The word cryptocurrency has come to encompass much more than just Bitcoin (BTC 0.51%). Therefore, knowing where to start can be confusing. To help with this, we can break down cryptocurrencies into different categories based on their properties. This categorization helps with distinguishing one type of cryptocurrency from another.
While there are many more than just three types of cryptocurrencies, the ones that we will cover here are a good place to start. The first are pure cryptocurrencies, such as Bitcoin. The second are stablecoins, which are backed or pegged to fiat currency. The last are tokens, which are a lot like stocks, but for cryptocurrency companies.
1. Pure cryptocurrencies
A pure cryptocurrency is built to be a form of money on the internet. Although Bitcoin was the first cryptocurrency intended to be the native currency of the internet, it has many competitors.
Shortly after Bitcoin began, other projects started sprouting up that sought to improve upon Bitcoin's model. Other coins such as Ethereum (ETH 0.67%) copied aspects of Bitcoin's model such as node count and block rewards.
As new projects emerged, they experimented with how many computers run the network (node count) and the issuance of new coins (block rewards). Node count is a rough measure of how decentralized and robust a cryptocurrency is. In large part, the block rewards determine the monetary policy of a particular cryptocurrency. That is, how many coins exist, and when do new coins enter circulation.
The key takeaway with pure cryptocurrencies is that they are independent financial assets best thought of as internet money.
Stablecoins have their price pegged to a fiat currency such as the dollar. They are appealing because of the stability and familiarity of digital currency or dollars. In most cases, stablecoins get to reap the benefits of cryptocurrencies such as near-instant transfer time and cheap transaction fees.
The design of stablecoins is such that they avoid price volatility, which is the main downside of pure cryptos. Stablecoins are the choice asset to trade against pure cryptocurrencies for this reason. They allow traders to take and keep profits in a stable asset instead of worrying about price volatility.
Although the intention of stablecoins is to have the price remain pegged to its corresponding asset, some stablecoins have lost their peg. This is because not all stablecoins are backed by fiat currency deposits. When this happens, holders of the stablecoin may be left unable to redeem it for the original asset or something of equivalent value. Some stablecoins have their price regulated by algorithms, which have proved to not be as reliable as a stablecoin with a physical backing.
Also known as crypto tokens, this category of cryptocurrency is quite broad. Tokens encompass more than 99% of digital currencies, partly because they're so easy to make and launch. Much of the time, tokens represent a stake in a cryptocurrency project, platform, or network.
Many tokens launch through a process called an initial coin offering (ICO). This is akin to a company going public through an initial public offering (IPO). At this time, investors may buy tokens from the project administrators if they believe in the use case or direction of the company. In general, the more ways to use a token within an app or product, the more value that is likely to accrue to the token.
Examples of use cases include paying for fees on a platform, opting into special offerings made by the company, and participating in the governance of a project. After a token has been launched, it is subject to fluctuation in price as the project progresses, and the market develops.
A good chunk of crypto tokens are governance tokens. These kinds of tokens operate like equity in a company. They are used to vote on the direction of the project, how the treasury is spent, and which new features should be developed next. This novel kind of company has been given the name DAO, for decentralized autonomous organization. Tokens play an important part in the governance of these organizations and represent a step in a new direction in administrative decision making.
There are many more subcategories
Although pure cryptocurrencies, stablecoins, and tokens are a good place to start, there are many more subcategories that can yield a more-granular understanding. The interplay among these high-level types of cryptocurrencies is what makes up the entire crypto industry. Most of it fits into one of these three categories. A notable exception are non-fungible tokens (NFTs), but that is one type of cryptocurrency that needs its own article to fully address.