Flip Ya for It? Crypto Coins or Tokens?
Lesson 9: Key Cryptocurrency Differences
Imagine that the Web3 (blockchain) space is guarded by Charon (the ancient Greek god who ferries souls to the underworld). If you had to pay him for passage, would you offer him a crypto coin or token?
Is there a difference?
A token is more limited than a coin when it comes to understanding cryptocurrencies. So if you chose a token, Charon may very well take you to where you wish, or he may simply refuse you passage . . . or worse yet, he may take you where you don’t wish to go.
Why?
The short of it:
- Tokens are specific to a certain “region” in the Web3 space; whereas coins tend to be more universal, or if you prefer, fungible.
Ok, so let’s get the long of it . . .
Hades . . . Err, the Blockchain Is Multi-layered
To recall from a previous post, the Web3 space consists of different layers. There is not just one foundational layer, but several. Each foundation is referred to as a “Layer 1” blockchain, which provides the rules for verfication and processing transactions. Ethereum, Bitcoin, and Solana are just a few.
Another term for “Layer 1” is “platform”. And each Layer 1 is essentially vying to be the first one to achieve certain goals — decentralization, scalability, and security. So Ethereum, Solana, Cardano — for example — are involved in “the Platform Wars”. (Bitcoin is a bit different since it’s not in the business of providing utility for users to the same extent as others.)
Layer 1 blockchains provide the foundation on which other projects can build themselves and offer services to users. For example, you can borrow cryptocurrency from Solend on the Solana chain or you can trade NFT art with Opensea on Ethereum. These projects are essentially applications,or apps. But because they are on the decentralized blockchain, they are called “dApps” (decentralized applications).
Sort of like the Upside Down in Stranger Things?
Well, if you’re new to Web3, it gets stranger.
Other blockchains can build “on top of” Layer 1 blockchains. These are called Layer 2 blockchains, and they also offer their own dApps, as well as providing other utilities to their Layer 1 host. For example, let’s take Polygon, which is a Layer 2 blockchain on the Layer 1 blockchain Ethereum. Polygon offers a huge range of dApps — games, crypto exchanges, staking pools, etc. As well, it helps Ethereum increase its transaction processing rate (or TPS).
Bearing in mind the distinction between Layer 1, Layer 2, and dApps, the coin-token relation can be unpacked:
- Coins are the native currency of a Layer 1; as such, they can be used on the Layer 2 blockchains that build on top of it, as well as the dApps built on it and its respective Layer 2 chains. (E.g. ETH can be used on Polygon.)
- Coins are the native currency of Layer 2; as such, they can be used on the Layer 2 blockchains that build on top of it as well as their respective dApps.
- Tokens are native to dApps, and are often not as fungible as their hosting Layer 1 or 2 coin. In fact, in some cases, you can’t get the token directly and have to first buy the Layer 1 coin to exchange for the token.
With me so far on this trip through Web3 Hades? Then, deeper we descend . . .
Tokens: Fungibility Is All
Tokens are exchangeable like their coin counterparts, but their scope of exchangeability will most likely not be as robust as coins. Coins like BTC and ETH are widely used and can therefore act as a store of value should their price remain stable.
In contrast, the main purpose of a token is to provide utility within the ecosystem of the dApp. Holding a native token will often provide the holder with voting rights within its respective dApp governance structure (the same is true of coins and voting within the Layer 1 governance process). Tokens may also provide the holder with access to specific features in the ecosystem.
The term “tokenization” is used to refer to the process of representing some utility or asset as a token so it can be owned, used, or sold. A non-fungible token (NFT) is a classic example of this.
You can even create a token of a token! For example, you can create a NFT basket or safe box which contains a certain number of tokens. Why do this? Start-up projects can use such NFTs to protect native tokens against price dumps since the NFT can utilize a smart contract encoded vesting schedule, which is more or less a hold period.
Tokenization can also involve taking one asset or value and breaking it into several “tokens”. The tokens are therefore like shares in the asset. (Just bear in mind that tokens are not like stocks since they do not entitle holders to assets or cash dividends. Instead, holders tend to get staking rewards that are provided in denominations of that token.)
“Tokenomics” refers to how a token provides utility for users, value, governance, and sustainability within the dApp’s ecosystem (and sometimes beyond if the token is also used for investments at yield farming pools).
The upshot: The remit of tokens tends to be very specific and utility-based. Because of this, they tend not to be used widely in trading.
However, when a Layer 2 blockchain does exceedingly well in terms of its ability to provide user utility, the value of its token tends to appreciate and thus be more fungible.
Back to the Hades Analogy (sorry!): So if you give Charon a token instead of a coin, you better hope that the “region” (or dApp) to which it is native:
- is accepted by Charon (i.e. the region exists within Hades); and
- is the kind of place you want to be (i.e. the dApp you want to use).
One last, important topic relating to fungibiliy of coins.
Coins: Fungibility Is Not All
Coins are more fungible . . . just not across all blockchains.
Coins on one blockchain can’t be easily used on another. This is important for commerce, finance, and investment in the world of Web3. Users want to be able to use the coins they hold on other networks in order to buy, sell, invest, etc. Wrapped coins therefore provide cross-chain utility.
For example, Bitcoin can’t be easily used on the Ethereum network; and vice-versa (Ethereum cannot be easily used on the Bitcoin network). To solve this, “wrapping” a coin allows for the original asset (say, Bitcoin) to be represented by another token (wBTC, or wrapped Bitcoin) which is compatible with the desired blockchain (in this case, Ethereum). All of this occurs with smart contracts.
The presented Bitcoin is stored in a vault and the wrapped token is created and can be used on the next network, worth the same amount as the originally presented asset. Think of the process as taking the value of the original coin on one blockchain and representing it on another blockchain.
So, with the example of using Bitcoin (BTC) on the Ethereum network. Wrapping the BTC would mean representing BTC as something that can be accepted on the Ethereum network. Thus, wrapped BTC (or WBTC) is a ERC-20 token which is compatible with the Ethereum network. Technically, the WBCT is pegged to the value of the original BTC amount. And so for every WBTC amount there is its original equivalent elsewhere.
Chainlink provides a Proof-of-Reserve audit process that can check and validate the correlating reserves between pegged coins.
Who provides the wrapping service? Third-party Automated Money Makers–such as AAVE and MakerDAO.
To reverse the process, the wrapped coin is “burned” effectively removing it from circulation, and the original asset (Bitcoin) is released from storage.
So there you have it. Some key differences between coins and tokens have been covered here. To be sure, there are other differences that might come onto your radar as you do more research — such as, coins are never owned since they exist on the blockchain, where as tokens can be owned. An interesting distinction between possession and owernship! But that’s a topic for another blog.
At the end of the day, the two terms — “coins” and “tokens” — are used interchangeably, and usually without much consequence.
This article is a part of the Crypto Industry Essentials educational program presented by The Art of the Bubble.
Though this article is credited to me, it contains some written material by Sebastian Purcell, PhD from his The Art of the Bubble education series on cryptocurrencies.
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