Developers around the world have taken Satoshi Nakamoto’s iconic first white paper, Bitcoin: A Peer-to-Peer Electronic Cash System and used it as the groundwork for a seismic change in financial technology. The white paper’s main thrust was – and remains – elegant and succinct; just eight pages of notes and guidance was enough to allow coders and technologists to take the radical concepts involved and build a brand new industry on top of them.
Today, as this evolving industry introduces innovations such as smart contracts and the next generation of blockchain-powered utility tokens, there is a question asked by many newcomers: Why do cryptocurrencies use blockchain?
Is each element of this new technology entirely reliant upon another, or are these discrete parts of an emerging, complex system, with each acting independently of the other? So, how does blockchain work and, specifically, how does blockchain work with cryptocurrencies?
There have been several attempts to create ‘electronic money’ on the Internet in the past – Beenz.com was a UK start-up which sought to bring its digital currency, beenz, to a global audience; users received beenz as a reward for carrying out everyday activities online, including shopping and visiting particular websites. And in the US, E-gold became an early internet success in the still-fledgling digital currency space. It was ultimately shut down by the US government, despite processing $2 billion of transactions at the peak of its success in 2006.
These precursor currencies were not built on blockchain technologies and did not use the token system which has emerged over the past 10 years through blockchain, Bitcoin and altcoin development. A blockchain and a system of tokens is an essential part of any workable cryptocurrency like Bitcoin, Litecoin, Ripple, DasCoin or the hundreds of other altcoins in operation today.
These tokens play a key role in the crypto system and there are many benefits to working with them in this way. At their most basic level, they are designed to be easily exchangeable with any other token, currency or even a real-world product or service with a stated value. They also offer total transparency – or, at least, they offer the opportunity of total transparency; some of the world’s biggest names in finance are spending significant amounts of money on research into private blockchains. Private blockchains make full use of cryptographic security functions and tokenisation, but the distributed nodes keeping track of the database are under the direct control of the blockchain operator; third-party node servers are not required.
But how do tokens work in a traditional, distributed ledger blockchain? Whether dealing with a public or private database, three main types of token are behind almost all cryptocurrency and blockchain projects operational today.
These are the tokens and coins most people will be familiar with – these tokens are essentially cash, synonymous with cryptocurrencies like Bitcoin. They are intended to be used as a form of payment for acquiring goods and services and also as a means of money transfer. Tokens acquired for an ICO blockchain are freely transferable and synonymous with the cash in your bank today. Financial watchdogs want to see these tokens held to precisely the same level of scrutiny and anti-fraud attention as any other regular currency, such as dollars, euros and pounds.
Asset tokens promise a return of some description, either at the time of purchase, or in the future. Asset tokens can be used to buy a stake in a start-up company (which may or may not base its entire business model around the same asset token), or dividends or revenue share. Governments and financial institutions say asset tokens should attract the same oversight as equities, bonds and derivatives. Lines can be blurred between asset and utility tokens and they can sometimes act as payment tokens, in which case they may also be described as a hybrid token.
These are tokens intended to provide digital access to an application or service using a blockchain-based system. The application or service should be fully available at the time of an ICO, say financial experts, otherwise the lines can become blurred between the effects and benefits of asset and utility tokens.
This system of tokens also presents the answer to our newcomer’s original question: Why do cryptocurrencies use blockchain? Cryptocurrencies use blockchain because they require the combination of a distributed, verified database and the blockchain token itself. With these two elements, a cryptocurrency has what it requires to be adopted at scale.