4 Types of Cryptocurrencies — A Framework to Think About Cryptoassets
On coinmarketcap alone, there are 2,347 unique cryptocurrencies listed as of September 3, 2019.
While each coin claims to be unique in its own way, the majority of all cryptocurrencies can be categorized under one of these 4 types:
- Store of Value — Maintain purchasing power in the long run
- Digital Currency — Used for everyday transactions
- Utility Token — Used for redeeming a service/good
- Security Token — Tokenized representation of a real-world asset
Note that these are not mutually exclusive categories. A single coin may fall in more than one category.
1. Store of Value Cryptocurrencies
Popular SoV Cryptocurrencies:
- Bitcoin Cash
A good store of value (SoV) cryptocurrency has three primary attributes.
- Ability to preserve or increase its future purchasing power
- Cheap to store
- Able to sell or buy quickly (liquidity)
The Problem SoV Cryptocurrencies Are Trying to Solve
Traditionally, cash, government bonds, gold, have all been considered good stores of value. But unfortunately, each house some deficiency because they are either are costly to store, difficult to buy/sell, or their purchasing power erodes over time.
Inflation erodes the purchasing power of cash every year. While it may be an appropriate store of value for the short and medium-term, it is not a good option for the long-run.
Government bonds are liquid, non-volatile, and historically have provided a fair rate of return (2–3%). But we are approaching an environment right now, where government bonds are beginning to yield a negative interest rate (-1% per year). If the return on government bonds cannot overcome inflation, then they can no longer guarantee the preservation of future purchasing power.
Land & property are volatile stores of value because they are affected by housing market price fluctuations. Volatility aside, they are not considered liquid assets. It takes weeks and sometimes months to buy or sell a piece of real estate. Any attempt to force liquidation will force the seller/buyer to transact on a discount.
Gold is the closest comparison to an SoV cryptocurrency, but the cost of storing gold is much higher since it is a physical asset. As per reports published by Nomura, the long-term average cost of storing gold is close to 2.4% annually.
The Solution SoV Cryptocurrencies Propose
Secure, and Cheap to Store
Compared to gold, SoV cryptocurrencies are much cheaper to store. All you need is a hardware wallet, and you can technically keep the coins secure forever at zero cost. One can also make the argument that cryptocurrencies are much more secure than gold since not even the state can forcefully repossess your assets.
Maintaining purchasing power through demand & scarcity
Maintaining purchasing power as an SoV cryptocurrency is extremely difficult since the currencies are usually not pegged to any real-world asset. Their price is completely determined by the dynamics of demand & supply in the market. This is to say, if nobody wants an SoV cryptocurrency anymore, the price will drop to $0.
While anyone can create an SoV cryptocurrency, the strongest ones out have a huge network of buyers, sellers, and HODLers. Network effects are what make SoV cryptocurrencies defensible. Strong networks keep the price stable and sticky. The more people who hold SoV cryptocurrencies, the more demand, trading volume, and liquidity and price-stability there will be.
Bitcoin is a good example of an SoV cryptocurrency because of its demand, liquidity, scarcity, and cheap cost of secure storage.
Scarcity provides Bitcoin owners with a guarantee they will not have to worry about wonton increases in the money supply, which will inflict inflation and erode the purchasing power of the currency in the future.
Bitcoin was designed to have a natural inflation rate similar to gold. In 2018, it was 4% a year. In 2020, it will be 2%. Eventually, it will edge closer and closer to 0%. Every 4 years on average (210K blocks), the reward granted to Bitcoin miners for adding a new block is cut in half.
In addition, selling and buying Bitcoin is much easier than selling or buying a house. Cryptocurrency-fiat onramps like Coinbase are providing liquidity for people trying to get in and out of the market.
Are Store of Value Cryptocurrencies a Good Investment?
SoV cryptocurrencies that exhibit the attributes aforementioned are worthwhile. Other SoV cryptocurrencies that don’t have liquidity, demand, or scarcity built into its monetary supply are worthless.
An SoV cryptocurrency is only a worthwhile investment if it holds its end of the bargain which is to hold or increase its purchasing power over time.
2. Digital Currencies
The second type of cryptocurrencies are digital currencies, coins that are designed for everyday transactions.
Unlike SoV cryptocurrencies, digital currencies don’t care about maintaining purchasing power in the long-run, as long as the currency’s inflation rate is comparable to cash.
In fact, deflation is typically a bad thing for digital currencies since that means everyone will want to hold it instead of using it to pay for goods & services. If it’s preferable to hold it than to spend it, then you may have yourself an SoV cryptocurrency instead of a digital currency.
Popular Coins that Fit This Category:
- Facebook Libra
Digital currencies face an even larger incumbent than SoV cryptocurrencies, as their main competitor is digital cash. According to Visa’s estimate, $40 trillion is spent via digital transactions every year.
Visa & MasterCard own most of the market share in this space. Their solution is extremely good because it offers:
- A form of payment accepted everywhere (a huge network of merchants)
- Behind the scenes settlement with thousands of banks (a huge network of banks)
- Trust (merchants rather deal with Visa than with the individual customer)
- Speed (low latency, instantaneous sales)
- Convenience (payments anywhere via scan, tap, online)
- Stable purchasing power
Visa & Mastercard are extremely difficult to compete against. It’s taken them a titanic amount of resources, and multiple generations to build-up an integrated network of banks, merchants, and cardholders.
So How Can Digital Currencies Compete?
The two main points of differentiation that digital currencies can have are:
Every electronic transaction through your debit or credit card can cost up to 1–2% for merchants. These fees are so high, that entire businesses have been nurtured off this revenue stream. For example, digital banks like Koho, Revolut, Monzo, make the bulk of their revenue off of debit interchange. That is to say, they take a percentage of the processing fee.
Digital currencies have the potential of being more cost-efficient, especially for large money transfers (cryptocurrency transaction fees are usually a flat fee that scales better with large payment) and micro-payments (just not feasible when processing fees are high).
What you spend money on is being tracked and recorded. This is not ideal for merchants who deal in the black/grey market. That’s why digital currencies centered around privacy like Monero, are really popular for illicit dealings.
Challenges to Overcome for Digital Currencies
It’s really difficult to enable digital currencies to be accepted everywhere. It took Visa, originally a conglomerate of banks, an entire generation to make significant headway.
In the digital age, it may be easier, but perhaps only something a big company like Facebook can do.
No one wants to use a currency for everyday transactions if the price goes up and down by 10% every day. Many digital currencies suffer from this problem. That’s why Facebook Libra is such a promising digital currency because it promises price-stability.
High Throughput & Low Costs and Latency
In order to be appropriate for everyday use, digital currencies must have low fees and minimal latency. Furthermore, the overall network needs to have high throughput and be able to handle a high degree of transactional volume.
In the past, proof of work systems failed to scale in an efficient and inexpensive manner. That’s one of the reasons why Bitcoin is not a good digital currency. New proof of stake innovations promise better throughput & lower costs, but time will tell whether they are just as secure & fair as their proof of work counterparts.
Not a Suitable Long-Term Investment
Typically digital currencies are not good investments if they are not also a good SoV. For example, no one should invest in Facebook Libra because investing in a digital currency is akin to holding cash. Sure you may want to hold some of your assets in cash, but you wouldn’t want to invest in it because of inflation (unless everything else is going down).
3. Utility Tokens
The third type of cryptocurrencies are utility tokens. Put simply, utility tokens are cryptocurrencies that are used to pay for goods & services on a given network.
For example, networks like Ethereum require users to pay a certain fee to expend computational power on the network. TRON, Cardano, Tezos, all work in a very similar manner. Users must pay a fee for interacting with smart contracts.
Popular Coins that Fit This Category:
- Binance Coin
Utility tokens offer initial coin offerings (ICOs) as a way to raise money, and subsidize the cost and development of the network.
As the network issues new tokens, there needs to be demand from new buyers in order to keep the price moving upwards. New buyers come from two streams: financial speculators/investors and actual users.
Financial speculation is transient. It can only last so long. In order for the price to stabilize or move upwards, it needs to be pegged to actual demand & usage.
If the service is valuable, then the utility token will be too. The price of a utility token is a proxy measure of the utility’s current and future demand.
Typically utility tokens are uncapped, meaning that they have a potentially infinite supply. If the network is irresponsibly printing out new tokens and inflating the supply, no amount of demand will be able to stop the coin devaluing. This renders inflation a large concern. Be wary of the token projects that have an unbounded cap, and a team that is aggressively selling their tokens to raise funds.
Should You Invest in them?
When you’re evaluating a utility token for a potential investment you should consider whether:
- The utility token will have future demand from people who want to actually redeem it
- Whether the supply is susceptible to inflation. If the project owners control the supply on a whim, they may be able to mint a bunch of new tokens and cash out while the rest of the tokens are devalued.
Most investors are really bad at predicting #1. Considering the fact that we don’t have many successful projects based on the utility token model, we should expect most of these projects to die and their tokens to be worthless.
In my opinion, utility tokens are the most speculative and risky area of cryptocurrency investing.
4. Security Tokens
- Bcap (Blockchain Capital)
- Science Blockchain
Security tokens are a digital representation of a real-world asset on the blockchain that is subjected to securities regulation e.g. equity, real estate, debt, currency, etc.
Why Tokenize Securities at all?
The majority of private-sector assets are not liquid and tradeable in a secondary market. For example, real estate and private securities are typically very costly to liquidate and to trade. It usually takes a long time to find matching buyers/sellers and to execute the deal.
On the other hand, security tokens can be instantly tradeable on exchanges. As a digital cryptocurrency, you can transfer ownership between buyers & sellers very quickly. Adding liquidation and market depth increases the value of the asset via a “liquidity premium”.
When a valuable asset is tokenized, its ownership can be broken down into many fractional pieces. This enables the asset to be more affordable and accessible to retail investors since they can buy a small piece of it at a fraction of the price.
Tokenization can allow you to unbundle specific features of a security to be digitized and sold separately. E.g. tokenizing specific revenue streams for a company, or voting rights on a share.
Problems with Security Tokens
Price Discovery & Liquidity
In theory, the price of the security token should closely resemble what the underlying asset is worth.
But in the real world, you may see a price gap between the security token and its underlying asset. Some may favour the security token if it is more liquid than the real-world asset.
If the security token is illiquid, and it is hard to redeem the security token for its real-world counterpart, then the price of the security token can actually be much lower.
The SEC is moving aggressively to apply securities regulations on tokenized securities. It is unclear how these regulations will play out, and whether they will take away several of their perceived benefits e.g. secondary market, public issuance.
Should You Invest in them?
The same rules apply for normal securities. Evaluate the value of the underlying security however you normally would.
Unless you’re in the business of arbitrage, price discrepancies between the security token and its underlying asset is usually a bad sign. It means that the creation & redemption mechanism is broken, or at the very least, full of friction.
In a frictionless market, there should be no discrepancy between the price of the security market, and the price of the underlying assets.
Sources/ Further Reading:
Security Token Thesis— Iliya Zaki
Negative Yielding Debt— Bloomberg
Estimated Gold Storage Costs— Nomura
Bitcoin Purchasing Power— BitcoinPPI
Libra White Paper— Libra
Crypto Token Network Design - Chris Dixon