The Different Categories of Cryptocurrencies
In many ways, the title “cryptocurrency” can be misleading and does not capture the differences in technology, incentive alignment, and structure between various coins. While the term “cryptocurrency” conveys attributes that define some coins, like a means of storing value and exchanging wealth, it fails to capture the nuances and capabilities of other coins.
In reality, there are a few different “types” of cryptocurrencies (these categories can be broken up further but are a helpful rough categorization):
- “Currency” Cryptocurrencies: This first category is the most familiar and refers to a cryptocurrency, like Bitcoin, that primarily serves the purposes of being a store of value, a means of exchange, and a unit of account. Like traditional fiat currencies (USD, EUR, etc.), Bitcoin itself has limited inherent value as a good or input and instead has value because other people attribute value to it.
- “Utility” Cryptocurrencies: Utility cryptocurrencies represent something new. This class of cryptocurrency creates an infrastructure that can be leveraged to build on top of. Ethereum, for example, allows developers to create smart contracts (code that can execute transactions without a third party or intermediary) on top of the platform the coin creates which can power decentralized applications. Filecoin, another utility cryptocurrency, creates a decentralized storage network that gives developers a new way to store and retrieve data.
- “App/Platform” Cryptocurrencies: This final category of cryptocurrency roughly represents the cryptocurrency equivalent of an app or platform and these cryptocurrencies are built on top of utility cryptocurrencies like Ethereum. Augur, for example, is a decentralized prediction market built on top of Ethereum where users can find and place bets on outcomes like who will be elected President, which team will win the Super Bowl, etc. and be compensated for being right. The 0x project is a platform on top of Ethereum for building a decentralized exchange of any type.
Bitcoin was the original cryptocurrency in this category but new coins have sprouted up to address some of the limitations Bitcoin has faced, like scalability and privacy.
Scalability: Bitcoin’s transaction scalability is limited by the one megabyte block size (transaction records) and average block creation time of 10 minutes which combine to limit the network’s throughput capability to roughly 3.3 to 7 transactions per second. Transaction scalability is necessary for a cryptocurrency to be capable of serving as a means of exchange, though is arguably not a necessity to serve as a store of value. Various forks, which are changes to the underlying protocol, have been proposed to address the scalability of the Bitcoin network. Alternative cryptocurrencies have also been created to address Bitcoin’s scalability problem:
- Litecoin: Litecoin attempts to address the scalability issue of Bitcoin by having a fixed verification period of 2.5 minutes and a larger coin supply of 84 million coins to Bitcoin’s 21 million which reduces mining competition and lowers transaction fees as a result.
- Bitcoin Cash: Bitcoin Cash is a fork of the original Bitcoin protocol and attempts to improve Bitcoin’s scalability by increasing the block size used for transactions from 1 MB to 8MB and frees up additional room in each block by not including SegWit (Segregated Witness), a way to separate transaction signatures. This fork was controversial because the increased block size means that smaller miners will have a harder time mining the blocks and power will become concentrated in the hands of larger mining pools which could undermine its long-term decentralized nature.
Privacy: A big push in this space is in “privacy coins” that serve the same economic functions as Bitcoin (store of value, means of exchange, unit of account) but also provide an additional privacy layer that Bitcoin does not. While Bitcoin addresses are anonymous in the sense that a wallet is not linked to a person in a database, the holdings and transactions of a given wallet are publicly viewable on a ledger. From a regulatory context it is not clear that additional perfect privacy is needed or even desired and some worry that privacy coins serve to enable black market transactions (there is debate here whether what is gained in privacy is lost in enabling bad actors).
- Monero: Monero differs from Bitcoin in that it does not display the wealth stored in a given wallet on the public ledger. Instead, Monero scrambles transaction information by creating temporary, one-time use addresses for transmitting coins which preserves the privacy of the sender and receiver. Money can still be sent to a public address but the wealth stored in an address cannot be viewed. Private transactions are the default on Monero.
- Dash: Dash offers an option to transact through a “private send” option that mixes transactions and obscures wallet identity. Dash utilizes a two-tier network unlike Bitcoin which relies on miners to perform all actions. Creating new blocks is handled by miners while “masternodes” perform PrivateSend, InstantSend, and governance functions. As Wikipedia explains, “Masternodes require 1000 DASH as collateral to prevent sybil attacks. That collateral can be spent at any time, but doing so removes the associated masternode from the network. Because masternodes provide vital network functions, the block reward is split between miners and masternodes, with each group earning 45% of the block reward. The remaining 10% of each block reward funds the “budget” or “treasury” system.”
- Zcash: Zcash employs zero-knowledge proofs, a new method implemented with zk-SNARKS. Zcash payments are published on a public blockchain, but users are able to use an optional privacy feature to conceal the sender, recipient, and amount being transacted. As Wikipedia explains, “Zcash affords private transactors the option of “selective disclosure”, allowing a user to prove payment for auditing purposes. One such reason is to allow private transactors the choice to comply with anti-money laundering or tax regulations.”
Well known cryptocurrencies of this type include Ethereum and Filecoin.
- Ethereum: As explained by the Ethereum documentation, “Ethereum is a decentralized platform that runs smart contracts: applications that run exactly as programmed without any possibility of downtime, censorship, fraud or third-party interference. These apps run on a custom built blockchain, an enormously powerful shared global infrastructure that can move value around and represent the ownership of property. This enables developers to create markets, store registries of debts or promises, move funds in accordance with instructions given long in the past (like a will or a futures contract) and many other things that have not been invented yet, all without a middleman or counterparty risk.”
- Filecoin: Filecoin is a blockchain-based digital storage and data retrieval method implemented and incentivized through a cryptocurrency and payment system. As explained by the Filecoin white paper, “Filecoin is a decentralized storage network that turns cloud storage into an algorithmic market. The market runs on a blockchain with a native protocol token (also called “Filecoin”), which miners earn by providing storage to clients. Conversely, clients spend Filecoin hiring miners to store or distribute data. As with Bitcoin, Filecoin miners compete to mine blocks with sizable rewards, but Filecoin mining power is proportional to active storage, which directly provides a useful service to clients (unlike Bitcoin mining, whose usefulness is limited to maintaining blockchain consensus). This creates a powerful incentive for miners to amass as much storage as they can, and rent it out to clients.”
There are many interesting projects being built on top of utilities like Ethereum and two promising ones are Augur and 0x. Many more are expected to be built in the coming years as the utility infrastructure continues to be built and consumer adoption of “currency” cryptocurrencies allows for new business models.
- Augur: As explained by the Augur white paper, “Augur is a trustless, decentralized oracle and platform for prediction markets. The outcomes of Augur’s prediction markets are chosen by users that hold Augur’s native Reputation token, who stake their tokens on the actual observed outcome and, in return, receive settlement fees from the markets. Augur’s incentive structure is designed to ensure that honest, accurate reporting of outcomes is always the most profitable option for Reputation token holders. Token holders can post progressively-larger Reputation bonds to dispute proposed market outcomes. If the size of these bonds reaches a certain threshold, Reputation splits into multiple versions, one for each possible outcome of the disputed market; token holders must then exchange their Reputation tokens for one of these versions. Versions of Reputation which do not correspond to the real-world outcome will become worthless, as no one will participate in prediction markets unless they are confident that the markets will resolve correctly. Therefore, token holders will select the only version of Reputation which they know will continue to have value: the version that corresponds to reality.”
- 0x: As explained by the 0x white paper, “We describe a protocol that facilitates low friction peer-to-peer exchange of ERC20 tokens on the Ethereum blockchain. The protocol is intended to serve as an open standard and common building block, driving interoperability among decentralized applications (dApps) that incorporate exchange functionality. Trades are executed by a system of Ethereum smart contracts that are publicly accessible, free to use and that any dApp can hook into. DApps built on top of the protocol can access public liquidity pools or create their own liquidity pool and charge transaction fees on the resulting volume. The protocol is unopinionated: it does not impose costs on its users or arbitrarily extract value from one group of users to benefit another. Decentralized governance is used to continuously and securely integrate updates into the base protocol without disrupting dApps or end users.”
It’s important to put a new cryptocurrency in the proper context when evaluating it. There will certainly be new developments in cryptocurrency and it will be exciting to see how coins address issues like scalability, decentralized consensus, and privacy.