Terminology is evolving quickly. While bitcoins and other cryptocurrencies are all referred to as ‘digital tokens’ in a generic sense (as in ‘a Bitcoin is a digital token’), a distinction now seems to be emerging between cryptocurrencies, such as BTC and ETH whose coins are tracked on their respective blockchains, and tokens which are usually issued by an issuer during an Initial Coin Offering (ICO) and tracked within smart contracts on Ethereum’s blockchain. The word ‘token’ can mean different things depending on the context in which it is used191.
What are tokens? What is a digital token? Why is it important?
It is easy to understand what a ‘token’ is in the physical world. Think of round plastic things like casino chips, beer vouchers, or fairground ride tokens. Essentially a token is something which is issued by an issuer (the casino, the beer festival organisers, or the fairground) and can be used in a specific context or in a specific marketplace, perhaps under specific conditions or timings. The token has value because the context gives it value, but if you take the token outside the context the value decreases or falls to zero. While a $5 casino chip is worth $5 inside a casino, it would be worth less on the other side of the world. And fairground ride tokens would not be worth much, if anything, outside the context of the fairground.
But what do people mean when they talk about digital tokens? If you digitise a beer voucher or casino chip does it become a digital token? Is a balance in a PayPal wallet a digital token? Is a bank balance a digital token? What’s special about a Bitcoin?
The characteristics of the different types of token vary widely, and generalisations lead to confusion. In this section, I hope to clarify the different types and characteristics of tokens by differentiating between blockchain-native tokens like BTC and ETH, asset backed tokens like IOUs, and utility tokens that can be spent on goods or services at a later date, usually recorded within smart contracts on the Ethereum blockchain as ‘ERC-20’ standard tokens192, but may also be recorded on other blockchains.
Owning a Token
We can be more specific and use the term cryptoasset. Ownership of any cryptoasset, whether it is a cryptocurrency or a token, is vested in the person who has the private key that corresponds to the address with which the token is associated. This private key allows that person—the owner—to create and sign transactions releasing the token and assigning it to someone else. In some respects, cryptoassets are like bearer assets—if you hold the private key, it is yours193.
The rules of blockchains require that if a token is to be sent (i.e., if a payment to be made), the transaction must include the digital signature related to the token’s current address. This digital signature is validated by all of the blockchain network participants. The digital signature acts as a single point of authentication to signal that it really is the address owner who is making the payment instruction.
With online banking, in contrast, you prove that you are you then instruct the bank to do something on your behalf. You provide a username and password and usually a one-time PIN created on another device—a so called ‘second factor’. Authenticating with a username and password has its benefits. If you forget or lose your password, you can have it reset if you supply more proof that you are the account holder.
With a cryptoasset, transactions must have a valid digital signature. If you lose your private key, you cannot access your asset and you cannot have it reset. If your private key is copied the thief can make transactions on your behalf, and you can’t stop them. In this respect cryptocurrencies are much less forgiving than banks. Not even those who maintain the ledger can alter the balances, because they can’t provide the necessary digital signatures. This is different to a traditional ledger maintained by a bank, which can be alter balances without any kind of cryptographic proofs.
Some people say that with Bitcoin, you are your own bank. You don’t instruct an entity to make a payment on your behalf: you are responsible for making payments yourself.
Categorising Tokens
New tokens are emerging almost daily. Their properties vary. While segregation and separation are difficult, I currently think of tokens in three categories:
Native blockchain tokens, which are essential for the underlying blockchain to work or be incentivised. Native tokens are usually the incentive for block-creators to do their work. Cryptocurrencies are usually native tokens.
Asset backed tokens, which represent title or ownership to some real-world asset held in trust by a custodian.
Utility tokens, which represent a claim on a service provided by the issuer of the token.
Data website onchainfx.com provides these categories for digital tokens194:
Currency Tokens: Currency tokens are native blockchain assets intended to be used as money. Networks classified as currencies typically do not have many ‘features’ beyond those necessary to define and transfer the native blockchain asset.
Platform Tokens: Platform tokens are required to use general purpose decentralised networks that support a wide variety of possible applications. Platform tokens are often used specifically to mediate use of the platform (ie, tokens are used to pay ‘gas’ in order to access the platform’s functionality).
Utility Tokens: Utility tokens are native to decentralised networks that are designed for specific application types. That is, they are open networks but designed with a specific-use-case in mind. For example, decentralised storage and decentralised asset exchange are both use-types for which targeted networks (and their corresponding tokens) are being built. The terms ‘Utility Tokens’ and ‘Protocol Tokens’ are often used to describe the same type of token.
Brand Tokens: Brand tokens exist as tradeable digital assets for use mostly on one company/entity’s platform. Some Brand Tokens may evolve into more generalised Utility Tokens over time.
Security Tokens: Security tokens represent a claim on a specific cash-flow, or off-chain asset. Networks which generate fees-for-service that accrue to token holders, explicitly grant voting rights to token holders, or where tokens are said the be ‘backed’ by some other asset, such as gold or company equity, are Security Tokens.
In the section on ICOs we will discuss how tokens may be classified by regulators as financial securities. For now, I will describe my own distinctions between native tokens, asset backed tokens, and utility tokens.
Here I will use the word ‘token’ generically to mean any units recorded on any blockchain.
Cryptocurrencies such as Bitcoin and Ethereum use native tokens BTC and ETH respectively. These units are needed to incentivise miners to create valid blocks without an external party to fund the participants. ETH is also used to pay Ethereum miners to run smart contracts. The tokens are also known as ‘intrinsic’ or ‘built-in’ tokens. They are inseparable from their blockchain systems, and are used both as an incentive for participants to keep the blockchains running, and as a payment mechanism to use the blockchains.
How do these native tokens come into existence?
Intrinsic tokens are created by the same blockchain software that keeps track of ownership of these units. They are created transparently by software in the mining process according to a schedule defined by the blockchain protocol. All participants agree to abide by the protocol rules.
What backs native tokens?
Nothing ‘backs’ these native tokens. They just exist and have value. The gold analogy is useful here. When you hold physical gold it is not ‘backed’ by anything; it is just valuable in itself. With native tokens there is no issuer to whom you can return a token, to redeem for an underlying asset, any more than you can go to a ‘gold issuer’ (mother nature?) and redeem your gold for something else.
Satoshi Nakamoto created the idea of Bitcoin, but is not the issuer of the BTC units. Bitcoin miners create BTC according to some mutually agreed constraints, but they are no more the issuer of BTC than a gold-prospector is the issuer of the gold that they discover.
Where do native tokens derive their value?
Their value comes partly from their usefulness and partly from their speculative value. Let’s use the gold analogy again. Gold derives its value from two sources. Firstly, it is useful for filling gaps in your teeth, for certain technical or industrial processes, and, because it is pretty and doesn’t tarnish, for wearing as jewellery. Secondly, gold has a speculative value arising from its scarcity, general desirability, and its long price history.
Native tokens are useful because they can be used in a specific context. The context for the BTC token is the Bitcoin blockchain and the context for the ETH token is the Ethereum blockchain. Bitcoins, like gold, don’t represent an asset, they are the asset. As considered in our earlier discussion about different types of money, bitcoins are representative money. Native tokens also have speculative value as some people want to buy and hold them, just like any other asset that speculators can buy and hold.
Examples of native tokens
Some of the more well-known examples of intrinsic tokens:
•BTC on the Bitcoin blockchain
•ETH on Ethereum
•NXT on the NXT platform
•XRP on the Ripple network
There are many more, and they all differ slightly. Since 2018, native tokens that are not issued or backed by anyone have been increasingly described as ‘cryptocurrencies’. The word ‘token’ is increasingly confined to those tokens issued by projects which are redeemable for a product or service at a later stage. But definitional boundaries are blurred. For example, ETH, although widely described as a cryptocurrency, was issued by the Ethereum Foundation during their crowdsale, whereas BTC has not been issued by anyone. EOS tokens were issued before their blockchain went live and those tokens can be swapped into native tokens that run on their blockchain. I suspect that terminology will continue to evolve.
What are intrinsic tokens for?
As discussed, intrinsic tokens are the incentives for miners to do their jobs. But each blockchain has its nuances. We have explored BTC and ETH in detail earlier. Ripple and NXT are two other cryptocurrencies which have some interesting twists.
The Ripple network uses tokens called ripples, with a ticker symbol XRP aligned with the ISO currency standards. On the Ripple network all, the XRP tokens were created at the beginning—all the XRP that will ever exist were pre-mined and shared out among key participants. Each transaction on the Ripple network needs to include a small amount of XRP as a transaction fee. Unlike Bitcoin and Ethereum, XRPs are destroyed by block makers, rather than being claimed by them as is the case with Bitcoin and Ethereum. Therefore the total number of XRPs in circulation decreases with time. The XRPs destroyed in each transaction ensures that transactions have a tiny cost, preventing transaction spam which can happen if transactions are costless to create.
The NXT network uses pre-mined NXT tokens. Each transaction on the NXT network requires a fee to be added. The fee goes to the block maker (in NXT this is called a ‘forger’ instead of a ‘miner’). Therefore, the total number of NXT remains constant with time.
Any financial asset can be recorded as a token, either directly, where the token is the financial asset, or as a depository receipt, where the token is a claim on a custodian for the financial asset. You may think of a share or a bond as a physical object, but financial assets are nothing but agreements between parties, usually an issuer and the owner of the asset. For example, a share of a company is a legal agreement between the issuer company and the owner of the share; a bond is a legal agreement between the issuer and the holder of the bond; a loan is a legal agreement between the borrower and lender. Money itself is an agreement between two parties. Deposits in a bank account are an agreement between the bank and the depositor, with many provisions including daily transaction limits, daily withdrawal limits, interest, etc. A banknote is an agreement between the central bank and the bearer.
These agreements can all be represented as tokens recorded on blockchains or distributed ledgers.
Asset backed digital tokens take a number of forms:
1.Depository receipt tokens
2.Title tokens
3.Contract tokens
Depository receipts are tokens that are claims on a specific entity for an underlying item. You can think of them as a digital version of a goldsmith’s receipt for gold stored in their vault, or like a digital version of a cloakroom ticket or left-luggage ticket. The tokens represent ownership of the underlying item held in trust by a custodian. The receipt could be for real world physical objects, such as gold, or for a financial asset, such as a share of a company. When a token holder wants to redeem a token, they go to the issuer with the token to claim back the underlying asset. The issuer then destroys the token once they have returned the underlying asset.
Title tokens are a slightly different concept. They are the digital document that represents proof of ownership of an asset, for example a digital title document to a car or house. Unlike a depository receipt token, the item is not necessarily under someone else’s custody.
How Do Asset Backed Digital Tokens Work?
Let’s take the example of Goldchain Inc, a fictitious entity. It stores physical gold bullion in its vault on behalf of itself and its account holders who have bought some of that gold. It issues digital tokens called GoldchainOz to the account holders when they buy that gold. Each token represents 1 oz of the gold bullion stored. These gold tokens are recorded on a blockchain. They may be recorded in smart contract on the public Ethereum blockchain, or on a private Ethereum blockchain, as assets on any number of other public blockchains or private blockchains such as Corda. It doesn’t really matter for these illustrative purposes. What matters is the ability for a customer of Goldchain Inc to withdraw the tokens and keep them in a wallet where they, and only they, have the private keys.
Let’s assume you want to acquire 1 oz of their gold bullion. So:
1.You create an account with Goldchain Inc by going to their website.
2.You make a bank transfer of fiat funds to Goldchain’s bank account to fund your account.
3.After a period of time (hours or days depending on how long your bank transfer takes to get to Goldchain’s bank), Goldchain sends you an email indicating they have checked their bank account and have received your funds. You can now buy gold tokens.
4.You log in again and click ‘buy’ for 1 oz of gold at $1,500 per oz.
5.The money in your Goldchain account drops by $1,500, and you see you have 1 ‘GoldchainOz’ token in your account. In the background, Goldchain reclassifies 1 oz of gold in its books from ‘Gold owned by Goldchain Inc’ to ‘Customer assets’. Goldchain has sold some gold to you, but instead of shipping the physical gold to your home it has issued you a token representing that gold. The gold token is still under the control of Goldchain Inc because you haven’t yet withdrawn it to a wallet entirely under your control.
6.If you wish to have the gold token completely under your control, you can withdraw the GoldchainOz token to your independent address. Goldchain will send a transaction to the blockchain transferring one GoldchainOz token from their address to your address.
7.You can keep the token, give it to your friends, sell it, or do whatever you want with it. Let’s say you transfer it to Alice.
8.Eventually Alice wants to redeem the token for real gold, if that is an option, or sell it for USD. She can do so by creating an account at Goldchain Inc, transferring the gold token from her blockchain address to their blockchain address, and requesting delivery of gold, or selling the token back to Goldchain Inc, assuming these options are available.
If Goldchain Inc, who controls the warehouse, is a central point of failure and control, what is the value in using tokens? Why doesn’t Goldchain Inc just use an Excel spreadsheet?
Firstly, the use of cryptography in blockchain technology makes the tokens very hard to fake, and this creates more transparency over the number of tokens issued and held by customers. The warehouse can prove that there are not more tokens than they have gold in their vault. An auditor would periodically match the amount of physical gold to the number of tokens outstanding.
Secondly, existing processes of passing title documents or receipts may be manual, time consuming or operationally challenging. Transfer of digital tokens may be more efficient, and increasingly so as new software and hardware is developed to manage digital assets.
Finally, in a peer-to-peer system, the warehouse itself doesn’t have to be online and participate in transactions between customers. All it has to do is issue and redeem the digital tokens. The trading of the tokens can occur on whatever digital asset exchange or exchanges are chosen rather than being managed centrally by the warehouse. The settlement of the tokens is recorded on the chosen blockchain.
This leads to a segregation of responsibilities and opens up the possibility of competition for each element of the end to end ‘trade lifecycle’. The warehouse’s job is to store gold, issue tokens representing that gold, and transfer gold to any party legitimately redeeming the token, as it would have done under a paper-based system of old. Trading, settlement, liquidity, collateralisation, and other functions unrelated to storage can be done elsewhere without the warehouse having to update their records or manage those functions. The title documents or receipts, by virtue of being on a blockchain, can be trusted as genuine and uncounterfeitable, and the ownership or liens on any particular lump of gold can be made more transparent, potentially reducing the confusion relating to who has what claim on which piece of gold.
Asset backed tokens are easy to transfer. Blockchains enable predictable and secure record keeping. The key risk is that the issuer must remain solvent. If the gold is stolen from the vault, or if the issuer becomes bankrupt, whether from fraud or otherwise, asset backed tokens can become valueless.
Contract tokens represent a contractual obligation between the issuer of the token and the bearer of the token, or between two parties who jointly agree to hold the token. For example, a token could represent a share of a company or an interest rate swap between two parties. Shares can be issued by a company in the form of a token, and the owner of the token is the shareholder. Two parties who agree on an interest rate swap enter into an agreement which is represented by the token.
Contract tokens are slightly different from depository receipts. In the case of a contract token, the token is the share; whereas with a depository receipt, the token is a claim on a custodian who is safekeeping the share.
The holder of a utility token can redeem the token from a specific entity for a product or service rather than for an asset. Sale of utility tokens is a popular ICO strategy.
Utility tokens represent a liability of the issuing company. Eventually, when the product or service becomes available, a token holder can redeem their token for that product or service. In this respect, ICOs that issue utility tokens are performing a pre-sale.
A transaction is just an entry to the ledger that changes the state of the ledger. We have previously discussed transactions that change the ownership of tokens. But transactions can also represent changes to the token itself, if allowed by the rules for that particular token. For example, a token representing a share could change status from ‘pre-dividend’ to ‘ex-dividend,’ if signed by the right participant and a dividend is paid. That same token could be marked with ‘voted’ after a shareholder vote has taken place. A token representing a bond could change status from ‘coupon due’ to ‘coupon paid’ if accompanied by a transaction that pays the coupon. A utility token representing a service could be marked as ‘partially redeemed’ if the service had a number of elements to it. And so on. At this stage in the evolution of cryptoassets, we are just scratching the surface of what is possible.
Blockchains and distributed ledgers work best when everything can be recorded on the chain, i.e. when everything is digital. So blockchains are great for cryptocurrencies or for tokens representing legal agreements between entities, whether shares, bonds, debt, or even a future claim on an entity. These tokens can be recorded digitally without any physical object being present. But problems start emerging when you want to track physical objects such as handbags, food, art, or elephants.
The interest in digital tokens for tracking ownership of physical objects seems to have come from the fact that bitcoins are traceable. This is true in a narrow sense. You can trace the provenance of any specific bitcoins through all of the previous addresses that they belonged to, all the way back to where they were first mined. This is possible because every transaction is recorded on the Bitcoin blockchain, and anyone can download the full blockchain and interrogate it. The provenance of bitcoins is traceable because that is the way Bitcoin works. You can’t make a Bitcoin transaction off the chain, because the very definition of a Bitcoin transaction is that it is recorded on the chain, and the UTxO model forces you to specify which bitcoins are moving where, resulting in a complete chain of provenance on the chain.
Can we extend that concept easily to real world objects? According to an article published online by Fortune in October 2016, ‘Walmart and IBM Are Partnering to Put Chinese Pork on a Blockchain’195. Apparently, blockchains may be used to track the provenance of pork and to stop potentially dangerous food from getting to consumers.
But stop for a second and think. How on earth would this work? I don’t know much about the pig supply chain but I suppose you have a bunch of companies who do everything from breeding the piglets, feeding them, slaughtering them, cutting them up, shipping them, packing, and delivering. Eventually, pork cutlets end up on the supermarket shelf for people to buy or on a plate in a restaurant. So… all the participants in the pig supply chain could have an address on a blockchain, with PigCoin tokens, issued presumably by the farmer, that represent pigs. Movement of PigCoin is recorded immutably on PigChain. When a farmer sells a pig to another farmer, the seller says, ‘Hey, what’s your PigChain address? Let me send you some PigCoins,’ and makes a corresponding PigCoin transaction on PigChain to represent the movement of the pig. But then, one fateful day, the buyer is a slaughterhouse who chops the pigs up into small bits and sends those different bits to different parties. Ah! But of course a PigCoin, like Bitcoin, is divisible, so the slaughterhouse splits up a PigCoin and sends fractions to different buyers. But which fraction is which part of the pig? Do we need a TrotterCoin and a LeftRearFlankCoin? What happens if one party doesn’t have an account on PigChain? What if a party loses their private key and all of their SnoutCoins end up trapped in their account while the real underlying snouts are being distributed? What if (horror of horrors), a bad person swaps out, in real life, a high-quality pig for a low-quality pig, but then still sends the PigCoin to the buyer, saying, ‘Oh look at the PigCoin’s provenance on PigChain, the pig you are buying is definitely high quality, you can download the PigChain and see for yourself?’ And when a pig becomes part of a sausage, then how would that work? We will need BreadcrumbCoin, HerbCoin, NastyBitsOfPigCoin and a market maker to exchange those for a WienerCoin. And how does the restaurant or person in the supermarket casually browsing the raw cutlets validate that the sausage in front of them is the real deal? Do they take a photo of the sausage and check it against PigChain? Do they scan a QR code that takes them to a website that says in large letters, ‘This is definitely a real sausage?’ Or do they pull out their handy DNA testing kit and track the sausage’s DNA on PigChain? How do you stop an enterprising chef from swapping out the high-quality cutlet for a cheaper one? This is all absurd.
According to the Fortune article, ‘Information to be stored on the blockchain, where fraud and inaccuracies are much harder to get away with, includes details related to farm origins, factory data, expiration dates, storage temperatures, and shipping’. That is good then. Of course none of that can be faked before storing it on PigChain.
It is easy to make fun, but tracking real world items by using a digital overlay is difficult. Blockchains are great for tracking unique digital items that only exist on that blockchain, but not as good when digital and physical worlds collide. Blockchains don’t tell the truth; they just record what someone tells them. Perhaps blockchains could increase certain aspects of transparency in a supply chain, but they are not foolproof and should not be used just because the phrase ‘supply chain’ has the word ‘chain’ in it.
Having said that, I can imagine a few cases which are interesting and, while not absolutely requiring blockchains, could use some of the same concepts. High value designer handbags could have tamper-resistant chips inserted; a buyer could then scan a bag to make sure that it is not a fake before buying it. The chip would contain a private key that would produce a digital signature when scanned. The digital signature could be validated against a list of public keys issued by the manufacturer. The chip would be embedded in the handbag such that it is obvious if it is removed or tampered with.
This system uses public and private keys but doesn’t need blockchains. The system would solve the issue of a bad actor passing off a fake handbag as real. However, many people buy fake designer handbags knowing that they are fake…they buy them because they look like the real thing but are cheap. So the system would only go so far. It is important to deeply understand the fundamental problem being solved.
Notable Cryptocurrencies and Tokens
There are many other cryptocurrencies that either exist as blockchains in themselves or as tokens recorded in smart contracts on other blockchains, usually on Ethereum’s public chain.
Onchainfx.com and coinmarketcap.com do a good job in cataloguing these if they trade over a certain amount of volume per day. At time of writing, onchainfx196 records the top197 tokens, with my comments, as follows:
Currency tokens (Primarily used as Money/Store of Value):
•Bitcoin (BTC)—the original cryptocurrency and store of value, created by pseudonymous Satoshi Nakamoto, launched in 2009.
•Ripple (XRP)—a token used to move value across the Ripple network, designed as a currency that was initially described to compete against banks then to be used by banks to improve foreign exchange and international payments. Created in 2012 by OpenCoin (rebranded to Ripple Inc in 2015198).
•Litecoin (LTC)—an early Bitcoin clone with faster blocks and a different mining proof-of-work. Called ‘Silver to Bitcoin’s Gold’ by its founder Charlie Lee who announced that he sold all of his Litecoin in Dec 2017.
•Zcash (ZEC)—a privacy focused coin using advanced cryptography called zero knowledge proofs to shield transaction data. Created by Zooko Wilcox-O’Hearn in 2016.
•Dash (DASH)—another privacy focused coin, created as XCoin in 2014 by Evan Duffield, renamed Darkcoin, renamed DASH.
•Monero (XMR)—yet another privacy focused coin, uses ring-signatures to obscure payer and recipient addresses. Launched in 2014.
Platform tokens (i.e. those used as gas to power smart contracts):
•Ethereum (ETH)—the original smart contract enabled blockchain platform, created by a Vitalik Buterin and launched in 2015.
•Ethereum Classic (ETC)—fork of Ethereum which didn’t bail out DAO investors. Proponents like immutability. Forked from Ethereum in July 2016.
•New Economy Movement (NEM)—a blockchain with ‘smart assets’.
•EOS (EOS)—a new blockchain structure designed to be more scalable than Ethereum.
Utility tokens (Built for Specific-Use Networks)
•Augur (REP)—a token used for betting on things on a ‘prediction market,’ i.e. a betting platform. Launched in 2015 from San Francisco.
•Siacoin (SC)—a token used for paying for encrypted decentralised file storage. Launched in 2015.
•Golem (GNT)—a token used for paying for decentralised computations & calculations. Launched in 2016.
•Gnosis (GNO)—another prediction market coin. Launched in 2016 from Germany.
Brand tokens (Specific-Use on Single Entity’s Network)
•Basic Attention Token (BAT)—Token used to make micropayments in a web browser called Brave. Launched in 2017.
•Civic (CVC)—Something to do with identity verification on the/a blockchain. I hope it solves the problem of having too many passwords. Launched in 2017.
•Steem (STEEM)—Token used for making micropayments on social media and forum sites. Launched in 2016.
This is just a short list of the many tokens and platforms that exist today. Many more are planned. The blockchain and cryptoasset industry in aggregate has attracted significant interest and investment, and I would guess that tens of thousands of developers are working to build viable platforms. As with businesses, I expect that most platforms will evolve and adapt, in search of long term viability. I expect a few to succeed and many to fail due to unviable models, insufficient interest, or insufficient network size. Those that succeed could become as relevant to people as the internet is today.