Cryptocurrency – the future of digital money

For all those newcomers out there, the easiest explanation of a cryptocurrency is that it’s a digital currency that uses cryptography (secure computer code) to ensure its integrity. Ok, so what are cryptocurrencies then? Lets first look explain some context. You see some cryptocurrencies like Bitcoin have no central authority – they are created from computers and stored on a digital ledger that each cryptocurrency holder has access to, whereas other cryptocurrencies like Ripple are created and managed by for-profit companies.

One of the main attractions of cryptocurrencies are their immunity to government interference and their decentralised nature. Cryptocurrencies are essentially digital money for the people, controlled by the people. Since Bitcoin first came onto the scene in 2009, the cryptocurrency world has exploded and there are now hundreds, if not thousands, of different currencies available for purchase and use.

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What is Cryptocurrency used for?

Some of its uses include wealth management, as a store of value, international transactions and payments, investing, buying goods and services, and even paying employees and staff.

As the world of cryptocurrency has evolved, even the word ‘currency’ itself now doesn’t encapsulate how broad the sector has become. New classes of cryptocurrencies such as utility tokens and security tokens have exploded onto the marketplace and in little time have become commonplace and now sit side-by-side among the actual currency-tokens.

Bitcoin and the bitcoin cryptocurrency

Bitcoin is the first of its kind – a digital currency known as a cryptocurrency due to the cryptographic algorithms that ensures it stays secure and accurate. Put simply, Bitcoin enables payments to be sent between people without passing through a bank or payment gateway. It is a brand new digital asset that governments do not control.

An image of Bitcoin wearing a hat, symbolising its stature and importance as the first cryptocurrency

For newcomers, the concept may be hard to grasp at first, but Bitcoin is created and held electronically. Like any cryptocurrency, Bitcoins aren’t physical and they don’t exist in the true sense of the word. Much like a photo on your iPhone, they exist only in the digital world and are produced by computers in a process called mining.

Cryptocurrency Assets

There are four different types of cryptocurrencies in the marketplace today, each with unique characteristics, purpose and technical design. These subclasses have emerged as innovation around decentralised applications, security tokenization and the requirement to differentiate these crypto tokens has emerged. Here is a brief summary of each.

Cryptocurrencies

As the name suggests, cryptocurrencies are digital currencies that are regulated by a set of secure algorithms to ensure that the currency maintains integrity on the blockchain (a digital ledger). They typically do not have a central structure and are decentralised, with no one person or organisation controlling the currency.

The intention of cryptocurrencies are that they are to be primarily used as a medium of exchange in replacement of more traditional paper and digital fiat currencies. The confusion lies in the fact that all crypto assets can in fact be used as a ‘cryptocurrency’, although that is not the primary intention of many tokens.

Some examples of cryptocurrencies are Bitcoin, Litecoin, Dash and Zcash.

Cryptocurrency Commodities/Protocols

A blockchain protocol is a set of rules that govern how a platform should operate; for example, the Ethereum network. These rules (in the form of programming language) control and govern how the network works and interacts with users. It defines the characteristics of the platform, as well as the features, boundaries, and how the platform actually works.

Think of protocols as the foundations of a home. For example, Ethereum is a platform that enables decentralised applications to be built and run on its protocol. It also allows the use of Smart Contracts, which can be coded to complete certain actions once the conditions of a contract have been met. Again, smart contracts are a feature of a protocol and many different protocols have smart contracts built into their platforms. Protocols such as NEO are even seen as crypto commodities due to their dividend-paying features. Holding these tokens means you own a stake in the network and the protocol essentially becomes a commodity, paying a holder in cryptocurrency as a dividend.

Some examples of Crypto Commodities include Ether (Ethereum), NEO, ADA (Cardano), EOS and LSK (Lisk).

Cryptocurrency Utility Tokens

Utility tokens are tokens that are purchased to provide the ability to use a product or a service on a particular platform. Companies create these tokens and use them for their particular service known as a DApp (Decentralised Application). These tokens can be for access (now or in the future) to their DApp, for example, to pay fees when using their DApp – Guardiam on NEO (NEP-5 tokens), to purchase goods and services on their DApp – OmiseGo on Ethereum (ERC-20 tokens), or even as currency on a data and DApp platform – Mobius Network on Stellar (Lumen tokens).

Imagine a utility token simply being the digital version of the tokens used in old-fashioned arcades, where a customer would exchange fiat (cash) for a bunch of tokens to be used in the arcade to play the games rather than using cash itself.

Utility tokens are often sold during fundraising ICOs (Initial Coin Offerings) or TGEs (Token Generation Events) in exchange for tokens such as Ether or Bitcoin, and are given to investors who mostly speculate on potential price rises in the future. Most investors buying these tokens are looking to speculate on price movements, but the utility token is intended for real-world use within the specific DApps ecosystem. The price of these tokens can fluctuate like all cryptocurrency, however, the main difference between the utility token and a security token is the utility is for use – there is no stake or claim to ownership in the company or platform.

The future price of utility tokens will be correlated with adoption and usage of their corresponding DApp. At this early phase of cryptocurrencies as a whole, many holders of utility tokens are merely speculating, but in the future, as DApps become more mainstream, utility tokens will be used much more for their intended use within the DApp itself.

As with any investment, purchasing utility tokens with a view to investing does have its risks. For more information on these risks and a guide to investing in cryptocurrencies, check out our Cryptocurrency Investment Guide.

Some examples of utility tokens include ETHOS (Ethos), OMG (OmiseGo) and PAY (Ten X).

Cryptocurrency Securities

Security cryptocurrency tokens are yet another emerging trend in the crypto space. These tokens are backed by real assets like equity, real estate, limited-partnership shares or commodities. For example, a holder of a security token would have ownership rights in a company’s share.

An important catalyst for the crypto space was in July 2017, when the Securities and Exchange Commission (SEC) released a report stating that tokens offered and sold by a “virtual” organisation were in fact securities, and therefore subject to the federal securities laws and subject to regulation.

Since security tokens are still a new concept to the crypto space and full regulation is pending, perhaps one way to easily illustrate a security token is to use Ethereum as an example. If Ethereum had a security token, a token holder would have part ownership of the Ethereum Foundation (seen as the company/organisation behind Etheruem), whereas their utility token (which we all know as Ether) is used for participation in the Etheruem network.

One interesting aspect of security tokens is that many analysts and crypto experts believe one day most, if not all, financial products will be traded on the blockchain as security tokens, evolving from the traditional model of stock markets.

The SEC has the authority to operate using the “substance over form” rule meaning that they look at a token according to how it is actually used, as opposed to the way it was intended to be used. They also apply something called the Howey Test, which is essentially a set of rules to determine if a financial product is a security. For example, these rules include “Is the investor investing their money?” and “Does the investor expect to profit from the investment?”. In layman’s terms, from the SEC’s perspective, if a utility token looks and acts like an investment, it therefore should be classed as a security.

As the SEC continues to refine and implement regulation into the crypto space, organisations that structure their tokens as a security gain legal clarity and protection for both themselves and their investors. In the months and years to come, it is of little doubt that the trading of security tokens will become second-nature in the crypto marketplace through licensed security token trading platforms such as tZERO.

Some examples of security tokens and platforms are Corl and Polymath.

Summary

Crypto assets such as Cryptocurrencies, Crypto Commodities, Utility Tokens and Security Tokens are constantly evolving, as is their intended use. The overall maturity of the crypto ecosystem is growing and refining each and every day, with external factors such as regulations and market behaviours, and internal factors such as DApp development and token economic models continually evolving.

In the future, there could be further token sub-classifications, like non-fungible tokens such as Ethereum’s ERC721 token, which are designed for one-time use, with popular examples like CryptoKitties using this token standard.

Overall, the very early development of cryptocurrencies does present risks if considering investing, but also presents exciting opportunities as the overall ecosystem develops and matures.

If you’re old enough to remember the beginnings of the internet in becoming a viable, commercial marketplace for business and services, you’ll understand that similarly, we are only at the very beginning of the possibilities cryptocurrency holds for the future of finance, investments and exchange of value. Exciting times are ahead.