Demystifying Tokenisation

There are many reasons why businesses want to create their own Tokens on the Blockchain. The biggest reason is that it is an easy and quick way to raise money for operations or research and development. The theory of decentralisation and the availability of the technology has made it tempting for businesses to adopt Tokenisation and present it as a value proposition in the business model. The technology has gained notoriety as well, due to quite a few fraudulent tokens and ICOs.

There are plenty of articles, blogs and videos on the internet that support as well as rebut Tokens on Blockchains. This has led to a confusion on when and what to tokenise, and whether it makes business sense at all. In this article we will analyse tokens and delve into some of the details in a hope that this information will dispel some of that confusion.

 

What does a Token represent

There are different kinds of tokens that represent different things on blockchain.

Currency

A token can serve as a currency. A currency token could be pegged to a fiat currency (like USD, GBP or EUR) or its value can be determined by trades on crypto-exchanges.

Resource

A token can represent a resource like a computing unit or a storage unit or any thing that can be represented as a resource in a traditional sense. For eg: Resource tokens can potentially be used to represent a car in a sharing economy application. When a car is represented as a resource, it can be rented out for a specific period.

Asset

A token could represent ownership of an asset like gold, house, car etc. Although the car can be represented as a resource, it can also be represented as an asset. In the case of an asset token, it represents ownership of the car, and has no notion of “availability” during a specified time.

Access

Access tokens have been commonly used on the web for accessing services on the internet. Typically these tokens have a validity for a small duration. Blockchain based tokens could extend that kind of access to Hotel rooms, Rental cars, or personal data on a secure P2P store. The owner of a resource can grant a limited time access to another user.

Equity and Security

A token can represent shares in a company. An equity token provides certain rights to the holder, including voting rights, rights to dividends etc.

Security tokens represents a broader set of financial assets. Both Equity and Security tokens have been regularised in some jurisdictions. This has led to further adoption of the technology. Businesses raise money for activities like Research and Development or Working capital etc through this mechanism.

Voting

A token could represent a voting right. Once exercised, the token will no longer hold any power. The voting tokens could be used for government elections or committee elections etc.

Collectible

A token could represent a painting or a digital collectible like a cryptokitty.

Identity

As the name suggests, an identity token represents a person or a company or any thing that needs to have an ID. Some companies have created identity tokens in an attempt to help the financial systems with their KYC needs. An identity token could also represent a digital avatar or a particular IOT device.

Attestation

An attestation token can represent a marriage record, birth certificate, or a college degree. There would be some central authority which would certify your accomplishments or devices. In the real world a certificate of any kind is actually a form of attestation. When MOOCs certify that a course has been completed by someone, it can be represented as an attestation by the MOOC.

Utility

Utility tokens could be used for accessing or paying for a service. Often under the guise of a utility token businesses raise money. Businesses create utility tokens and offer them on a pre-launch sale. This allows the business to raise money and provides the “investors” an opportunity to buy utility tokens at discounted prices. The buyers are actually buying a promise that the service will be made available in future, and they could use the service. In some cases they are genuine utility tokens, while in other cases they are a wolf in sheep’s clothing. Possibly regulators have started viewing such tokens suspiciously.

Some examples of utility tokens are Golem Token (GNT), Basic Attention Token (BAT), The Fun Token (FUN)

Commingled tokens

A token may represent multiple of the above. If a new token is created, it could at times be an Equity token, and at other times possibly represent a Voting right. We call such tokens Commingled tokens.

In the real world, a Driving Licence could serve as an ID (identity token), a License (attestation token) and also an address proof (again an attestation token). This means that the license document serves multiple purposes and therefore has commingled functions. In the real world it is hard or even impossible to separate some of these functions.

Decoupling commingled tokens

In the digital world, we could have a system of tokens which decouples each of these functionalities. For eg: the license attestation can be provided without revealing the Identity of the holder. The technology mentioned below enables such a thing.

Direct Anonymous Attestation used by hardware manufacturers allows for a secure way of sharing hardware configuration with anonymity. A small embedded processor on the motherboard called Trusted Platform Module is used to attest the configuration. As it is anonymous attestation, the Identity is not revealed. In this way DAA has decoupled the identity and attestation.

It is easily possible to decouple Identity and yet provide attestation of Licence in the blockchain world as well. Where a “derived” public key could be used to create a License token. The ID token could be the root of this derived token. One simple technique is using the Hierarchical Determinism. One of my earlier articles explains this in significant detail.

Fungible and Non-Fungible Tokens

This is possibly one of the most discussed aspect of Tokens on the web. If a token of a kind, say XAU token, can be interchanged for another token of the same kind (another XAU token), then the token is considered fungible. The reason I used XAU as an example is because this symbol is used for gold in precious metals trading. One gram of 24 carat gold is considered equivalent to another gram of 24 carat gold and they can be interchanged. Therefore 24 carat gold is fungible. The tokens that exhibit this property are called fungible tokens. The tokens must be equal in all comparable properties of the token.

Non-fungible tokens cannot be interchanged. For eg, if tokens could represent cars, then a Bugatti Chiron cannot be interchanged with another Bugatti Chiron. The registration number, usage pattern, mileage, colour etc are examples of properties that makes them not interchangeable. Another example is a painting by Picasso is not interchangeable with another.

Properties on tokens

To achieve fungibility, the token must not store any property. An example for such a property could be the token issue date. If the issue date is different in a few tokens and there is a way to compare the tokens based on token issue date, then we will not consider the tokens to be fungible. Another example could be a token serial number. One could argue that the valuation could be independent of the property like the issue date. However, in the world of public blockchains, we cannot prevent exchanges from comparing such properties, and deducing different valuations.

The purist’s view of fungibility

The purists insist that a fungible token must not be distinguishable from another token of the same kind in any way. In this view even popular crypto-currencies on public blockchains like Bitcoin (XBT) and Litecoin (LTC) are not truly fungible. It is interesting to note that the US government has blacklisted some addresses, which makes these coins black-coins (if I may use the term). On Bitcoin, transactions can be traced back to the source address, thus the coins from these addresses can be identified. Exchanges that allow trading coins tracing back to these addresses could be viewed as performing suspicious activities. This implied property of the coins makes it non-fungible in the purist’s view.

This is an overly stringent view for the pragmatist. Even bank accounts of fiat currencies get frozen by regulatory bodies. Therefore for a pragmatist, Bitcoin or Litecoin is still fungible. This article is not for judging what is right or wrong, instead it is for understanding as many aspects of tokenisation as possible and hence we leave it at that.

Tokenisation of assets and counterparty risk

In any trade, there is always a settlement risk. Money flows in one direction (buyer to seller), and the goods flow in the other direction (seller to buyer). This is typical in the over-the-counter market. Let us now see how it plays out when real world items are digitised and represented as a token on a blockchain.

To settle a trade involving digitised assets represented as tokens on a blockchain, crypto-currency flows in one direction (buyer to seller) and tokens flow in the other direction (seller to buyer), however, even the asset that is represented by the tokens must change ownership (seller to buyer).

Let us consider gold represented as token on blockchain. If a trade happens on blockchain, not only should the currency and tokens be exchanged, even the physical gold needs to change hands. The gold may be in the custody of someone or some company and it needs to acknowledge the transfer of ownership and physically transfer the gold if needed. What if the the custodian of the physical asset does not honour the trade? In the traditional financial systems this is modelled as counterparty risk.

Since this transfer of ownership of physical asset needs to happen outside of the blockchain, it is not controlled by the protocols of the blockchain. Hence, whenever a physical asset is digitised and represented as tokens on blockchain, there would always be a counterparty risk.

Intrinsicality and counterparty risk

Generally I prefer calling out the distinction between coins and tokens on the blockchain.  Although, from a pure technological perspective, coins are also tokens.

Coins like Bitcoin, Litecoin, Ether etc are an important part of the blockchain design and protocol. When these are traded, the blockchain protocol ensures the transfer of ownership / value. These coins are the ones that incentivise good behaviour on the blockchain. We call these tokens intrinsic tokens.

Then, there are tokens on the blockchain like the ERC-20 tokens, most of the ICOs in the recent past were based on the ERC-20 and ERC-721 standards on Ethereum. The smart contracts are responsible for the transfer of ownership of such tokens. There could be bugs or security loop holes in smart contracts. Also, these tokens do not play any role in incentivising good behaviour on the underlying blockchain. We call these extrinsic tokens.

With intrinsic tokens there is no counterparty risk because the transfer of ownership results directly in the transfer of value. There is no third party operating outside the blockchain protocol to ensure that the value is transferred, and therefore intrinsic tokens have a significantly reduced risk of settlement.

Physical tokens v/s Tokens on Blockchain

Before the advent of Tokens on the Blockchain, tokens had a very nominal value or as they say, a token value. These would be used only for some small kind of utility like laundry or food or gaming console etc. They were mostly physical tokens. It was not something that users would trade in exchange for some other token. With blockchain, tokens became digitised and the double spend issue was fixed. Therefore trading tokens became easy. This provided the ability to convert tokens to other cryptocurrencies or even fiat currency. People started “investing”, albeit speculatively, in tokens in a hope that they would be able to trade these tokens later at a higher value.

For the time being, let us ignore the effect of speculative investing by investors and aggressive marketing tactics used while marketing ICOs. With that behind us, let us look at some factors that impact the valuations of tokens based on simple and basic analysis. This will help us understand why physical tokens are generally of insignificant value, and depending upon the business model, the same factors could make blockchain tokens worthless.

User base

Physical tokens: Typically the size of the user base is limited to the population in a particular area. Physical tokens can be handed over in person only.

Tokens on Blockchain: The size of the user base depends upon the adoption of these tokens. It could be as huge as the whole world or as small as none. However, digitisation makes marketing and distribution easy.

Acquisition of tokens

Physical tokens: Typically acquiring physical tokens is difficult as users have to physically go and collect the tokens.

Tokens on Blockchain: Acquisition of tokens is relatively easier. Also, tokens and the rules to mint the tokens are coded in smart contracts which makes it transparent to the world, and therefore the investors can predict the supply of tokens.

Conversion of tokens

Physical tokens: Tokens from one provider can not be exchanged for tokens from another provider. Private trades are possible, however, no-one exercises such trades.

Tokens on Blockchain: Tokens from different providers can be easily exchanged on crypto-exchanges. The transparency of blockchain and tokenisation standards, provide confidence to buyers and sellers about settlement issues.

Issuing tokens

Physical tokens: The practicality of managing tokens, manufacture / procurement, storage, replacement of broken tokens etc… is too much to do, when simple fiat currency coins or notes can be used. Most slot machines these days use fiat currency coins or notes instead of such physical tokens.

Tokens on Blockchain: It is extremely easy to create tokens on blockchain, many companies have Platform-as-a-Service offering for blockchain based tokens. Besides this, high valuations of tokens tempt many service providers to create tokens and issue them.

Usability

Physical tokens: Typically physical tokens have limited usability and only the provider accepts these tokens. The token could represent various things like membership to a club or one-time use of a service etc.

Tokens on Blockchain: Blockchain based tokens are unique in the sense that multiple service providers are in a position to trust the validity of these tokens. This makes a token usable at different service providers.

Considerations before creating utility tokens

Businesses create tokens to raise money. This is often considered as a quick and easy way to crowd-fund the business. However, quite a few times the reason for creating tokens is just that. When that is the case, it is better to call those tokens Security tokens and make sure that all regulatory requirements are met.

New utility tokens are quite often not needed at all. A simple transaction which transfers value to the service provider could provide a temporary access token to the service. Even the intrinsic coin of the blockchain suffices as a utility token in many cases. As an example, transfer of Ether (ETH) and invocation of a smart contract is done with the same transaction, without the need to create any special token.

Business risk

A startup takes on a huge risk by trying to create a new market space or trying to enter into an existing market space. Startups try out new business models, which is a huge risk in its own. Adding a new dimension of crypto-economics (unless really necessary for the business) increases the technology risk and needs higher investments and working capital. Therefore it is important to see what level of decentralisation is needed for the success of the business before embarking on creating tokens.

Factors that reduce token value

Creating utility tokens which provide access to a service and are fungible, creates similar circumstances as the physical tokens. There is a cost to acquire the token, a cost of conversion in the form of exchange fees. If tokens remain unused, the owner needs to sell it to acquire other tokens or coins, which is the cost of divestment. Just like the physical tokens, these tokens have a smaller user base, a limited usability, difficulty in acquisition and conversion due to limited availability on crypto-exchanges. Note that it is cumbersome and costly to list your tokens on crypto-exchanges. To increase the user base, it may be tempting to increase the number of exchanges these tokens are listed on. This increases the cost of acquisition or conversion further.

Attracting investment capital

To raise money, there are standards created on blockchains. One such standard is the ERC-20 standard. It is better to use these standards instead of inventing your own way of raising money and creating your own smart contract. This reduces the risk of security loop holes significantly. Also, we call the tokens what they actually are, Security tokens. This makes regulatory requirements very clear, and reduces the risk of being at odds with Law.

To raise money this way, and provide privileges like discount or free usage of service is what makes these tokens utility tokens. The same tokens therefore act as both, Security tokens as well as Utility tokens. Thus they are commingled tokens. They could be decoupled using various techniques.

It is important to consider all the above factors before creating your own tokens.

Conclusion

In this post, I have tried to cover aspects like when and what all can be tokenised, different aspects of tokenisation, and a different perspective so that the pitfalls of tokenisation may be avoided. Hopefully this clears up some of the confusion that people have when it comes to tokenisation and using blockchain in their business models.

Apart from the links that are shared through out the post, a huge portion of this research comes from the book Mastering Ethereum by Andreas M Antonopoulos and Gavin Wood.

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