Newcomers to the cryptocurrency industry are faced with steep educational barriers in the way of understanding even the most basic components of the technology. Despite being only a 10-year-old industry, there have been thousands of alternative cryptocurrencies (altcoins) created and billions of dollars invested in blockchain-based projects. The technology is growing rapidly and as result, the barrier to entry is rising.
To my surprise, even self-acclaimed “experts” and “gurus” don’t understand the distinctions between coins and tokens. In this article, I will explain the differences from both technical and economic standpoints. Let’s dig in.
Back It Up
First, it’s important to understand a couple of basic facts about decentralized networks, which is where blockchain shines.
Decentralized networks — such as LAN messaging or Onion Routing — have been around since the 1980s but never grew in popularity because there’s a cost for each user to contribute to the network. With no financial incentive, most people won’t care to run a piece of software in the background of their computer to join a decentralized network. Believe it or not, contributing to these networks can actually increase your electricity bill.
But, which decentralized networks have prospered? Ah! Torrenting sites, where people gain value by downloading software for free — hence, economic value.
Now, thanks to blockchain technology, and the cryptocurrencies along with it, there are real profit incentives for mass amounts of people to join in on these networks. The boom begins.
The catalyst for the cryptocurrency (decentralized) revolution, are the cryptocurrencies themselves.
Follow this logic:
1. Contributing to a decentralized network requires leaving your computer on and downloading the proper piece of software. In Bitcoin’s case, you would sync up with Bitcoin’s blockchain by downloading a Bitcoin wallet.
2. Sometimes, running this software (acting as a node) can noticeably increase your electricity bill, costing you money.
3. Making these networks high-speed, reliable, and robust, requires lots of computing power, which involves lots of money.
With these blockchain-based cryptocurrency networks, contributors are rewarded in cryptocurrency for their work. The cryptocurrencies act as the financial incentive for people to join in.
This opens the door to tech geeks, gamblers, and investors to speculate on various decentralized networks.
Okay, now back to the point — what is a coin, and what is a token?
What is a Coin?
A coin is the native cryptocurrency to the network.
Let’s use Ethereum as an example. Ethereum is a decentralized blockchain network which allows developers to create and deploy decentralized applications (dApps). From a user perspective, think of Ethereum as Apple’s App Store or Google Play of the blockchain. From a technical perspective, it’s really the operating system for which applications run off.
Ethereum even has its own programming language called Solidity, created specifically so developers can create applications that can communicate with the decentralized Ethereum network.
This is different than Bitcoin’s blockchain which is focused only on monetary transactions.
Ethereum’s cryptocurrency is called Ether (ETH), while Bitcoin’s cryptocurrency is naturally called Bitcoin (BTC).
Coins, such as Ether, are used to pay for transaction fees on the network and reward miners for their work. Without Ether, miners would have no incentive to contribute to the Ethereum network. Most likely, the network would be stale and transactions would be stuck in limbo.
To bring even more clarity to the integral role of a coin, let’s break down the mining process as simple as possible.
What is Mining?
Many people confuse regular nodes (full nodes or lightweight nodes) with miners. Miners download special mining software that allows them to hash away at the Proof-of-Work algorithm of the coin — in Bitcoin’s case, the mining algorithm is SHA-256.
Miners secure the network, validate transactions, and solve the hash for the next block. A hash is simply a mathematical function that condenses large amounts of data to a smaller, fixed size. Each block on the blockchain has a reference hash to the block before it — but ‘solving’ what the next block hash will be requires lots of ‘guesses’ or in other words, computing power.
For the SHA-256 mining algorithm, there are 2²⁵⁶ combinations…which is a big number. 1 trillion is nothing compared to this. (It’s actually 1.1579209*10⁷⁷)
As a reward for their work, miners receive the block reward, which is set in the code of a cryptocurrency’s codebase as a set number of coins that are minted with each block reward. The block reward generally goes down over time, but that is irrelevant for now. Bitcoin has a block time of 10 minutes, which means that every 10 minutes a new block is found and block reward distributed. Most miners do not mine alone, and instead, point their hashing power towards a mining pool, combining forces with other miners to better their odds at “winning” (solving the answer to the next block).
Let’s see this in action.
1. New transactions are broadcasted to the network
2. Each node on the network collects these new transactions to be included in the next block
3. Each node ‘turns their back’ and individually solves the Proof-of-Work algorithm for its next block
4. Once a node solves the answer to the next block, it proposes the new, updated blockchain ledger including the new block, to the rest of the network
5. If all transactions in the new block are valid (not double-spent) and a majority of nodes agree, then all nodes update their current blockchain ledger to include this new block. History has been recorded.
The node(s) which first broadcasted the updated ledger are rewarded in coin — they’re the winners!
6. Meanwhile, more transactions are continuously being sent on the network, so nodes grab unconfirmed transactions and begin this process over
You can learn more about the basics by reading Bitcoin’s whitepaper.
Note: In a future article I will explain what happens if two nodes propose different blockchain ledgers at the same time, what a 51% attack is, and why the block time is set to 10 minutes. For now, just understand how mining works and notice the role that the coins play. The coin acts as the reward to miners and also pay for fees to the network. They are integral and required.
Next up, tokens. Coins and tokens are often used interchangeably, but this is wrong.
What is a Token?
Let’s move back to Ethereum — a blockchain platform that allows projects to launch applications on the decentralized network. For Ethereum, Ether is the coin used to pay for transaction fees and rewards miners for their work.
Tokens, on the other hand, are cryptocurrencies which projects use as their application-specific currency. They are generally IOUs and we see these in everyday life from airline mile points, poker chips, Chuck-E-Cheese tokens, and more. They have a substrate, they represent something.
For example, let’s say I started up a decentralized e-commerce platform, like a decentralized Amazon. Let’s call it D-Amazon.
D-Amazon is my decentralized marketplace, and if you use my token, ‘DAMZ’ — then you get discounts on my products. I also may have funded the development and operations for D-Amazon by issuing my DAMZ tokens through a formal crowdsale, commonly known as an ICO (initial coin offering).
Well, that’s it! A token is an asset, which should have some sort of utility, but is only important or useful for the specific dApp (decentralized application).
DAMZ token is not important for Ethereum to run, while Ether is required for Ethereum to run. Ether is the magic crypto incentivizing (and disincentivizing bad actors) to contribute to the network. DAMZ is just a token created by the D-Amazon team and has use for their specific app.