Types of tokens and what are they for? [Guide]
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Crypto tokens can be issued with just a few lines of code, using a smart contract that runs on a blockchain – all at a relatively low cost. Businesses can now use tokens to represent many types of real-life assets digitally. Fractional ownership of the real estate and other high-value assets is possible now thanks to tokens. Ultimately, the rise of tokens may fundamentally impact our economy in the near future.
If you’ve been wondering what types of tokens are in use today and how they all differ from one another, this article is for you. Read on to learn everything you need to know about different types of tokens, their definitions, benefits, and challenges they bring to their owners.
What are tokens?
Tokens had existed long before blockchain became part of our technology landscape. Traditionally, tokens represent any form of economic value. An example of a token is a casino chip, voucher, bonus points in a loyalty program, stock certificates, bonds, a club membership, or even a dinner reservation.
Most of the time, tokens come with built-in anti-counterfeiting measures that offer different levels of security. This is meant to prevent people from cheating the system. Moreover, tokens are also used in computing where they represent the right to perform an operation or manage access rights. For example, a web browser can send a token to a website when users surf the web and visit that site.
Cryptographic tokens on the blockchain come with unique benefits.
In the cryptocurrency world, the term “token” works like a metaphor. A token refers to assets or access rights that are collectively managed by a network of computers, a blockchain network, or another type of distributed ledger. A distributed ledger offers a public infrastructure in the form of a distributed record of transactions which keeps track of the ownership data (to which wallet addresses a given token belongs).
How do digital tokens work?
Tokens represent a set of rules that are encoded in a smart contract – in this context called the token contract. Every token belongs to a specific blockchain address. Such tokens can be accessed with a dedicated wallet that communicates with the blockchain and manages the public-private key pair related to that particular address. Only the person who owns the private key for this address can access the token.
How can token owners use tokens?
- If the token represents an asset, it’s the owner can transfer tokens by signing them with their private key. This action generates a digital fingerprint or signature.
- If the token represents an access right to something, the owner can initiate that access by signing with their private key and creating a digital fingerprint.
- What if the token represents a vote? Again, the owner of the token can use their vote by signing with their private key. This is how they create a digital signature.
The most important types of tokens today
To simplify the matter, we can divide tokens roughly into two categories: utility and security tokens. Since they function differently, it’s important that you distinguish between the two types. Additionally, we explore the different types of security tokens available on the market today.
Utility tokens
The easiest way to describe a utility token is that it’s basically a coin backed up by a project. When users buy utility tokens, they usually want to receive some defined benefit in return. This could be a profit or service.
Since there exists an upper cap on the maximum utility token availability, their value usually increases because of the supply/demand equation. The higher the demand for an asset, the smaller the supply is going to be. As a result, the token price shoots up.
Note that utility tokens are considered investment instruments because of their characteristic traits. Still, many investors decide to buy utility tokens in the hope that their price will go up because of the growing demand for the goods and services the project in question aims to provide. However, the price growth of utility tokens has speculative nature and is not bankable.
Security tokens
Contrary to utility tokens, security tokens don’t have a utility attached to it. A security token is a digital form of traditional security, such as an ownership position in the company, bonds, and other ownership rights.
In short, security tokens are basically securities in a tokenized form.
From the legal and compliance standpoint, the critical difference between utility and security tokens comes down to this: Security tokens are much more heavily regulated by governments and organizations. That’s because, in the light of the law, they function just like other securities. Running a Security Token Offering (STO) is an increasingly popular way of investing in a blockchain company – in contrast to Initial Coin Offerings (ICOs), which offer a volatile and unreliable form of utility tokens.
5 types of security tokens
Investors can choose from five types of security tokens today:
Equity tokens
– they represent the value of shares issued by a company on the blockchain. How do they differ from a traditional stock? It’s all about the way in which the ownership is recorded. A conventional stock is logged on a database and the records are represented by a paper certificate. An equity token, on the other hand, is registered on a secure and immutable blockchain. If you own an equity token, you basically own a portion of the company’s profits. In some cases, that might go together with the right to vote in general meetings.
Debt tokens
– these are tokens that represent the real estate mortgages, corporate bonds, and other debt instruments. This type of security tokens usually produces a regular dividend, which is based on the payments of the underlying debt instrument. A debt token is subject to the risks of debt default or dramatic changes in the valuation of the debt. The security token can be represented by a smart contract, which includes repayment terms and even different risk factors related to the underlying debt.
Real asset tokens
– they represent ownership of all real-life assets such as commodities, real estate, artworks, and others. The blockchain technology allows for transparent records of complex transactions and helps to track goods, reducing the potential for fraud.
Hybrid convertible tokens
– such tokens convert between debt and equity-based tokens in their behavior.
Derivative tokens
– such tokens derive their value from the underlying tokens or assets. Once the token ownership is verified, owners can trade their tokens for other assets, use them as a bargaining chip for a loan, or simply store them in different wallets.
Dealing with different types of tokens – 6 mistakes to avoid
If you’re looking to enter the cryptocurrency scene and invest in tokens, here are a few pointers to help you avoid the most common mistakes of beginner crypto investors.
- Beginners often make the mistake of choosing tokens for which the price doesn’t really correspond to the price of the provided functionality. For example, you may purchase a token that provides 1GB of cloud storage for $5. However, if you take a look around, you will see that there exist traditional services that can provide you with the same functionality for a much lower cost. In this scenario, buying the token doesn’t make sense.
- Another common mistake is forgetting that a single project can issue different types of tokens. For example, Kairos issued two types of tokens: security and utility. This type of variety helps to make the best investment decision.
- Avoid buying tokens that don’t have any value-generating mechanisms in their growth drivers or economy.
- Always analyze the type of token and the economy behind it when making your investment decision. You need to have clarity on what value tokens represent at the moment and how this value is going to change in the future.
- Remember that the token’s price will be based on the basic principles of economics, such as the law of demand/supply and fair value. Just because they come wrapped in the cutting-edge atmosphere of blockchain and cryptocurrency, it doesn’t mean that you shouldn’t use common sense when investing in tokens.
- Make sure to always understand the base value of a token, as well as its current and potential price – for example, in the scenario where the project reaches all of the expected targets within the set timeline.
Types of tokens conclusion
The world of tokens is constantly changing as new fundraising alternatives arrive, and others fall into oblivion. This is what happened to the notoriously fraudulent ICOs.
If you’re looking to invest in tokens, do your homework and research the project in question deeply. Even if the token is supported by a solid group of people and a reliable exchange platform, you still need to use your common sense as an investor to make sure that you’re making the right decision.
Do you have any questions about utility or security tokens? Share your thoughts in the comments; our experts are always happy to share their knowledge about the latest trends in cryptocurrency and blockchain.
Read also:
Ethereum Token – how to create, set up and deploy ERC20 ?
What are security tokens? Here’s everything you need to know
Security Token Offering – is it good for you and your company?
