The Three Types of Tokenization in the Long-Run

As we move toward the end of 2018, we have a lot to reflect on for the year within the world of cryptocurrency.

In the beginning of the year, the SEC began issuing subpoenas to many of the non-compliant ICOs that sprang up before and during the ICO Mania of 2017. Throughout the year, the SEC has been going after a lot of the low hanging fruit to establish litigative precedence for the future. They also seem to have taken a deliberative approach to assessing where cryptocurrency futures lie.

The CFTC, meanwhile, has warmed up to a lot of potential that the cryptocurrency ecosystem offers, though they still have some figuring out to do as well. ICO launches seem to have been at a low this year, as law obscurity and proactive litigation by regulators, have disincentivized the “rush to market” mindset. For similar reasons, recent startup companies with token offerings centered around cryptocurrency-based offerings have been meticulous about prioritizing compliance over innovation during this “Year of the Security Token” in an effort to avoid massive fines or jail time.

On the corporate front, blockchain incumbents like IBM Blockchain and Consensys continue to make strides, while enterprise giant after enterprise giant after enterprise giant make their way into the fold. The ecosystem overall has consolidated further with consortiums joining forces and market factors culling the weak. Sufficed to say, this year has seen a few big players get involved, and the next few years will see who can really stand the test of time.

With this in mind, I think it would be prudent to really give a thoughtful evaluation of where we are now and where we are headed. The way I see it, right now we still have a divided ecosystem that has certain misconceptions about the way the world works. Although that’s a bit of an arrogant thing to say and something where I can theoretically be disproven, when the day comes where everyone signs on to use Bitcoin or Ethereum as a currency, I’ll concede.

It is my belief now that the sands of time will render public ledger, decentralized cryptocurrency to be valued in (virtually) only four fashions:

(1) as a novelty token with sentimental value to those who were members of the ecosystem in its heyday;

(2) as a gambling and illegal-purchase-based currency, circling back to its roots in Silk Road;

(3) as a form of currency for B-grade markets that legally can be used, but is discouraged to be used due to a lack of controls;

and (4) as an alternative currency for the people of authoritarian, abusive regimes.

While we’d still be (many) years out, I believe that centralized, regulated cryptocurrency models will come in to replace the decentralized models for the majority of economic activity and value storage. To be clear, I do believe that tokenization will transform the vast majority of societal infrastructure in the long-term. However, the road to get there will be a long one, and will probably exist outside of our lifetimes. There will be very contentious conversations over time about placement of the line between individual privacy vs government oversight accesses. I think there are some “Option C” choices which I’ll get to in later sections.

It is my belief that there will be three types of tokenization pervading daily operations of the future. They are as follows:

Transactional

Transactional tokens are what people will use for commercial activity in the future. Each token will be constructed as a fungible token, and will serve as a unit of currency. This sort of token will be used to buy and sell goods and services between individuals, companies, and institutions. It will need to be nationalized in order for this transformation to take place, with each nation having their own nationalized token, and having its token currency supply & controls overseen by regulators of that nation. Depending on the future of the single-currency policy, the transactional token will displace or complement the nationalized one-fiat currency model that we have in place today. The monetary and fiscal policy will mirror that which we have in place today. Price will be held artificially stable by inflationary/deflationary measures every quarter, just in the same way we have currently. Anybody from any country that has Internet freedom will be able to query the currency supply of each nation, ensuring no currency manipulation.

In addition to having the backing of the nation’s monetary authority, different agencies within the nation’s government will have direct or indirect access to certain metadata regarding each token. Depending on the legislation surrounding privacy rights, watchdog agencies and 3rd party auditors may serve to validate citizen data rather allow governments direct access to it. This data will largely include the identities of parties transacting on both sides of the token, the date/time of the transactions, and the quantity transacted. With controls embedded directly into the metadata of the token, the government will have access to freeze token supplies and do forced transfers of tokens. This will be done only with proper authorization through the court system, and only for the purposes of stopping criminal or terrorist activity.

Speculative

Speculative tokens are what people will use for speculating on commodities or securities. Speculative tokens will be non-fungible tokens, but function largely as fungible tokens. Speculative tokens, unlike transactional tokens, will be volatile, unpredictable, and have multiple different kinds within a national jurisdiction. Each exchange will likely have its own speculative tokens, and the only way to get speculative tokens is by exchanging transactional tokens.

Within commodity exchanges, there will be sub-speculative (ie commodity) tokens representing a unit of the commodity. These commodities can have different quality grade seals-of-approval highly correlated with the quality grade seal-of-approval of the exchange. These quality grade seals-of-approval will be determined by the exchanges’ legitimacy, liquidity size, reputation, and openness to government regulation/oversight. For these reasons, there will be a hierarchy of different exchange grades, with exchanges like the CME gaining A status, while cryptocurrency markets gain B or C status. Regarding the sub-speculative tokens representing each commodity: they can be transferred off-exchange, but will carry its quality seal with it. The exchange token and the commodity token valuations are left to the free market, but have certain checks in place by the regulatory agencies. It is in the exchanges’ best interest to maintain a high token value, and they can do so by vetting their broker-dealers, providing transparency to customers, and by playing ball with the commodity-trading regulatory agencies.

Within securities exchanges, there will be securities tokens. Following the similar template of commodity tokens, individuals buying security tokens must first buy the individual security exchange token. Companies looking to list their securities tokens on an exchange can do so by making an agreement with the exchange, and the listing fee will largely be based on the current valuation of the exchange token. Like commodity exchange tokens, each security exchange token will be determined by similar factors.

For all exchanges, regulatory agencies will monitor all activities, and exchanges that self-regulate the most effectively will be better positioned to have a higher exchange token value. Watchdog agencies and 3rd party auditors may be needed at times to provide objective investigation and arbitration. Down the line, future models may see international investment rules, and even international exchanges, but that is only a possibility and would require evolution of this multiple-within-a-nation model first.

Foundational

Foundational tokens are the tokenized identities of people, property, and institutions. Foundational tokens are non-fungible tokens, and will have varying levels of government oversight when it comes to distribution, data changes, and visibility. These tokens largely function to identify certain things and people, and to contain certain data about them. Certain foundational tokens will have the ability to issue sub-foundational tokens (also NFTs), while others will be constricted by regulation and so will remain as a singular token.

People

Tokens will serve to represent an individual’s identity. Individuals will be given identities at birth, the same way they are now, except now there will be a token that reveals the history of the individual. The personal identity token will show all of the transactions that the person has ever made using transactional tokens, and will show all of the speculative or foundational token assets that the individual owns. It goes without saying that there will need to be checks in place so that governmental regulatory agencies don’t go full ‘Minority Report’. A few options to maintaining privacy would be to have most government access restricted, and only allowable through the opt-in of the individual. Additionally, there may need to be 3rd party auditors and watchdog agencies that oversee the investigations of individuals when it comes to judicial arbitration, rather than providing direct government surveillance carte blanche. As well, zero-knowledge proofs, zk-STARKs and other data structures provide interesting possibilities for confirming user data, without being able to view or otherwise discover what that data actually is. For these user identity tokens, externally-obtained or internally-split regular tokens and sub-tokens would be shown as data of the user identity token that the individual could then view within the portal. This data could be all of the licenses that person has gotten, all of the purchases made, all of the insurance coverage that person currently has, tax status etc. The ability for an individual to issue his own subtokens on this profile token is still yet to be determined in my mind, but I do see that different tokens generated from institutions can enter into the individual’s token profile (eg NYS Driver’s License).

Property

Tokens will serve to represent the identity of some sort of commercial asset. In the beginning, high valuation assets like real estate, vehicles, and technology will be tokenized. As regulation becomes more ubiquitous and technology advances allow for it, regular consumer goods will become tokenized as well. The process of effectively managing tokenized assets at all touchpoints along the supply chain will require regulatory oversight. Tokens and subtokens will need to be able to be interchanged by a higher authority in the event of a material change of the asset (eg a tornado destroying a house). Certain tokenized assets can be given authorization by the servicer and regulating bodies to further subdivide into more granular tokenized assets.

An example of a highly-regulated asset with an identity, represented by an NFT that could break down into further NFTs, would be a piece of real estate property. This piece of real estate could be broken down into subassets including the house, the land, and the environmental factors on the land. These subtokens would then hold all of the data surrounding the individual subassets (eg the blueprints for the house, the geomap for the land, and the fuel and electricity line placements for the environmental factors). Supposing there was a tax on all three components, the municipal housing authority could easily collect the tax on each component by setting up smart contracts with each subtoken. Additionally, if there are changes to any of the three components (eg renovations, changing landscape, new environmental considerations), there could be mandates in place for the individual to go directly to the municipal housing authority to have them swap out the subtoken (perhaps after an audit of the house, land etc).

Probing deeper into the possibilities, with proper oversight in place individuals could theoretically go as far as to utilize their digital rights management with the subcomponent tokens. With the house subcomponent, for instance, if a housing developer is passing by and decides he likes the look of your house and wants to take advantage of it, you could duplicate your ‘house’ token (with only certain rights and accesses available) so that the housing developer could take advantage of the blueprints to your house. This could all be done with a smart contract, where in turn for selling or leasing your blueprints, and potentially other rights (eg like being able to sublicense the blueprints to other housing developers), you will receive some amount of money in return.

An example of a consumer-facing asset with an identity, represented by an NFT that could break down into further NFTs, would be a computer. Imagine that your specific personal computer has a digital identity represented by an NFT where you can go online to a portal and see all of the subcomponents of the computer. The different components surrounding the computer token would be represented by drop-down categorization. Maybe, for example, if you aren’t a computer technician or software engineer the hardware and software components wouldn’t interest you and so you wouldn’t look at the ‘hardware’ or ‘software’ categories of that product’s token listing; but if you are a consumer, the ‘warranty’ category might interest you, where you can view the warranty information directly from your product’s token profile. From here, you could see the content of the warranty, the time remaining on the warranty, and even go as far as to set up to extend the warranty directly with the manufacturer through a smart contract.

For some firms, commodities purchases will no longer remain commodities and will become instead raw materials for a manufactured item (eg palladium in a catalytic converter). Taking into account both classes of tokens, there would need to be a regulatory body in place to oversee the transition of commodities (and commodity tokens) to property (and foundational tokens).

Institutions

Tokens will serve to represent the identity of governmental, non-governmental, and business entities. Much in the same vein as personal identities, corporate and governmental institution identities will give the ability for the entirety of the organization’s profile to be viewable within the token (to the extent than internal and regulatory controls will allow). Through use of this token as a representation, bureaucratic, municipal, and business interests become more easily met through enhanced traceability, commercial viability, and internal management. It would draw similar parallels to the personal identities in that there would need to be 3rd party auditors and watchdog agencies to ensure data rights can be maintained whilst enabling certain data to be released as needed by the regulators. Depending on the classification of the institution, the ability to create NFT to represent various departments and organizational components will be overseen by the pertinent regulatory body.

One example could be a manufacturing firm that makes widgets. Provided supportive legislation, the manufacturing firm could have the autonomy to subdivide its profile token into various departments, and then further subdivide those departments into process cohorts. From those process cohorts, individual tokens could be subdivided further by client, process etc. These tokens would then host and secure the data obtained from other departments and outside entities, and would require execution of a smart contract in order to reveal such information. With certain regulatory agencies having certain visibility and data withdraw access, some processes can be streamlined, such as delivering taxes to the IRS directly at point-of-sale.

Conclusion

I imagine that some may disagree with certain assumptions made in this estimation of the future of tokenization, and so I implore feedback on this. I recognize this to be incomplete in thought, and some of that boils down to not hashing out each specificity for the sake of time, space, and granularity (there will be follow-up articles). The core function of this piece was just to outline my perspective of where the world is headed down when it comes to tokenization.

In a nutshell, a lot of the assumptions made above are rooted in the belief that regulatory oversight and regulatory backing are what will maintain economic stability and identity issuance. While not a perfect metric, human history has shown that the government has always had a role in establishing order and maintaining economic prosperity (ie show me a prosperous nation without a government). I don’t believe this will change. I believe that the government will always serve as a sort of safety net when economic swings set the economy back, and that the government is the only force for ensuring that internal and external bad actors are punished and realigned. While I believe that national, state, and local governments always need to be kept in check to avoid rent-seeking and corruption, I believe they are a force of societal functionality.

Looking at it from the other side, I don’t see a model where decentralization will provide stability (at least any time within the foreseeable future). With a common psychological understanding of economic strategies surrounding supply and demand, the idea of an economy left in the hands of the people will see it gamed from the beginning, and society failing as a result of short-sightedness. What we trust in our dollars currently is that the government believes and legislates in fairness, and I believe this to continue onwards as new technology opens the door to more efficient and consolidated commercial activity.

While this article is posted here, it’s posted elsewhere as well. In an effort to create a cross-platform discussion, I invite you to expand on any thoughts you have here in the comments as well as over on treadie, which is very much a microcommunity twitter. The reason I use treadie is because (1) it’s free, signup only with Facebook or Twitter; (2) you don’t get the walled garden of only one platform comment section, instead combining everyone for discussion. Link: https://tttotitlr.treadie.com/

Distributed Ledger Consultant; Working toward bringing together DLT within the social, investment, and regulatory realms.

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