What Makes Crypto Tokens Disruptive?
Tokens are nothing new. In fact, humanity’s history with tokens dates back at least 7000 years and possibly much longer¹, with many early civilizations including Egypt, Babylon, India and China having employed certificates of deposit to represent warehoused goods.
In essence, a token is just a voucher that endows its holder with a claim to future value² from an asset³. For example:
- a stock certificate is a token that represents ownership of stock, which in turn can be regarded as a claim on a fraction of the future shareholder value generated by a company
- a property deed is a token that represents ownership of land
- a lease is a token that represents the limited right to use an asset⁴
- a bond is a token that represents a claim on interest and principle to be paid by the issuer at some future date
- an insurance policy is a token that represents a claim to a financial payout if certain predefined events occur
- a lottery ticket is a token that represents a probabilistic claim on receiving a future prize
- a theater ticket is a token that represents the right to attend a particular performance and to sit in a particular seat
- a gift certificate is a token that represents a claim on particular goods and/or services from a particular vendor
- a rebate coupon represents a claim to a discounted price for goods and/or services from a particular vendor
The defining characteristic of a token is that it is a proxy or pointer to something of value. It assumes value extrinsically through the assets it represents. The details of the value assumption can be implicit, as when the expectation of value follows from the trust one places in a known or reputable counter-party, or it can be explicitly defined in the terms of a contract or agreement, implying trust in an authoritative arbitrator or intermediary. Either way, trust is the glue that binds a token to its value.
Shortly after the emergence of Bitcoin, and the concept of the blockchain which it introduced, it came to be recognized that a key capability of this technology, namely the solving of the double spend problem, also make it ideally suited to creating cryptographic digital tokens that can represent any arbitrary asset⁵. Because assets are necessarily in limited supply at any given time, digital tokens representing such assets must exhibit the property of being correspondingly limited in supply. Prior to blockchain and smart contracts, there was no way to enforce this property without the participation of an authoritative intermediary (e.g. a legal system for enforcement of contracts).
Standardized protocols for token issuance, allocation and transfer such as Mastercoin/Omni and ERC20 have lowered technical barriers and risks, enabling cryptographic digital tokens to explode in popularity. By 2017, a tsunami of ICOs (Initial Coin Offering), for better or worse, were raising astronomical levels of investment and bringing massive attention to the disruptive potential of asset tokenization use cases.
While the hype surrounding tokens has outpaced the practical impact so far (2018 crypto asset prices notwithstanding), there are indications that the new capabilities unleashed through tokenization will be massively disruptive to a swathe of incumbent business models in a wide range of industries from finance to content distribution. The potential disruption could be likened to that of analog photography by digital photography: cryptographic digital tokens radically transform the economics of traditional tokens by effectively removing the barriers of time and space.
But what are the properties of DLT cryptographic digital tokens that could allow them to unlock so much value?
The Properties of Traditional Tokens vs Crypto Tokens
The properties of traditional tokens generally extend to cryptographic digital tokens, with some notable differences owing to the nature of digitization and distributed ledger technology (DLT):
- Tokens are proxies for assets
All tokens represent assets such that the holder of the token holds rights to the asset⁶.
Holding a crypto token implies controlling the private key of the public blockchain address associated with the token. The private key is important because it has the exclusive capability to sign transactions involving the token, such as its transfer to another public blockchain address.
2. Tokens are physically/geographically decoupled from their assets
All tokens are physically/geographically decoupled from the assets they represent. A transaction involving a token may occur at any arbitrary location that need not correspond to the location in which the extrinsic asset is found.
Crypto tokens go one step further. They are physically/geographically decoupled not only from the underlying assets but from everything. Since they exist only on a public decentralized peer-to-peer blockchain network, they cannot be confiscated or counterfeited⁷. In addition, any number of participants within a token ecosystem can interact in real time regardless of their location.
3. Tokens are temporally decoupled from their assets
All tokens are temporally decoupled from the assets they represent. A transaction in which a token is acquired may occur at any arbitrary time prior to the moment in which the utility of the underlying asset is realized. In other words, the acquisition of the token is temporally decoupled from the utility/delivery of the underlying asset. A ticket for a music concert can be sold months in advance of the actual performance. This is an advantage because:
- by acquiring a ticket in advance of a show, the show-goer reserves a seat and eliminates the risk of being turned away at the door if the show sells out
- by selling tickets in advance, the show promoter can gauge the demand and adjust supply by adding show dates
Crypto tokens can be created, transfered or otherwise processed at a velocity which is orders of magnitude beyond traditional tokens. They can therefore be employed to realize previously inconceivable use cases such as smart-contract based derivatives that perform real time value tracking⁸.
4. Tokens require a trust link to their assets
All tokens require a reliable trust link to the asset value they represent, which can be achieved via collateral, a notarized contract, reputation, etc. It is important to consider how the linkage between a token and its extrinsic value can be enforced. If the trust link is not well established, the extrinsic value of the token’s associated asset will not extend to the token.
The link between crypto tokens and off-chain assets (such as real estate) does not differ significantly from that between a traditional token and its asset (i.e. the link is established through a legal contract, financial collateral, or reputation, etc.). Though we are beginning to see facilities become available to simplify the linking to off-chain assets⁹. In cases in which a cryptographic token represents an on-chain asset, such as another token, the trust link can be implemented through an on-chain smart contract that allows the token to be exchanged for its underlying asset without the requirement to trust a third party intermediary.
5. Tokens have a limited value range for which they are economical
All tokens have a limited value range for which they are economical, owing to the overhead required to implement solutions with them. For example, it may make sense to create a gift certificate for a 30 minute massage, but the overhead required for creating and processing traditional coupons make it impractical to have gift certificates for each second of a message that can be combined to pay for a massage of arbitrary length. In other words, fine grained tokenization is not economical using traditional tokens.
Crypto tokens make fine-grained tokenization economical. The cost and effort for creating and processing them is orders of magnitude lower than for traditional tokens and they therefore enable use cases with very low value transactions.
All tokens assume their value through assets, and therefore, their value cannot easily be transferred to another purpose. Transferring a token’s value to another purpose requires access to liquid markets¹⁰.
Crypto tokens, owing to their standardization (eg. Omni, ERC20, ERC721, etc.) can be integrated into centralized or decentralized exchanges where they can be traded for fiat, cryptocurrencies or other tokens. Depending on the use case, tokens can be designed for any required level of liquidity/illiquidity.
7. Programmability and compliance
All tokens can be “programmed”. For example, if I print “Valid only until December 31, 2018” on a discount coupon, I am programming for the incentivization of coupon recipients to make a purchase before that date. A non-crypto token may be “programmed” in great detail by the terms and conditions of a legal contract but these are subject to applicable laws and interpretation by legal authorities. Getting parties to comply to the terms of “the program” may have significant limits due to the required time, effort and cost.
Crypto tokens are more readily programmable than traditional tokens. Thanks to smart contracts, complex interactions involving tokens can be designed to incentivize participants, respond to changing circumstances, and automate the issuance, allocation and transfer of tokens in an infinite variety of configurations. This flexibility allows for the optimization of tokenomic properties to the maximum benefit of network participants. Most importantly, the interpretation of smart contracts can be objectively predicted given particular input conditions.
There is, of course, vastly more to be said about the disruptive potential of cryptographic tokens. So much research and experimentation is occurring that no article could begin to do the subject justice. Hopefully the points above help to illustrate some of the fundamental principles that make up the essence of crypto token’s disruptive power.
¹ The so-called “Wolf Bone” discovered in 1937 in Czechoslovakia is thought to be an early tally stick dating back about 30000 years.
² I define value as “a benefit that someone, somewhere, would be willing to pay for”.
³ While there are a number of definitions of the word asset, the one that I am referring to for the purpose of this discussion is “an entity that generates value”.
⁴ limited by time or the condition that reciprocal obligations such as the payment of rent are fulfilled.
⁵ J.R. Willet released “The Second Bitcoin Whitepaper” in 2012 describing the basis of the Mastercoin protocol which later become Omni Layer.
⁶ Such as, but not limited to, ownership.
⁷ This is true only to the extent that the network is secure, the private keys remains secret and control of the network remains decentralized.
⁹ Such as trusted oracle services and blockchain based property registries.
¹⁰ It should be noted than illiquidity is not necessarily a bug. For some use cases it is a valuable feature such as when a coupon or gift certificate is used to draw customers to a particular vendor.