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Insights |15.01.2022

What are tokens?

Although the commonly known date when the first blockchain concept was widely introduced is 2008, the real origin of the idea is dated back to 1991. Then two scientists, Stuart Haber and Scott Stornetta, started the project involving work on a cryptographically secured chain of blocks so that no one could manipulate the timestamps of the digital documents. However, the blockchain idea started gaining true popularity and relevance in 2008 when someone under the alias Satoshi Nakamoto conceptualized the theory of distributed blockchains, released the whitepaper “Bitcoin: A Peer-to-Peer Electronic Cash System”, and in 2009 Bitcoin, as the first blockchain application, has been offered to the open-source community. That was the public debut of Blockchain technology.  


Over the years, blockchain technology has grown in popularity, bringing many use cases beyond cryptocurrency. Despite these developments, some people still use the terms “blockchain” and “bitcoin” interchangeably, which is a common mistake.  
Starting with a quote from Sally Davies, FT Technology reporter, let us help dispel those doubts and introduce you to some basic definitions.  


“Blockchain is to bitcoin, what the internet is to email. A big electronic system, on top of which you can build applications. Currency is just one” (Sally Davies, FT Technology reporter). [1]

Different Blockchain Layers 

Blockchains are ledgers that publicly record all transactions amongst participants using cryptography, executed through a distributed network of participants or devices connected via the internet. This makes it different from the traditional financial industry, where individual trusted players (such as banks or clearing houses) validate transactions, a centralised system that is prone to errors. The transactions are directed by a different set of rules, the protocol.  These rules may include: the type of consensus algorithm that determines how transactions are validated through the network, the governance structure, incentives, or penalties. With growing investments in blockchain use cases, the overall sophistication of the ecosystem has increased. Today, one can distinguish between different layers.  

The Layer 1 protocols can be simplified as the ‘operating systems’ for one or multiple crypto use cases. Examples of Layer 1 protocols are the Bitcoin, Ethereum, Solana, or Avalanche blockchain.  

The Layer 2 protocols refer to third-party integration that can be used in conjunction with a Layer-1 blockchain. Again in a simplified explanation, see it as the ‘software’ running on the operating system. Some notable examples of Layer 2 networks built on Ethereum are Polygon, Arbitrum, or Optimism, which are solving crucial problems around speed and transaction fees. The Uniswap v3 protocol is an example of using the latter two to scale up operations. Uniswap enables decentralised trading of crypto assets, maybe one day disrupting the business model of centralised crypto exchanges such as Coinbase or Binance. And so successfully that in August 2020, Uniswap handled more trading volume within 24hr than Coinbase, a listed and central crypto exchange, according to the founder of Uniswap. [2]
Generally, applications based and running on Layer 1 protocols are called DApps, and there are thousands of such decentralised applications only on Ethereum and counting. These DApps provide solutions for social media (e.g., Steemit), service marketplaces (e.g., Braintrust), content sharing (e.g., Mirror), supply chain management (e.g., Woltanchain), or financial services (e.g., Oasis), to name a few application domains.

Crypto Coins vs. Crypto Tokens – stop mixing up terms 

The coin and token are very much alike on a fundamental level: they both represent value or can process payments; coins could also be swapped for tokens and vice versa. Despite the similarities, coins and tokens are not the same things.  

The coin operates on its own independent blockchain and acts like a native currency within a specific financial system. [3] Coins must represent a unit of account, a store of value, and a medium of exchange, with its most prominent example bitcoin.

   
On the contrary, a token does not have its own blockchain - it operates on top of an existing another blockchain that facilitates its replication. Tokens rely on smart contracts - each blockchain uses its smart contract. Tokens represent a particular asset or utility. Some well-known examples of tokens on Ethereum include LINK (Chainlink), SHIB (Shiba Inu) or MANA (Decentraland), and various stablecoins like the USDT (Tether), or USDC (USD Coin), just to name a few. [4]    

Tip: If you’re still unsure whether something is a coin or a token, the simplest way to quickly check is to look for the specific name on coinmarketcap.com and check the tags. Even the name itself can be confusing: both USD Coin and Bitcoin have the word “coin” in their name, but the first one is a token, and the second one is a coin. 

 

  Token.png (122 KB)   bitcoin.png (497 KB)  

Bitcoin, Altcoins, Stablecoins – what’s the difference? 

Bitcoin is the first decentralised cryptocurrency powered by a public ledger (blockchain) that chronologically records and validates all transactions. It operates free of any central control or the oversight of banks or governments. Instead, it relies on peer-to-peer network and cryptography. 

Altcoin stands for alternative cryptocurrency coin, which refers to a coin that is an alternative for bitcoin. Plenty of the altcoins is a variant of bitcoin, built using bitcoin’s open-source protocol with changes to its underlying code, therefore creating entirely new coins with new sets of features. Although ether, by definition, was initially considered as an altcoin, defining ether as altcoin is not relevant anymore. Its correlation to bitcoin is significantly higher than bitcoin’s correlations to other coins. [5] There is also another important cryptocurrency type, which can be understood as an altcoin subcategory – stablecoins. A stablecoin has its value linked to an outside "stable” asset such as the US Dollar, other fiat currencies, or gold. Stablecoins are designed to reduce volatility relative to cryptocurrencies unpegged to an outside stable source (like volatile Bitcoin). Examples of stablecoins are USDC (USD Coin), founded by Coinbase and Circle; the often disputed, because of lack of transparency, USDT (Tether) with the highest market capitalisation, BUSD (from Binance) or DAI, which is often used for DeFi applications. Last but not least, there are Central Bank Digital Currencies (CBDCs) working like Stablecoins but issued by Central Banks, hence not controlled by a dencentralised network but by central institutions. These CBDCs are currently being tested in multiple jurisdictions, and we can be curious about what comes. 

The Emerging Token Landscape 

Token definition 

A token is a unit of value issued by an organisation, accepted by a community, and supported by an existing blockchain. In simple words, the token is a representation of something in a particular ecosystem, a piece of data that serves as a representation of a fact or right. The token can represent something tangible (physical) or intangible (non-physical, i.e., a service) within its ecosystem.  


Although tokens may seem to be a new concept in the digital context, they have been with us in a physical form for a long time, going back to the time of the Roman Empire. Coin-like objects from that period have been interpreted as an early form of token. Bringing contemporary examples, a dollar note representing its corresponding value, or a driving license card is a physical token representing the fact that you have been taught how to drive a car and are permitted to do so. A digital token would represent that license in the digital world.  


Just like in the physical world, we also need to distinguish between two overarching token categories in the digital world: Fungible and Non-Fungible Token. Fungible goods are goods or items that can be interchangeable, e.g., one sack of rice which can be replaced by another sack of rice. In the digital world, one Bitcoin can be replaced by another Bitcoin. Both goods and items are therefore fungible. Non-fungible goods, items, or tokens, on the other hand, are those that are not interchangeable due to their unique character. For example, the Mona Lisa, or the one jumper that you have knitted yourself or bought, now has many memories attached to it and is therefore unique, only exists once. These are non-fungible items. Digital non-fungible tokens now allow for securing ownership of such non-fungible digital assets, price and trade them. 


The examples of digital tokens can be countless: the certificate of course completion verified via blockchain, which confirms that you finished the course and passed the test or a digital art piece from the Bored Apes collection.  


While essentially all tokens are either fungible or non-fungible, there are multiple different types of tokens, which can be categorised into utility, payment, and security token – a framework spearheaded by the Swiss Financial Market Supervisory Authority (FINMA):  
 
Security tokens are created to represent legal ownership of another asset, which must be verified on the blockchain. Security tokens are simply securities in a tokenized form – typically a share of a business, but also for real estate and other alternative assets. Unlike utility tokens, security tokens don’t have any utility attached to them.  
To determine if the token is a security or utility token, regulators often use the Howey Test (which is originated in the US, but other countries follow a similar rule). This test aims to check if a transaction is considered an “investment contract” and hence a security. If the token passes the Howey Test, it is categorized as a security token and subject to securities law.  
 
Security tokens have the potential to replace or at least complement other securities, such as stocks, bonds, or alternative investments such as funds or Actively Managed Certificates (AMC). However, the way they are regulated makes it very difficult to implement them than other tokens. Security tokens are subject to greater regulatory scrutiny than utility tokens from the US Securities and Exchange Commission. They require full SEC approval to be sold in public offerings to non-accredited investors or traded in the primary or secondary market. 
 
According to reports, the security tokens market capitalisation in November 2021 stood only at $1,1 billion. But the global security token market could reach $3 billion by 2025, growing at 56.9%, compounded annually. [6], [7]

Utility tokens have a value tied to the ownership and therefore ‘can do something’. In contrast security tokens don’t do anything besides representing and storing value and giving the possibility to trade them. The easiest way to describe a utility token is that it’s the token backed up by a project. Utility tokens are released by a company to provide its users with a mechanism to pay for a new digital product of the company or service, often combined with a discount or benefit.  
 
An example of a utility token is BAT (Basic Attention Token), backed by the Brave browser project, a new internet browser similar to Chrome but claiming to be even faster. In exchange for your attention, you can accumulate tokens for browsing and earn 70% of the revenue that Brave receives from advertisers. Another example of the utility token is VRA (Verasity) that can be used in the Verasity ecosystem for different applications: esport, gaming, digital content, and AdTech industries, e.g., you can earn VRA as staking rewards or for engagement on the ad network, as well as use VRA for participation on VeraEsports.  

A special scope of application within utility tokens is so-called governance tokens. Governance tokens represent voting power on a blockchain project. They also allow their holders to stake, take out loans, and earn money by yield farming, e.g., used by DeFi protocols to govern the decentralised network. 

Payment tokens are a unit of value that serves as a means of payment. Examples of pure payment tokens with the largest market capitalisation are the stablecoins USDC or USDT. 
Interestingly, a token is not restricted only to a particular role and could address various roles in its native ecosystem. The example here can be a BNB token that has its application on the Binance exchange platform - it fulfills the role of the utility token as it gives you the right to vote on new token listings, but also the role of the payment token as you can pay fees on the platform using BNB. Tokens with multiple ‘use cases’ are so-called hybrid tokens. [8]


When investing in digital assets, investors should have a closer look into these differences in tokens, which offer different value propositions and investment opportunities. Generally, tokens as digital assets are worth considering as an investment category with a huge upside potential (and for the sure risk involved) and as a means of diversification in any portfolio. As security tokens are mainly treated as an investment vehicle, like the funds or AMCs, but offer general advantages of tokens, we may be curious about how this will evolve in the near future. First, it allows fractionalisation of assets and trading thereof, which is possible 24/7/365 and generally on multiple marketplaces. Once you’re invested in digital assets, another significant advantage is that you do not need to switch back and forth to traditional fiat currencies anymore, as the tokens can fulfill the role of medium of exchange between any digital assets.  

It will be interesting to see how the treatment of tokens as securities evolves and how the major jurisdictions, especially the US, deal with it from a regulatory perspective.

 

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Digital Waves makes a wide range of tokens investable. A partnership between a DeFi player and Digital Waves aims to make this asset class accessible to private investors through a partially rules-based and actively managed investment product investing in the most valuable tokens and most promising applications in the space.

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Would you like to learn more about trends in the tokens landscape? Read our article here!