As a guide for those not immersed in the intricacies of crypto-technology, here's a look at the four major types of cryptocurrency, and what they're good for.
4 types of cryptocurrency
- Proof of Work (PoW)
- Proof of Stake (PoS)
1. Proof of Work (PoW)
To get started, the first type of cryptocurrency is the one that began with Bitcoin, which relies on blockchain technology that uses a concept known as proof of work (PoW) to process transactions. To understand what that means, though, you first have to understand what blockchain is.
Put simply, blockchain is a distributed ledger system. On a blockchain network, every participating computer (called nodes) maintains a complete copy of the system's ledger. It's a bit like sharing a copy of a check register with multiple people – except that no individual member can add something to that register alone.
To add a transaction, nodes compete to solve a complex cryptographic problem that represents the data to be added. The first to solve the problem then broadcasts the answer to the rest of the network for verification. This process is what has commonly become known as mining because the node that gets the right answer first gets a reward from the network. It's a secure and self-policing way of keeping airtight records.
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The security of blockchain technology, besides making cryptocurrencies possible, is also making its way into other industries of all kinds. Walmart is using it to manage its produce supply chain, Maersk is using it to track shipping containers as they travel the globe, and even the diamond industry has adapted it to track precious stones as they move through the value chain.
The upside of PoW
That process is the work referred to in proof of work. The proof part is the follow-up process of verification by the rest of the network. That's what keeps the complete ledger both valid and agreed upon by all parties. It's a system that's inherently secure and robust because the only known way to compromise it would be for a single actor to control more than half of all nodes (making it possible for them to make changes at will).
The downside of PoW
The major downside to a PoW blockchain system is the sheer computing power it takes to function. Since every node has to work on every transaction, simply adding nodes has no effect on the total speed or throughput of the network. For that reason, PoW systems don't scale well and are somewhat inefficient. One study even found that the blockchain network alone consumes the same amount of electricity as the city of Las Vegas, which may present an obstacle to its continued dominance in the crypto market.
Cryptocurrencies using PoW
Right now, the two major cryptocurrencies that rely on proof of work also happen to be the biggest, in terms of market value: Bitcoin and Ethereum. Together, they have a market capitalization of around $150 billion, a figure that dwarfs all other competition. As the legacy technology of the cryptocurrency world, PoW has proven stable and resilient, powering the two aforementioned currencies to unheard-of values in the past few years.
2. Proof of Stake (PoS)
The major problem with PoW systems is the fact that they don't scale well. To overcome that problem, a different consensus model for blockchain was developed that allows smaller pools of nodes to validate transactions. It's known as proof of stake (PoS), and it ensures security in a fundamentally different way than PoW.
In a PoS system, not every node must validate every transaction. Instead, participating nodes have to use their own cryptocurrency holdings as a deposit to join a transaction validation group. That deposit is where the concept of proof of stake gets its name. Any node that tries to cheat or pass bad data into the ledger automatically forfeits their stake as a penalty. Those that play by the rules receive interest on their deposits as a reward for their work. In a PoS blockchain, that's the incentive system that keeps things secure and operating fairly.
The upside of PoS
As you may have guessed, the main upside of a PoS blockchain is processing speed. Since participating nodes can split up into smaller groups to work on individual transactions, cryptocurrencies that use it gain the ability to operate using parallel transactions which mean lower processing costs. The importance of that can't be overstated.
Even Ethereum, one of the main pillars of the PoW crowd, is already in the middle of shifting to a PoS blockchain. They see it as the only way to avoid the eventual bottlenecks that will bring ever-expanding PoW systems to a virtual standstill.
The downside of PoS
The major downsides of PoS blockchains are that they're theoretically less secure than PoW systems, and they run the risk of becoming far less decentralized over time. On the security front, the threat of a participant forfeiting their stake only works as a deterrent if their stake is greater than what they would gain by breaking the rules. If, for instance, a node succeeded in adding a fraudulent transaction to the blockchain in an amount greater than their stake, the incentive to do the right thing would disappear.
The other problem relates to how much of a PoS cryptocurrency each node controls. The larger their holdings, the more transactions they can become involved with, and the more interest they collect. That could create a snowball effect where the most powerful nodes become even more powerful over time, eventually coming to dominate the network itself. Since one of the key draws of cryptocurrencies is that they're not under any centralized control, that could prove to be the Achilles heel of the PoS cryptocurrencies at some point in the future.
Cryptocurrencies using PoS
Right now, there are several cryptocurrencies that rely on PoS blockchains. The most notable among them are Eos, Dash, and Tron. Although they are tiny when compared to the PoW behemoths, that's about to change in a big way. That's because as mentioned earlier, Ethereum's about to join their ranks within the coming year. It's also worth noting that the vast majority of new and planned cryptocurrencies rely on PoS, as it's seen as the future of scalable blockchain technology.
The two cryptocurrency types we've covered so far have been distinguished from one another by the technology that powers them. That's not the only kind of difference you'll find in the market, though. There are also differences in the purposes of the various offerings on the market. That brings us to the next major cryptocurrency type: tokens.
Tokens are distinct from traditional cryptocurrencies in that they're not intended to be used as general-purpose currency. They're also created on top of existing blockchains, such as Ethereum, and do not exist as stand-alone systems. In a way, the simplest way to understand the concept is to think about the chips you use to place bets in a casino. While they represent cash or other assets of value, they may only be used in the specific casino who issued them.
For example, online music streaming service Musicoin facilitates direct payment from listeners to artists using a token called Music. The token itself is built using the Ethereum blockchain (which is home to the majority of tokens), and cannot be converted directly into fiat currency. Instead, artists paid in this way must convert their tokens into standard cryptocurrencies like Bitcoin or Ethereum before cashing out their earnings.
The upside of Tokens
As you might imagine, there are a wide variety of use cases for crypto tokens. Since they can be used to represent assets or units of value, they're perfect for single-purpose applications built atop existing blockchains to provide liquidity in illiquid markets. Real estate is a classic example of that idea. By representing real estate holdings as tokens, owners can swap property shares as they might trade stocks or bonds. Tokens are also being put to use in commodity markets, such as energy trading and the like.
The downside of Tokens
When used as a simple medium for exchange, crypto tokens work quite well. The problem, however, tends to happen when trying to extract value from whatever ecosystem the token belongs to. As mentioned earlier, tokens can't be exchanged directly for fiat currency, so it's difficult to pin down their exact value at any given time. In addition, they're also at the mercy of whatever happens to the underlying blockchain they're built on.
If that blockchain suffers an attack, it would affect all associated tokens. Also, if the underlying blockchain makes a technical change (like the aforementioned Ethereum switch to PoS), it can have wide-ranging implications for all associated tokens.
Oddly enough, there are so many tokens currently in existence that it would be impractical to list them all. To the general public, however, there are two worth mentioning – BAT and Tether. BAT, which stands for Basic Attention Token, is used as a payment system within the recently-released Brave web browser. The idea is to compensate users for viewing online advertising as a means of changing the current equation which has led to rampant use of ad blocking technology.
Tether, on the other hand, is a token whose sole purpose is to remain at a value that's on par with the US dollar at all times. It's also a member of the next group of cryptocurrencies we're about to discuss: stablecoins.
As the name suggests, stablecoins are cryptocurrencies created for the sole purpose of providing reliable value storage. They came about because standard cryptocurrencies like Bitcoin and Ether (the Ethereum coin) can fluctuate wildly in value over a short span, making them difficult to manage. That's the reason that some crypto-investors have become multi-billionaires overnight, only to see their net worth evaporate almost as quickly.
Stablecoins represent something of a hybrid between tokens and standard cryptocurrencies, in that they are built on existing blockchains but may be exchanged for fiat currency. Within the market, they play a vital role in allowing day-to-day, repetitive transactions that are free from value swings. Most stablecoins achieve this feat by pegging their value to one or more fiat currencies, and keeping reserves of those currencies as a guarantee of the token's value.
The upside of Stablecoins
One of the major roadblocks to the integration of cryptocurrencies into the wider world economy is the volatility that is their hallmark. That has made it difficult for banks to work with cryptocurrencies, for retailers to accept them as payment for goods and services, and for individuals to use them as a savings vehicle.
Stablecoins like Tether (which is pegged to the US Dollar) are now used by crypto exchanges as their default storage medium for investors – kind of like a tokenized fiat currency. Without them, it would be very difficult for investors to buy and sell crypto-assets because of the need to pull out holdings to avoid losses.
The downside of Stablecoins
The major downside of stablecoins is the fact that holders of the coins must rely on the companies that manage them to keep real cash reserves to guarantee their value. There's been some question, in particular, about Tether's practices with regard to its currency reserves. Since stablecoins aren't government-backed, there's nothing to stop one from blinking out of existence due to poor management.
Besides Tether, which represents almost 90% of stablecoin trading volume, there are a few more examples in the market today. The most well-known among them include Paxos, Gemini, and TrueUSD.
There is, however, another stablecoin on the way that has grabbed the spotlight in recent months. It's Libra, the Facebook-backed cryptocurrency that sparked controversy when plans for its debut became the subject of a Congressional hearing this past year. Still, if Libra can clear the regulatory hurdles, it might become the dominant stablecoin almost overnight – changing the face of the cryptocurrency market in the process.
The crypto bottom line
By now, it should be obvious that there's more to cryptocurrencies than meets the eye. It's a diverse market that is made up of the four distinct groupings covered here, as well as some types of coins and tokens that blur the lines between them. It's also worth mentioning that it's a market that's in near-constant flux. As proof, consider the fact that nothing you've read about in this article existed prior to 2009 – and most of the developments like stablecoins and proof of stake are much more recent than that.
For that reason, it's easy to forecast that the four cryptocurrency types detailed here won't be the last. In fact, there's a good chance that they'll be replaced by newer variations in the years ahead. Still, it's worth understanding things as they stand today. It'll form the basis of an understanding that will help you grasp the changes that are sure to take place in the near future and leave you well prepared to embrace the crypto future that's unfolding in front of our eyes.
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