Introduction
According to the data provided by CoinMarketCap, 21,910 cryptocurrencies are trading in the DeFi market today. Considering the massive number, it can be a real challenge for anyone to find the best cryptocurrencies to add to their portfolio.
The reason that there are so many cryptocurrency variants available is the fact that most of these products serve a unique purpose. This article is going to help the readers understand how to classify cryptocurrencies to manage them effectively.
What are Cryptocurrencies?
When it comes to cryptocurrencies, it is important to establish what they are and how they work. Cryptocurrency is a combination of two words, namely crypto and currencies. The first word is taken from cryptography, and the second is derived from normal currencies. Cryptocurrencies are financial instruments that are issued by a blockchain project.
Since the introduction of the internet in the 90s, many programmers and computer scientists have been working on creating the perfect money for online transactions.
It is important to note that with sufficient resources and proper skills, hackers can break into any financial network. Therefore, there was an urgent need for a type of protected online payment method that was not susceptible to online attacks.
This requirement inspired developers to use cryptography technology to encrypt the currencies issued by blockchains. Thus, cryptocurrencies were born. These encrypted online currencies were safe from any exploits or cyber invasion and also performed more functions in comparison to fiat currencies.
What are the Basic Components of a Cryptocurrency?
Each cryptocurrency is composed of four necessary components as under:
Software
Software is the most fundamental component of cryptocurrency. Software is created by a programmer using a mixture of different programming languages. All blockchains, such as Bitcoin, are also composed of programming and coding. These blockchains are the units that are designed to issue cryptocurrencies.
At the same time, the software part of the blockchain ascertains important rules such as verification criteria, encryption standards, the total number of currencies, mining difficulty, etc, that are essential for the accurate and streamlined operations of these cryptocurrencies.
Cryptography
Cryptography was invented by the Greek historian Polybios. Over the years, philosophers and mathematicians have improved these technologies. Blockchains like Bitcoin make use of cryptography to validate the transaction between two parties.
At the same time, this encryption method is used to ensure that all the fungible cryptocurrencies issued by a blockchain cannot be replicated or manipulated.
Thanks to cryptography, it is impossible for a hacker to enter an alien Bitcoin into the network, meaning the Bitcoins cannot be forged like fiat currencies.
Hardware
Hardware is another important foundational unit of cryptocurrencies. Even though blockchains are decentralized, meaning that they are not stored on a specified server, it still needs to remain stored on multiple servers or nodes. Additionally, the developers of Bitcoin need computers to encode the blockchain.
Meanwhile, Bitcoin users also require hardware to access the network and perform a transaction. Furthermore, Bitcoin miners set up mining machines and computers to verify transactions and mine new Bitcoins.
Mining
Blockchains can use consensus mechanisms to ensure that all the transactions performed on the network are authentic. Bitcoin uses a PoW mechanism where miners need to compete with each other to solve the cryptographic puzzle first and verify the transaction.
Miners aim to increase their chances of earning mining rewards by increasing the computation power. Blockchain devs have come up with other types of consensus models, such as PoS and PoH, that do not need a lot of energy input.
What are the Types of Cryptocurrencies?
When talking about the classification of cryptocurrencies, the nomenclature can be distributed on account of various aspects such as origin, standardization, function, and technical specifications. There are many different ways that investors can approach cryptocurrencies to split them into various types. Here is the most basic differentiation for cryptocurrencies:
Crypto Coins
Crypto coins are like the central currencies that are issued by a blockchain. A crypto coin is bound to perform all the basic functions of a given blockchain. Without the issuance of the core coin currency, a blockchain might not be able to keep functioning. In most cases, Crypto coins work as a monetary representative of value.
The price of these cryptocurrency coins is tethered to the demand for their utility and traction among investors. In other cases, crypto coins can also serve other functions in addition to serving as a monetary unit for a blockchain, such as sharing data or representing voting rights, etc.
Crypto coins are never present in physical form. They are fungible, and they are made of data or code. Crypto coins are issued by blockchain, and their total value is determined by the internal protocol of the blockchain.
Bitcoin is a good example of a crypto coin. Bitcoin is often touted as a standalone cryptocurrency with a plan to become a unit of account in the future. The total amount of Bitcoins is capped at 21 million, which can never exceed.
Altcoins
For those who view Bitcoin as a unique blockchain project, it takes some effort to make sense of the rest of the cryptocurrencies. Every other cryptocurrency in the DeFi sector is classified as Altcoin or alternative coin, which is a cryptocurrency but not Bitcoin.
Bitcoin creator Satoshi Nakamoto made Bitcoin an open-sourced project that allowed various developers to take inspiration from the program and generate new blockchains and cryptocurrencies.
There are many blockchains and altcoins, such as Ethereum, Litecoin, Bitcoin Cash, Cardano, Solana, etc.
Altcoins have taken inspiration from the Bitcoin blockchain, but they make an effort to improve the blockchain by introducing new use cases and improving the operational method of the decentralized distributed ledger. Some altcoins, such as Bitcoin Gold, are a fork of the Bitcoin blockchain.
Tokens
Crypto tokens are much like any altcoins, but they are not the main cryptocurrency issuance of a blockchain project. Take, for example, the Ethereum network. Ethereum is a host for several decentralized applications.
Ethereum main cryptocurrency is ETH, while the Dapps hosted on Ethereum issue other cryptocurrencies that are classified as tokens.
Tokens do not have a native blockchain, but they are associated with hosted protocols such as second-layer software or decentralized applications. Tokens can play the part of a currency, and they are also capable of serving various functions such as yield rewards or governance participation etc.
Types of Cryptocurrency Tokens
As mentioned above, tokens are capable of performing various services for a decentralized project in addition to serving as a monetary unit. Based on their different types of a function, here are all the classifications of crypto tokens:
ERC-20 Tokens
ERC stands for Ethereum Request for Comment. ERC is a token standard that is published by the Ethereum blockchain. Ethereum blockchain can host decentralized applications.
Therefore, the blockchain has mandated a standard for the developers to ensure that the crypto tokens they are creating are in line with the requirements set by the Ethereum network.
The cryptocurrency tokens that fulfill the ERC-20 standard are compatible with various decentralized projects on the Ethereum network and the local digital wallets. Ethereum has issued several ERC standards, and decentralized application developers follow them based on the requirement for their projects.
Complying with ERC-20 standard in the minimum requirement for all tokens listed on the Ethereum blockchain.
Exchange Tokens
Investors who wish to purchase a cryptocurrency need to visit a cryptocurrency exchange. Cryptocurrency exchanges work much like stock exchanges, and they list various cryptocurrencies for investors. Both centralized and decentralized crypto exchanges are either regulated or non-regulated.
In addition to cryptocurrencies purchase, the exchange account holders can also access services such as options, futures, margin trading, yield farming, leverage trading, lending, and borrowing cryptocurrencies, among others.
Cryptocurrency exchanges are high in demand, and many cryptocurrency exchanges have issued their native currencies, which are known as Exchange tokens. These tokens support the function of the exchange and earn the users exclusive privileges such as governance and voting etc. Some examples of exchange tokens are BNB, Kucoin, Bibox Token, Huobi token, etc.
DeFi Tokens
Just about everyone who is connected to the cryptocurrency space has heard about DeFi tokens. DeFi stands for decentralized finance, and it entails the sector that contains all decentralized entities, including blockchains, exchanges, applications, liquidity pools, etc. The term is thought to first appear by Ethereum developers in a Telegram chat in 2018.
The DeFi summer gained popularity in 2020. Decentralized applications were serving various functions, such as derivatives, synthetics, lending, liquidity, and insurance, among others, at the time.
Since Bitcoin is considered a truly decentralized project, it is also covered under the umbrella term. Other DeFi tokens include the likes of Uniswap, Chainlink, AAVE, etc. It is important to keep in mind that regulated exchanges and private blockchains are not part of the DeFi ecosystem.
Governance Tokens
Governance or administration of a blockchain is an important matter of discussion among blockchain enthusiasts. When the Ethereum blockchain was created, it had the vision of developing a community that is ruled by the democratic voting method. For every entity making decisions about administration is necessary.
However, governance tokens grant the right to vote to investors and stakeholders. In this manner, the users can participate in the decision-making process rather than just accepting the decision made by a CEO or board of directors in a typical software company.
In some cases, users have the option to delegate their governance tokens to validators to cast the votes on their behalf. Dai is a good example of a governance token.
Security Tokens
Just about everyone in the world knows about stock trading. However, in the past, only wealthy and accredited users were able to invest their money in the stock market. The advancing technology has allowed everyone to participate in stock markets.
Companies issue stocks to give the investors a chance to gain a stake in ownership and share the percentage in profits.
Security tokens are the type of cryptocurrencies that are digital alternatives to stocks and securities. These tokens also represent the ownership rights of the issuer and share in the profit margin.
Companies can issue security tokens using a method called tokenization, where the cryptocurrencies are tethered to the value of a real-world asset such as securities. However, security tokens should be regulated by relevant financial agencies such as the Securities and Exchange Commission.
ICO Tokens
ICO stands for Initial Coin Offering. ICO event is arranged by a new startup that airdrops currencies to new investors before the project has made its public debut. ICO events are popular in the IT sector; they allow new companies a chance to collect funds to support and develop their businesses.
On the other hand, investors can get a chance to get the first chance to invest in new ventures that have a chance to grow exponentially. In TradeFi, only big players and acquisition companies were able to multiply their capital by investing in the businesses with the best potential.
However, now anyone can participate in online ICO, where companies incentivize their investors with ICO tokens. Other forms of ICOs are IPOs, IEOs, and IDOs in the DeFi space.
Web 3.0 Tokens
Web 3.0 is a novel concept that was introduced by Ethereum and Polkadot co-founder Gavin Wood. The concept talks about the next evolution of the internet, where users can have complete control over their data and legal ownership of their online presence and space.
At present, the concept has not been fully realized, but there are companies such as Microsoft and Meta that are working on adopting the technology. A big breakout from the Web 3.0 sector is the new gaming industry that aims to introduce virtual, augmented, and mixed reality for gaming consoles.
Some of the biggest Web 3.0 gaming platforms are Axie Infinity and Sandbox. These platforms are introducing games where users can purchase new features and characters using native currencies that are called Web3 tokens.
These gaming platforms adopt a play-to-earn model. Other web3 tokens follow the same mechanism to create a new type of online economy in the future.
Utility Tokens
Utility Tokens are cryptocurrencies that offer some type of special utility for the users. These coins can be used for purchasing or selling goods and services. These tokens are not used as a direct investment, but their ownership can grant the users special discounts and options.
For example, the holders of Binance Coin can get gas fee cuts on account of their BNB stash. On the other hand, utility tokens can also be used as gift certificates, travel bill wavers, and other types of boosts. Utility tokens can be viewed as bonus points rather than holding the main value.
Non-Fungible Tokens
NFTs are media files that are minted using blockchain technology. Each NFT is unique and maintains specified online ownership. NFTs can be used to purchase artwork, real estate, virtual space, gaming gear, gaming skins, online advertisements, etc.
They are also optimized to increase in value on account of their rarity and demand among investors. Investors can also earn money from NFTs by staking them. Platforms like OpenSea, Rarible, and Decentraland are considered the biggest NFT marketplaces.
Yield Tokens
DeFi protocols such as AMMs and liquidity pools allow investors to stake their currencies to earn yield. Some wallet projects incentivize users to stake their currencies by offering them yield income.
Most cryptocurrency enterprises reward their stakes in the form of yield tokens. Investors can stake these yield tokens or use them to purchase more cryptocurrencies to increase their yield income.
Value Tokens
Value tokens are all cryptocurrencies that represent some type of monetary value. Cryptocurrencies like stablecoins, NFTs, security tokens, and yield tokens can all be ranked as Value tokens.
Stablecoins
Stablecoins are cryptocurrencies that hold a constant value, unlike other cryptocurrencies whose prices are subject to volatility. Stablecoin prices are pegged to another asset to ensure their stable value. Stablecoins can be backed by commodities, cryptocurrencies, or fiat currency reserves.
There is another type of stablecoin that maintains its value using an algorithm to issue or burn pegged cryptocurrencies to retain a constant value at all times. PAXG, USD, USDC, BUSD, and Gemi Dollar are some examples of stablecoins.
Privacy Tokens
Privacy tokens are just like other cryptocurrencies, but their emphasis is on ensuring the privacy of the users. Most blockchains are open-sourced, which means everyone can track the transaction history and data of any user.
However, privacy blockchain uses various techniques to make sure that identity, transaction amount, and transaction activity of their users remain a secret and is almost impossible to retrace. Monero, Dash, Secret Network, and Zcash are some of the most well-known privacy tokens.
Meme Coins
Meme coin is a type of cryptocurrency that is a satirical representation of cryptocurrencies. These meme currencies are usually based on a popular online meme that helps them to gain popularity online. Dogecoin and Shiba Inu are the two most popular meme currencies online.
Conclusion
Cryptocurrencies are considered the most important invention of the 21st century. Many people believe that cryptocurrencies are going to have the same impact on the DeFi markets as the internet.
However, at present, the cryptocurrency market is working on ways to reach its maximum potential, all the while enabling users to upgrade their technological apparatus and skills.