What Are Crypto Tokens, and How Do They Work?

Crypto Token
Investopedia / Zoe Hansen.

What Are Crypto Tokens?

A crypto token is a representation of an asset or interest that has been tokenized on an existing cryptocurrency's blockchain. Crypto tokens and cryptocurrencies share many similarities, but cryptocurrencies are intended to be used as a medium of exchange, a means of payment, and a measure and store of value.

Crypto tokens are often used to raise funds for projects and are usually created, distributed, sold, and circulated through an initial coin offering (ICO) process, which involves a crowdfunding round.

Key Takeaways

  • Crypto tokens are a digital representation of an asset or interest in something and are built on a blockchain.
  • Crypto tokens can also be used as investments, to store value, or to make purchases.
  • Cryptocurrencies are digital representations of value designed to facilitate transactions (making and receiving payments) using blockchain technology.
  • Often purchased through an initial coin offering, crypto tokens are generally used to raise funds to develop projects.

History of Crypto Tokens

Although there were cryptocurrencies that forked from Bitcoin and Ethereum previous to the 2017 ICO boom, the first recognized ICO and token was Mastercoin. Mastercoin was created by J.R. Willet and announced on January 2012 via Bitcoin Forum. He titled his whitepaper "The Second Bitcoin Whitepaper."

Mastercoin was one of the first projects to describe using layers to enhance a cryptocurrency's functionality. The project linked the value of Mastercoin to Bitcoin's value and explained how the project would use the funds to pay developers to create a way for users to make new coins from their Mastercoins.

The ICO Boom

Between 2012 and 2016, crypto token creation and ICO increased until 2017—token offerings skyrocketed as investors seemed to become aware of them and the possible increase in value they promised. Developers, businesses, and scammers began creating tokens rapidly in attempts to take advantage of the fund-raising boom—so much so that regulatory agencies began issuing alerts to investors warning them about the risks of ICOs.

Not all crypto tokens and ICOs are scams. Many are legitimate efforts to raise funds for projects or startups.

After the Bubble

The ICO bubble burst in 2018—shortly after, initial exchange offerings (IEO) emerged, where exchanges began facilitating token offerings. Exchanges claimed to have vetted the token offerings, reducing the risks to investors; however, scammers used the exchanges to promote their scams.

Regulatory agencies issued alerts to investors about the risks involved in participating in an IEO; they also alerted exchanges that they were required to register with the authorities if they were facilitating these fund-raising efforts. The logic was that the exchanges might be acting as alternative trading systems or broker/dealers, which by law are required to register.

Crypto tokens are still being created and used to raise funds for projects through ICOs. Whitepapers read like pitchbooks, outlining the token's purpose, how it will be sold, how the funds will be used, and how investors will benefit.

Concerns About Crypto Tokens

The single most important concern about crypto tokens is that because they are used to raise funds, they can be and have been used by scammers to steal money from investors.

However, it can be difficult to distinguish between a scam token and one representing an actual business endeavor.

Here are some factors to look for when you're looking at a crypto token:

  • Based on jurisdiction, it might need to be registered. The SEC uses the Howey Test to see if an asset is a security. If it needs to be registered and isn't, it is illegal in its current form.
  • Look at the team behind the ICO and their backgrounds. Determine if they are a legitimate business by checking the address and phone numbers, and visit the website of the Secretary of State for the state they claim to be registered in and search for them. If you can't find information about it other than in a white paper and custom website, it might be a scam.
  • ICOs from outside of the U.S. might be difficult to research. One such token was BananaCoin, issued as a fundraiser for banana plantations in Laos. Investors were told they could exchange their tokens for an equal value of bananas or funds after launch.
  • Many crypto tokens are listed on non-regulated exchanges outside of the United States. If it isn't listed on a regulated exchange, the odds of it being a scam are much higher.
  • Even crypto tokens listed on a registered exchange can be scams.

How Crypto Tokens Work

Crypto refers to the various encryption algorithms and cryptographic techniques that safeguard these entries, such as elliptical curve encryption, public-private key pairs, and hashing functions. Cryptocurrencies, on the other hand, are systems that allow for online secure online payments.

Crypto tokens often serve as the transactional units on the blockchains that are created using standard templates like that of the Ethereum network, which allows a user to create tokens. Such blockchains work on the concept of smart contracts or decentralized applications, wherein the programmable, self-executing code is used to process and manage the various transactions that occur.

A smart contract is a self-executing program that automates transactions. Contrary to popular belief, the terms of the contract are not written into the lines of code. Terms are agreed upon by the parties involved, and the code is written to execute them.

For example, you might receive a crypto token representing a certain number of customer loyalty points on a blockchain that manages such details for a retail chain. Another crypto token might give the token holder the entitlement to view 10 hours of streaming content on a video-sharing blockchain. A token can even represent other cryptocurrencies, such as a crypto token equalling 15 bitcoins on a particular blockchain. Such crypto tokens are tradable and transferrable among the various participants of the blockchain

Investors can use crypto tokens for any number of reasons. They can hold onto them to represent a stake in the cryptocurrency company or for an economic reason—to trade or make purchases of goods and services. As a practical example, decentralized storage provider Bluzelle allows you to stake your tokensto help secure its network while earning transaction fees and rewards.

The Financial Industry Regulatory Authority (FINRA) continues to issue alerts about ICO fraud, so be sure you research before investing in any cryptocurrency—the same way you would with any stock.

Crypto Tokens vs. Cryptocurrencies

The term crypto token is often erroneously used interchangeably with "cryptocurrency." However, these terms are distinct from one another.

A cryptocurrency is used for making or receiving payments using a blockchain, with the most popular cryptocurrency being Bitcoin (BTCUSD). Altcoins are alternative cryptocurrencies that were launched after the massive success achieved by Bitcoin. The term means alternative coins—that is—cryptocurrency other than Bitcoin. They were launched as enhanced Bitcoin substitutes that have claimed to overcome some of Bitcoin's pain points. Litecoin (LTCUSD), Bitcoin Cash (BCHUSD), Namecoin, and Dogecoin (DOGEUSD) are typical examples of altcoins. Though each has tasted varying levels of success, none have managed to gain popularity akin to Bitcoin's.

Crypto tokens operate on a blockchain, which acts as a medium for the creation and execution of decentralized apps and smart contracts. The tokens are used to facilitate transactions on the blockchain. In many cases, tokens go through an ICO and then transistion to this stage after the ICO completes.

What Is the Purpose of Tokens?

Crypto tokens generally facilitate transactions on a blockchain but can represent an investor's stake in a company or serve an economic purpose, just like legal tender. This means token holders can use them to make purchases or trades just like other securities to make a profit.

Is Bitcoin a Token or a Coin?

Bitcoin is a cryptocurrency, generally used to trade, make purchases, or store value.

What Is the Difference Between a Crypto Coin and a Crypto Token?

Crypto coins are designed to be used as currency, while crypto tokens are intended to represent an interest in an asset and facilitate transactions on a blockchain.

What Are Some of the Different Types of Tokens That Reside on Blockchains?

Blockchain tokens include reward, utility, security, governance, and asset tokens.

The Bottom Line

Crypto tokens are digital representations of interest in an asset or used to facilitate transactions on a blockchain. They are often confused with cryptocurrency because they are also tradeable and exchangeable.

Crypto tokens are often used as a way to raise funds for projects in initial coin offerings. ICOs have been abused by many parties to fool investors into contributing funds, only to disappear, but many are valid fundraising attempts by legitimate businesses. If you're considering crypto tokens as an investment, be sure to do your research on the team or company offering them.

Investing in cryptocurrencies and other Initial Coin Offerings (“ICOs”) is highly risky and speculative, and this article is not a recommendation by Investopedia or the writer to invest in cryptocurrencies or other ICOs. Since each individual's situation is unique, a qualified professional should always be consulted before making any financial decisions. Investopedia makes no representations or warranties as to the accuracy or timeliness of the information contained herein. As of the date this article was written, the author does not own cryptocurrency.

Article Sources
Investopedia requires writers to use primary sources to support their work. These include white papers, government data, original reporting, and interviews with industry experts. We also reference original research from other reputable publishers where appropriate. You can learn more about the standards we follow in producing accurate, unbiased content in our editorial policy.
  1. Sites.Google.com. "MasterCoin Specification (AKA The Second Bitcoin Whitepaper)," Click on MasterCoin Specification 1.0 20130731.pdf and download the document.

  2. European Securities and Markets Authority. "Esma Highlights ICO Risks for Investors and Firms."

  3. U.S. Securities and Exchange Commission. "Investor Alert: Public Companies Making ICO-Related Claims."

  4. U.S. Securities and Exchange Commission. "Initial Exchange Offerings (IEOs) – Investor Alert."

  5. ICODrops.com. "ICODrops."

  6. Metacade. "Metacade ($MCADE) Whitepaper."

  7. BananaCoin. "Whitepaper BananaCoin."

  8. Bluzelle. "Understanding Bluzelle Mainnet: Block Rewards."

  9. Bluzelle. "Web3 Belongs to the Creators."

  10. Financial Industry Regulatory Authority. "Initial Coin Offerings (ICOs)—What to Know Now and Time-Tested Tips for Investors."

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