Tokens are nothing new and existed long before the emergence of blockchain. These programmable assets or access rights are used widely in the financial sector to represent financial assets like stocks or bonds. However, they have many applications outside the financial sector, such as certificates to bestow certain skills or open badges. They are also used as an authentication method in identity solutions. The advantage of using blockchain to generate tokens is that there are lower issuance and management costs involved. Using blockchain, a token can easily be issued and securely traded without an intermediary or escrow service. While digital assets are currently controlled by centralized trusted parties, such as banks and central exchanges, blockchain tokens can be issued with a few lines of computer code. The blockchain makes sure the token infrastructure is publicly verifiable and mathematical rules can be used to prevent double spending and counterfeit tokens. The use of blockchain-generated tokens could reduce fraud and corruption significantly in supply chain and financial transactions. It could also lower entrance barriers to create marketplaces for products and services that are not currently tokenized, such as art or real estate. In this blog, we will explore blockchain tokens and their potential applications. First, let’s explore the differences between cryptocurrencies and tokens.
Cryptocurrencies vs tokens
The first blockchain use case was Bitcoin. This cryptocurrency leverages the Bitcoin blockchain to prevent double spending and settle transactions without a bank as intermediary. Bitcoin also serves another purpose: to reward miners that validate the network. Without Bitcoin, there wouldn’t be an incentive to keep the Bitcoin blockchain up and running. Using consensus algorithms, Bitcoin incentivises good behaviour. Trying to undermine the system is a waste of resources, and users are rewarded when they help the system become stronger. At this point in time, there are no public, permissionless blockchains that can guarantee the security of the network without the use of a cryptocurrency. A cryptocurrency is always built directly into the protocol and it’s meant to pay the validators to keep the blockchain secure. This is also the difference between a cryptocurrency and a token. A cryptocurrency will always be based on its own stand-alone blockchain. They are built directly into the blockchain protocol. By contrast, you can create tokens that are hosted on one or multiple blockchain platforms, and even exchanged between platforms. Most tokens are currently hosted on the Ethereum blockchain and follow standards such as ERC20 or ERC721. Let’s delve into some use cases in the financial sphere.
Using tokens for decentralized finance
As we discussed earlier, Bitcoin prevents double spending and removes the need for central trusted parties by leveraging blockchain. Still, it hasn’t fully replaced money or, at least, been embraced as a replacement in a widespread way. There are many reasons for this. First, while there are solutions in development that improve transaction speed and fees (such as the lightning network), Bitcoin transactions are still very slow and expensive. Second, using Bitcoin isn’t very user friendly. Users have to manage their own wallets and keys, and if they lose their wallet, they lose all their Bitcoins. Smart wallets are emerging to address this, but with banks, a user can simply ask the bank to reset their account to regain access. If the user were to lose money due to some kind of phishing attack, they would be insured and can get their money back. With Bitcoin, this isn't the case. But that’s not even the biggest problem. The biggest issue that hinders Bitcoin adoption is its volatility. Some people claim this volatility will decrease over time, and as the number of Bitcoin users increase. Tokens are playing an important role in decreasing this volatility, and there are many examples built on top of existing blockchain protocols which are worth exploring.
One way to get around volatility is to use tokens to create so-called “stablecoins” tied to the dollar or euro. There are different types of stablecoins. Some have literal dollars as collateral, which are generally managed by some third party. Tether is an example. This violates the whole idea behind blockchain in a sense, since we have to trust a third party to secure this collateral in the first place. Besides, this central party is a single point of failure. If the third party goes bankrupt, the stable currency would be reduced to zero. The challenge is creating stablecoins that are decentralized. Dai, created by MakerDAO, is an example of a decentralized stablecoin. MakerDAO achieves stability using smart contracts, the most important one is called the CDP. Investors can lock-up ether in the CDP to create Dai, where the ether acts as collateral. Dai is always overcollateralized. So, to create $100 dollars of Dai, approximately $150 of ether needs to be locked up. This amount differs over time. The complete mechanisms behind Dai are rather complex - we would need a separate article to explain them. To keep it short, investors in Dai basically speculate on the ether price. By locking up ether in the CDP, they either make more profit as the ether goes up or lose more money as the ether goes down. To keep Dai stable, the locked ether is sold to the highest bidder during an auction when ether falls below a certain threshold. If ether rises, on the other hand, the investor will be able to buy back the ether for the original price in the CDP while also earning extra interest. The system comes with a risk: when the market crashes too fast, this mechanism will fail. Luckily MakerDAO also has mechanisms in place for this scenario and has been extremely stable thus far. It’s viewed by many as one of the most successful projects implemented on ethereum.
A tokenized central bank currency
Another approach to create a stablecoin is tokenizing fiat currency. Many banks are experimenting with blockchain and looking to create a tokenized central bank currency. Many are studying the advantages of Bitcoin quite closely, for instance when it comes to international money transfers. Using traditional banking systems, this requires a lot of time due to the bureaucracy involved and different systems having to communicate with each other. Bitcoin has proven to be an easier and faster solution. Financial institutions can create a blockchain of their own, with banks being the nodes, in order to reduce bureaucratic hurdles and costs for cross-border payments. The challenge here is for different banks from different countries to agree on the governance structure and standards, which, in our experience, is more difficult than most technical challenges. There are also initiatives that may start smaller, on a national or european level.
Tokens in other defi projects
Decentralized finance (defi) is much broader than just having a stable currency for spending. Decentralization can also be achieved by tokenizing assets, bonds and other financial instruments with the goal of making the financial sector more efficient and accessible. Take, for instance, real estate. Currently, only people with a lot of money can enter this sector since real estate is generally very expensive. It is possible to tokenize real estate and have people buy pieces of a building to lower the entrance barrier for investment. There is also a lot of efficiency to be gained using decentralized finance when trading these assets. Currently, trading financial assets requires a central trusted party to oversee the trade. Using defi these trades can be performed peer-to-peer. Decentralization can also reduce the amount of paperwork needed for these kinds of transactions. For instance, when buying real estate a notary is typically involved and the buyer needs to provide all kinds of information from different sources, which requires validation. Having a distributed platform can make this system much more efficient by removing the need for a middle man when trading assets.
Besides tokenizing assets, you can use tokens to decentralize insurance, decentralize prediction platforms and many other use cases. Some promising ones can be found here.
Using tokens outside of the financial sector
Tokens can also be applied outside the financial sector. A token can prove ownership of assets or achievements. Crypto kitties are a funny example on the Ethereum blockchain. Krypto kitties could be bred and traded with others. Some were sold for millions of dollars. The kitties’ unique (c)attributes were stored in a ERC721 token. Every ERC721 token is unique and can’t be copied. Although Krypto kitties are not exactly useful, the underlying technology can have more practical applications, such as the creation of digital twins. An example would be Everledger, where the unique properties of diamonds are stored in a token to prove someone’s ownership over the diamond. The token can also be used to store the entire provenance of the diamond.
So far, we have explored how tokens can be used to represent financial instruments or assets, but they can be used to represent other things as well. For instance, they can be used to tokenize achievements in education or human resources. Currently, we spend a lot of money to validate certificates and ensure they aren’t fake. Universities and governments are looking into tokenizing achievements. Rather than just getting a degree, you could earn badges which are stored on the blockchain. Using your blockchain wallet, you can then prove ownership of those badges and create a portfolio of all your achievements. This would help users provide a complete and reliable portfolio more easily. HR departments would benefit as well since they would spend less resources on validating CVs. Tokenizing achievements will not only give a more complete and reliable picture of your achievements, it will make graduating more efficient as well. When you complete all the requirements to get your degree, it often takes several months before you actually get it. This even happened to me when I graduated from university. I got my certificate 4 months after I got my last grade. In the meantime, I got hired by my first employer and they required the degree to give me a certain pay rate. I was lucky enough to get help from a professor, who assisted me in securing proof of my degree from the administration. This helped me get higher pay. By tokenizing achievements, we can automate this process and simply create a badge when the last requirement is completed. Getting the actual degree is then only ceremonial.
Besides providing proof for achievements, tokens can be used to create decentralized communities, which is something colony.io is working on. Colony wants to make it easy to create a decentralized autonomous organisation (DAO) which can be used to create new communities where money, decisions and shares are managed collaboratively. If we combine this with the portfolio we talked about in the previous paragraph, we could make it easier to hire the right people without having to actually see and test them. Organizations can use Colony to easily find the person most suitable for a specific job. Colony has also introduced a reputation token which increases or decreases if a person did the job correctly. Every time someone is hired for a job, a smart contract is signed containing tokens that are released when the job is done. The reputation token also decreases over time, since not doing anything for several months or years generally reduces a person's skills.
As we explain above, blockchain tokens have many use cases beyond preventing double-spending and cryptocurrency counterfeits. When trading assets, bonds or other financial instruments, it is important to know they aren’t double spent or counterfeit as well. The distributed characteristics of blockchain can potentially help make these industries more accessible and efficient. Even outside the financial sector blockchain tokens have potential. For example, in education they can be used to provide proof of achievements or degrees. At this moment there are countless initiatives working on tokenized solutions, some creating completely new markets such as decentralized communities. Wondering how tokens might benefit your business? Feel free to contact us.