Altcoins: What They Are and How They Work

Altcoins are, by definition, any cryptocurrency that isnt bitcoin, which means there are a lot of them: more than 10,000, according to CoinGecko. And considering bitcoin currently makes up around 40% of the total crypto market cap, more than half of the crypto markets value is floating around in altcoins.

But all altcoins arent created equal. Some cost pennies, while others are hundreds of dollars per coin. Some have promising long-term applications, others are a flash in the pan. Many aim to build on bitcoins successes, others claim to solve its problems.

All this adds up to an altcoin universe thats vast and full of risk. Heres how to make sense of it.

To understand altcoins, it helps to first have a firm grasp on bitcoin (read up on bitcoin for beginners). Its also helpful to know the basics of blockchain technology, on which all cryptocurrencies operate.

Altcoins have the same premise as bitcoin: to use the blockchain as an incorruptible, distributed public ledger, which allows and records a transaction only if theres consensus that the transaction is legitimate. But many altcoins have taken this premise and either used it to achieve different goals or sought to improve a perceived flaw in bitcoin.

Litecoin, for example, started out as a clone of the Bitcoin blockchain’s source code, but included changes to speed up transaction times and improve storage efficiency. Litecoins purpose is the same as bitcoins to be a peer-to-peer internet currency but its founder sought to improve the way bitcoin went about it.

Ethereum, on the other hand, saw an opportunity in bitcoins blockchain technology beyond just recording financial transactions; the Ethereum blockchain also records agreements in the form of smart contracts. Ethereum advocates say these smart contracts computer programs that automatically execute an agreement if certain conditions are met could upend industries that currently rely on costly middlemen, like insurance, banking and copyright management.

Other altcoins have emerged that promise to be even faster, more decentralized, more scalable, more secure or a combination of all these core cryptocurrency tenets. The result is a dizzying ecosystem of altcoins thats hard to categorize, but can be roughly broken down into these four buckets:

Native cryptocurrencies are the coins that were originally created to run on a specific blockchain network. Bitcoin is a native coin (youll see native coin, currency, cryptocurrency and token used interchangeably; its the native part thats important here) because it is the currency thats used on the Bitcoin blockchain.

Ether, the second-largest cryptocurrency by market cap, is the native coin of the Ethereum network. To run applications like smart contracts on the Ethereum network, youll need to pay a transaction fee in ether.

Binance coin (BNB), currently the fourth-largest cryptocurrency by market cap, is yet another native coin, as its the currency used on the Binance Chain. Binance is currently the largest cryptocurrency exchange in the world, and its users can greatly benefit from owning BNB. For example, trading fees are reduced by 25% when paid with BNB, and small amounts of cryptocurrencies that would otherwise be untradable can be gathered and converted into BNB.

A token is a unit of value that operates on an existing blockchain and can be used for specific purposes within that environment. Using tokens is similar to going to an old-school arcade: You exchange your U.S. dollars for tokens that are only accepted by those video games.

Chainlink, for example, is built on top of the Ethereum blockchain, and developers can use it to convert real-world data into a blockchain-friendly format that can be read by smart contracts and vice versa. LINK is the token thats used to pay for Chainlinks services. So, if an investor believes demand for smart contract-based services is going to rise, they might buy LINK; the more Chainlink technology is used, the thinking goes, the higher the demand for LINK, which could send its value higher.

Another example is the Uniswap platform, a decentralized exchange built on top of the Ethereum system. Centralized exchanges (such as the stock market or Binance.US) require deposits into an account or wallet thats connected to the exchange. However, a decentralized exchange enables direct peer-to-peer trading from one personal wallet to another. UNI is the token of the Uniswap exchange, and its whats known as a governance token holders of UNI can vote on proposals that determine how Uniswap will operate, similar to the way traditional shareholders have a say in corporate governance.

Stablecoins were developed to offer the advantages of cryptocurrencies and tokens without the price volatility. They accomplish this by tying their value to an existing currency, one for one. Tether, the largest stablecoin by market cap, is tied to the U.S. dollar; one tether will always equal one U.S. dollar.

You wont earn any profit through price appreciation with stablecoins, but there are plenty of applications for a coin whose value doesnt rise and fall by the minute. For some, stablecoins offer a way to hold funds in a crypto exchange and easily convert them into another cryptocurrency, rather than converting from U.S. dollars. Others may use stablecoins to easily send and receive funds globally.

But perhaps the most popular use for them today is in decentralized finance, or DeFi. Essentially, DeFi platforms let users lend stablecoins to others and earn interest in return, all without the need for an intermediary like a bank. Whats more, some platforms incentivize users by offering tokens, such as the governance tokens outlined above, on top of the interest they receive.

Many exchanges have greatly simplified this process. On Coinbase, for example, its currently free to convert U.S. dollars into the stablecoin USD coin (USDC), after which it will start earning 0.15% APY. (Note that this rate is subject to change.)

In a cryptocurrency blockchain, groups of recorded transactions (the public ledger) are organized into blocks, and each block is connected to the next via complex cryptography. For a new block to be appended to the existing chain, all the previous transactions in all the previous blocks must also be verified, and there must be a consensus that all is right with the chain.

This consensus is required for the list of transactions as well as the rules that govern the blockchain network. And when a group decides it wants to change the rules, it can validate a split in the chain; this is a fork. A new chain emerges, ready to start logging transactions under the new rules agreed upon by those who chose to validate the fork. Meanwhile, the other prong of the fork keeps going on as normal.

Forks can happen over and over again, creating new protocols and cryptocurrencies all the while. Bitcoin cash is a fork of the original Bitcoin blockchain, while Ethereum Classic is a fork of the Ethereum system. Dogecoin is a fork of Luckycoin, which was a fork of Litecoin, which was a fork of Bitcoin.

So, as an investor, if you like the ideas, rules and changes found in a fork of an existing blockchain, you could buy that forks currency in the hope that it rises in value.

Before diving into any altcoin, take the time to read through what the organization behind it is trying to accomplish. Ask yourself:

• Does the altcoin seem like a plausible way to improve upon bitcoin?

• If its a token, does it have real-world application?

• If its a stablecoin, how are you going to use it?

• If its a fork, why was it created and do you agree with that decision?

Be warned that this is a nascent market where shakeout is inevitable. Some of these projects will fail theres already a crowded graveyard of dead altcoins and some will succeed.

Thats why financial pros often put altcoins firmly in the alternative investments column: something you might dabble in if youve already got a healthy, diversified investment portfolio.