Cryptocurrency – Coins, Tokens & Layers

Knowing the difference between Cryptocurrency Coins, Tokens and Layers will help you identify specific areas when targeting your investments.  It’s also really useful when listening/watching media about crypto.  We also need to know how they came into being and what is meant by mining a coin.

First though, lets looks the question most beginners ask about coins and tokens, “What is the difference between a Coin and a Token?“

This is the fourth section of the Cryptocurrency and Blockchain awareness programme, How to Crypto.

Typically, a cryptocurrency Coin is a currency that uses its own blockchain (e.g. Bitcoin (BTC), Litecoin (LTC) & Ethereum (ETH)). For the most part that’s basically all they are about.  The coin is exchanged for goods and services just like any other currency but these times, there are instances where we need more functionality from our currency. 

Cryptocurrency Tokens are normally created on someone else’s blockchain.  An example of a token is the Basic Attention Token (BAT) which utilises the ecosystem on the Ethereum blockchain.  There are many more Tokens than there are Coins since it is much more difficult to develop a proprietary blockchain network than it is to simply use one that already exists.  Tokens are most commonly associated with the ability to include smart contracts.  These add considerable power to financial transactions and services on the blockchain and help secure transactions from interference and malicious third parties.  So, we should also define them more clearly.

Smart Contract (definition from IBM.com): “Smart contracts are simply programs stored on a blockchain that run when predetermined conditions are met. They are normally used to automate the execution of an agreement so that all participants can be immediately certain of the outcome, without any intermediary’s involvement or time loss.”

Smart contracts are a tremendous innovation and are one of the main reasons why cryptocurrencies are destined to require less interaction with banks.  such contracts enable trustless transactions between people.  I don’t need to trust someone when I exchange Bitcoin for Ethereum, I rely on the smart contract to handle the transaction competently and honestly.  It’s really that simple!

Blockchain Layers are a little more difficult to define.  Essentially, the two main layers are rather unimaginatively called: Layer 1 and Layer 2:  

Layer 1  

This is the ‘root’ or ‘base’ layer – it manages the key elements of the blockchain such as its immutability, security (e.g. validity and consensus protocols) and all the necessary parameters that keep the blockchain running. 

Layer 1 blockchains can validate and finalize transactions without the need for another network. They can have more complicated features too, such as smart contracts which enable decentralised autonomous applications to run on them.

Examples of Layer 1 Coins are:

Polkadot	Elrond	Solana	Binance Smart Chain	Ethereum

Layer 2 

These are the overlapping applications and protocols that sit on top of the Layer 1 infrastructure. They are typically used to improve scalability and speed by separating out some of the key work elements of the base layer.

The Lightning network is a Layer 2 solution that sits on the Bitcoin Layer 1 blockchain.  It has greatly improved Bitcoin’s speed and operability.

Tokens can eventually become coins when they migrate to their own blockchain (e.g. Binance Smart Chain Coin and Tron). Some of the most commonly talked about Layer 2 tokens are:

Polygon (Matic) Offers fast transactions and applications on Ethereum	Arbitrum Uses Ethereum’s main chain to verify transactions	Loopring Verifies transactions with privacy	Immutable X Specializes in NFT trading at low fees	xDai Chain A decentralised sidechain and stablecoin

 

There is also a Layer 3 on some blockchains.  Layer 3 is commonly known as the application layer of the blockchain.  It would contain the DEFI (Decentralised Finance) Applications and the Gaming and Metaverse ecosystems.  A good example of a Layer 3 would be Uniswap, a decentralised exchange enabling users to buy and sell (by swapping) a very large range of different cryptocurrencies.

I should also mention Layer 0.  This is the layer that everything sits on.  A good example of a Layer 0 is of course, the internet.  Most of the news you will hear about blockchain ‘Layers’ will concern Layer 1 and Layer 2.  Layer 3’s can come and go without affecting the base blockchain but if there was a problem with the Layer 1 or 2 of a blockchain it would have serious consequences for users trying to access currency or data information.  Changes to Layer 1’s and 2’s are taken very seriously with security being a key concern and as a result they can take years to implement.

Mining & Consensus Mechanisms

Mining is the process that is used to create and validate new coins and transactions on the blockchain. In the case of Bitcoin, anyone can become a Miner provided they can afford the huge costs of powerful computers needed – and provided it is legal in that country (e.g. Bitcoin mining is illegal in China). The Bitcoin miner will solve a complex mathematical problem in order to verify and validate a new block on the bitcoin network.  They can also validate individual bitcoin transactions. If they do this effectively, miners are paid in bitcoins (BTC).      

 

There has been a lot of bad press lately about the environmental cost of mining bitcoin.  Some of the mining installations use more power than some small towns and cities and the carbon footprint of such installations is considered very high.  If you dig a little deeper though, you will see that mining companies are desperate to find the lowest cost of power for their mining operations and invariably, this is in the form of renewable energy – especially off-peak energy that would normally go to waste such as a hydroelectric power station or by using ‘stranded’ natural gas that would otherwise have been flared. The president of El Salvador wants to set up a mining facility that utilises the power from a volcano!

Bitcoin mining is becoming greener each year and many of the doom and gloom environmental reports have been debunked (see the CNBC report, the article from CATO or the report by Forbes Magazine ).

Consensus Mechanisms

There are protocols that are used in the recording and validation of crypto currencies that are mined and these are known as ‘consensus mechanisms’.  Consensus is not done in the same way for all blockchains, some utilise complicated calculations such as bitcoin and some use nominated validators.  Consensus must be self-regulating and incorruptible as it involves adding/deleting/updating transactions and the responsibility for maintaining the ledger on the blockchain. There are many types of consensus mechanisms.  The two most talked about are ‘Proof of Work’ and ‘Proof of Stake’.

Proof of Work  

Investopedia states that, “Proof of work describes the process that allows the bitcoin network to remain robust by making the process of mining, or recording transactions, difficult.” This means that a complicated calculation needs to be solved by the miner before the block is recorded on the blockchain and the miner is paid.

Current mining difficulty levels are so high that only large computer installations are able to solve them. Complexity is built in to ensure difficulty. Only the most powerful computer systems are able to solve the proof of work algorithm and this increases in difficulty the more powerful the computers become.

The very first bitcoins were mined without much competition on small desktop computers about as powerful as our mobile phones (maybe even less powerful!). As more and more computer nodes came onto the network to earn bitcoins, the more complex the calculation needed to become and  the ‘hashrate’ (which is determined by the complexity of the computer calculation needed to confirm a new block on the blockchain) increased. It is said that the higher the hashrate, the more secure the network is from attack. 

Proof of Stake

This is a little more complicated in that they work by selecting validators to append records in the blockchain.  Validators are approved subject to their value status of holdings in the associated cryptocurrency.

Validators are not rewarded with coins but are allowed to charge fees for validating transactions.  The charges are usually quite small but there are a lot of them.

Ethereum’s developers have been trying to combat the present limitations in scalability of Ethereum because as Ethereum-powered decentralized finance (or DeFi) protocols have surged in popularity, the blockchain has struggled to keep up, causing fees to spike.

Their solution has been to build an entirely new blockchain (called ETH2) which should be finished sometime in 2022 (though it keeps getting delayed). The upgraded version of Ethereum will employ a faster and less resource intensive consensus mechanism, proof of stake. Cryptocurrencies including Cardano, Tezos, and Atmos all use proof-of-stake consensus mechanisms which are supposed to maximize speed and efficiency while, at the same time, lowering fees.

This has so far had limited success, Cardano, a very much respected cryptocurrency, is suffering problems with scalability and performance that seems to be holding up it’s adoption.

The first example of Proof of Work was Bitcoin and the first example of Proof or Stake was Peercoin (2012) although the most commonly recognised Proof of Stake cryptocurrency is Ethereum.

There are other consensus mechanisms and it may be that new ones will become the norm in a few years time.  Current consensus mechanisms are either too energy intensive or suffer poor performance.

 

In section five we go into a little more detail about the types of digital asset and how they are grouped: Cryptocurrency Use Cases looks at Store of Value, Play to Earn, NFT’s, Decentralised Finance and others.

 

This article is copyright 2022 by Tony Fawl, CryptoNET.

This page is part of the How to Crypto Web Series, an awareness course for beginners interested in blockchain projects and cryptocurrency investment. Please checkout the Bibliography and Glossary of Terms pages for other useful resources and links. To find out what we do, take a look at the About Us page.

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