A Classification of Crypto-tokens

Published in

towardsblockchain

13 min readApr 10, 2019

Introduction

Blockchain has taken the world by storm. Since the inception of Bitcoin in 2008, cryptocurrencies have grown to the point where the most popular crypto-exchanges quote a net market cap of over $170 billion, reaching an all time high of $ 834 billion towards the end of 2018[1]. It had all started with Satashi Nakamoto’s paper titled Bitcoin: A Peer-to-Peer Electronic Cash System, more popularly known as the Bitcoin Whitepaper, which explained the workings of the first ever blockchain. The genesis block of the first ever blockchain, the Bitcoin blockchain, was mined on 3 January 2009. Since then, the technology has grown exponentially. Within 10 years, it has reached the trough of disillusionment in the Gartner Hype Cycle and is expected to reach the plateau of productivity, the stage where technology becomes widely implemented across several industries, within the next 10 years [2].

10 years of fast growth has seen blockchain branch and expand to cover several applications, ranging from distributed computing to reforming governance to enabling newer financial systems and markets. At the core of all these applications lies the concept of the cryptographic token or simply crypto-token, which performs several crucial roles to enable any application that is built on a blockchain. As an analogy, a crypto-token is to blockchain, what electricity is to a factory.

Presently, CoinMarketCap alone lists over 2000 crypto-tokens, most of which have emerged over the last 3 or 4 years. The deluge, and the fast-paced events of the past 2 years have left most people overwhelmed when it comes to blockchain and crypto-tokens. In this report, we try to delve into the world of cryptocurrencies and attempt to classify to gain a better understanding of their functions and what we can do with them.

A Brief History of Blockchain

Why It Matters

Blockchain technology is set to revolutionize the future, already offering significant business benefits over legacy systems such as improved transparency, security, auditability, efficiency and speed. It has proven to be exceptionally effective to improve the financial sector, amongst others, by automating transactions. It could also be argued that blockchain technology is the most suited for any kind of application in the fintech industry, as it provides one of the most efficient ways of complying with regulatory requirements while also providing the service in an efficient, and cost effective manner.

More importantly, large investments are being made in blockchain. VC funding grew from $876 million in 2017 to more than $3 billion in 2018[3]. That is a growth of almost 250% in just one year. Non institutional funding in the form of ICOs also saw a huge raise, rising from $5.4 billion in 2017 to $16 billion in 2018, almost tripling in size over one year[3].

While the technology is still immature and unsuitable for large scale adoption, it is under development, and once ready, it can prove to be the ideal solution for several industry problems, especially in the public sector, financial sector, technology, media and telecom.

Already, the government of Estonia has successfully shifted onto a digital governance system built on top of blockchain. Several other governments across the world, including those in the USA, India, Switzerland and the UAE, to name a few, have invested in several projects to test the viability of blockchain in governance, voting, identity management, land record registry etc.

There is no doubt that blockchain is here to stay. Independently, the technology already has the potential to provide security, efficiency, speed and cost savings at a scale the overshadows the existing systems. However, when combined with complementary technology such as AI and IoT, it can bring us one step closer to achieving the dream of complete automation, by enabling smart factories, smart cities and smart economies. For an individual who might have to one day rely entirely on crypto assets to live in a smart city, an understanding of its various types and their significance can make the vibrant ecosystem less confusing and easier to understand.

A Classification of Crypto-tokens

Crypto-tokens, while based on the same concept, vary in terms of their functions, effects and roles on their respective blockchain networks. With the use of smart contracts, tokens transactions can be used to trigger several more events, adding more utility to the blockchain application. Tokens have also been as a way to store value as well as distribute rights. Based on their use, we can classify tokens into 3 major categories, which can then be further classified as shown.

Payment Tokens

Payment tokens are possible the simplest type of crypto-tokens to exist. Also known as cryptocurrencies, these were the first crypto-tokens to be created. These tokens are used for the sole purpose of transferring value, or making payments for any kinds of goods or services. These tokens however, do not have any additional utility. They can be transferred from one wallet to another using the underlying decentralized protocol, and the records of the transaction are made on the underlying blockchain network of the coin. The most famous example of a payment token is the Bitcoin, which was also the first crypto-token to be launched.

Following the launch of Bitcoin, there were several other tokens (such as Litecoin), termed as altcoins, which replicated the purpose of Bitcoin, but failed to achieve its popularity. Now, Bitcoin and other cryptocurrencies have gained a lot of hype, especially amongst investors wishing to make a quick buck off trading in cryptocurrencies. However, a major issue with investing in cryptocurrencies is the fact that the market is highly volatile, with prices capable of swinging up and down in a highly unpredictable manner. This exposes investors to risk, but more importantly, the cryptocurrency loses its value as a means of payment, as $ 50 paid via Bitcoin could become with $ 25 before the transaction is even complete. In order to solve this issue, programmers introduced the idea of the Stablecoin.

Stablecoin

As the name suggests, the value of a stablecoin is fixed, or stable. It is usually pegged against the value of some fiat currency. For example, USD Tether is a stablecoin whose value is always 1$. The major advantage of stablecoin hence is that its value will always remain constant, making it an efficient means for payment. There are different systems which are used to ensure that the value of a stablecoin remains constant. Based on the kind of system used, stablecoins can be further categorized into 3 types[4]

Fiat-collateralized Stablecoins

Fiat collateralized stablecoins are issued by a centralized institution and are backed by fiat reserves, which are held by the issuing organisation in its one or more bank accounts. Whenever someone deposits fiat into the bank account associated with the stablecoin, new coins are minted by the network and sent to the depositors wallet. Conversely, if the stablecoin is liquidated in exchange for fiat, the coins are burned, and the collateral is returned. In its essence, a single stablecoin acts as a digital IOU contract between the holder and the issuer.

A major issue with fiat-collateralized stablecoins is that it is based on a centralized system, which required trust in a third party organisation which holds the fiat and issues the coins. This makes it vulnerable to fraud and scam, while also leading to intense regulation. Popular examples of fiat-collateralized stablecoins are USD Tether(USDT) and True USD(TUSD). The two coins are widely used on exchanges, as an alternative to BTC and fiat markets.

Crypto-collateralized Stablecoins

Crypto-collateralized stablecoins arose an alternative to fiat backed stablecoins. These are generally built using a system of smart contracts, rather than banks, to store deposits for collateral, and as a result provide more security and transparency. The common idea between all types of crypto-collateralized stablecoins is that the stablecoins are backed by a limited supply of on-chain digital assets, which are locked into ‘deposits’ via smart contracts. These deposits can be withdrawn by effectively liquidating the stablecoin in exchange for the backing crypto-asset.

A prominent crypto-backed stablecoin was introduced by the MakerDAO project, which uses a 2 coin model — the Makercoin (MKR) and Dai, MKR acts as a token to govern the system built on top of the Maker platform, whereas Dai is the stablecoin. Dai is issued against deposits of Ether by locking it up in a collateralized debt position (CDP) by means of a smart contract. The Ether deposits are pooled and the interest is calculated over time. The deposit can be withdrawn by returning the same amount of Dai that was initially ‘borrowed’ against the deposit, regardless of the actual value of the Ether deposit. Other mechanisms for crypto-backed stablecoins also do exist, such as the one used by project Havven.

Non-collateralized Stablecoins

Non collateralized stablecoins form a whole new and interesting class of stablecoins. Instead of being backed by an existing asset, the value of these stablecoins are maintained by controlling the supply of the stablecoin itself. Non collateralized stablecoins function on the concept of seigniorage shares, which was introduced in 2014 by Robert Sams. In this concept, smart contracts are written to mimic a central bank with the sole objective of issuing a currency with a fixed value. Hence, that smart contract automatically adjusts the total supply of the coin in the market by issuing or burning coins as required. For example, if the value of the coin is to be pegged at 1 USD, but exceeds 1 USD, more coins will be issued by the network until the value is brought back down to 1 USD. Conversely, coins are bought or destroyed by the network if its value falls below 1 USD.

Basis[5] is one of the leading projects in this area, which functions by maintaining three different coins, two of which act as bonds or shares, and the third as the actual stable coin. The coins representing bonds or shares help control the supply of the stablecoin and hence help stabilize its value.

Utility Tokens

ICOs rose a popular form of raising funds as an alternative to traditional VC funding. It allowed companies to maintain control of their projects while having access to sufficient funds. As an added advantage, it also helped build a community for the project even before its launch, guaranteeing a number of users at the time of launch. The coins offered in such ICOs can be termed as utility tokens. Simply put, these are tokens which are initially issued for the purpose of fundraising, but can later be used to purchase products and services from the issuer.

Projets which issue such tokens are generally aimed at building applications on blockchain networks. The utility tokens hence allow holders to access these applications and avail its services directly. The value of the utility token is hence determined by the perceived value of the services it provides access to.

As a simple example, consider the Golem (GNT) token. The token was offered in an ICO which raised $ 8 million. The funds raised from the GNT token are being used to develop a blockchain which forms a distributed computing network which can be used for computer graphics, video rendering, big data analysis and other computing intensive tasks. Once the platform is live, users can spend their GNT tokens to borrow computing power from the network, and will be rewarded in GNT tokens for providing computing power to the network. GNT here acts as a utility token.

Utility tokens are actively traded on crypto-exchanges by traders looking to make profits off its price movements. The general idea is that the value of the token is driven by the number of ways it can be used on its platform or applications, as well as the value of the application in terms of the real-world problem it tackles.

Security Tokens

Security tokens form a very different class of crypto-tokens. The concept of a security token arose as a result of a dispute between the SEC and DAO, a project being built on Ethereum. The SEC argued that the tokens issued by DAO were a form of financial securities, and hence were subject to similar stringent regulations.

A security token is defined as any crypto-token that passes the Howey Test. These are tokens which are backed by some external tradeable asset. The major benefit of security tokens over the traditional assets that they represent is that they offer more liquidity and simplify regulation for these assets in an efficient manner. They also help increase the pool of investors for such securities, ultimately unlocking newer financial assets anNEd improving the market.

Security tokens can be viewed as new types of financial derivatives, whose value is derived from some underlying asset. A major difference between security tokens and utility tokens are that security tokens are offered and traded while ensuring regulatory compliance in their jurisdiction. This means that not everyone can buy or sell security tokens, and even then, there are several other restrictions they must comply with at any point of time. Security tokens are issued via Security Token Offerings (STOs) on specially designed platforms which encode the regulatory requirements into the blockchain on which the token is issued. Even the exchanges they are traded on are specialised so as to ensure that no trade violates any rules set by the regulatories bodies in their jurisdiction. Another property of security tokens is that they give certain rights to the holder, much like how shares give rights to the shareholders. These rights include voting rights, the right to sell the token back to issuer etc.

Security tokens are still a very new form of crypto-tokens, leaving a lot of potential for development. Polymath is one of the most promising projects in this area, which is essentially trying to create something similar to Ethereum, but for security tokens. Securitize and Smart Valor are some other promising projects in the field. The development community is still engaged in discussion on forming or selecting a uniform standard for security tokens. Few of the platforms mentioned above have also introduced their own standards.

Security tokens can be further classified into three types depending on the asset they are backed by.

Equity Backed Security Token — These tokens are similar to traditional equity. The holder of these kind of tokens are entitled to voting rights, as well as receiving dividends from the company whose equity the token represents

Debt Backed Security Token — These tokens represent debt instruments such as mortgages or corporate bonds

Asset Backed Security Tokens — These tokens can be backed by any real world asset. Some examples of such assets include diamonds, real estate, ships etc.

Most security tokens in the current ecosystem are functional only in private finance, i.e., only accredited investors are able to trade in these tokens’ primary and secondary markets. However, there is a general consensus within the community that the aim is to open such financial investments to all kinds of investors in the future as well.

Summary

We see that crypto-tokens cover a diverse type of uses and derive their value from multiple sources. The future might see more types of crypto-tokens emerging, deeming the current classification as discussed irrelevant. While we wait for that to happen, the classification discussed above can suffice to understand how tokens can be classified on the basis of their functional purpose. Regulatory classification however, is a different ballpark, and can apply differently in different jurisdictions. Furthermore, very limited countries have frameworks to provide an adequate classification of cryptos for the purpose of regulation. However, as blockchain develops as a technology, more use cases arrive, and the technology grabs the attention of governments in all countries, frameworks are sure to appear within the next 3–5 years. The future of crypto-assets is very bright. They will soon become an integral part of how the world will function and will become as common as money itself.

Glossary

Bitcoin — The first cryptocurrency ever introduced. It was made by the group or individual known as Satoshi Nakamoto in 2008. It is the most popular cryptocurrency to date.

Blockchain — A distributed ledger technology which records all transactions made using the native crypto-token. Blockhcain acts as the backbone that enables the use of any crypto-token as well as applications that are built on it. The ledger records transactions cryptographically and stores them as a single chain of blocks which are ordered in a chronological manner

CDP — CDP stands for Collateralized Debt Position. It is a special kind of smart contract which locks a certain amount of Ethereum in exchange for Dai, and helps maintain the stability of the Dai coin

Crypto-Exchange — A centralised or decentralised platform which allows token holders to buy and sell tokens by executing buy or sell orders.

dApp — A dApp or a decentralized applications is an application that is built on a blockchain platform and can provide the benefits of blockchain to the users of the application

Ethereum — Ethereum is an open source blockchain platform and operating system introduced by Vitalik Buterin in 2015. It allows developers to build applications on the blockchain using smart contracts

Genesis Block — Genesis block is the first block of a blockchain.

Hard-Fork — A hard fork refers to the splitting of a blockchain into two components, with each new component having new protocols

Howey Test — The Howey test is a test created by the US Supreme Court for determining whether certain transactions qualify as investment contracts or securities

ICO — An Initial Coin Offering (ICO) is an event in which a project sells utility tokens to investors to raise money. The utility tokens are expected to have some kind of utility on the project being developed. It can be considered to be analogous to an IPO.

Satashi Nakamoto — Satoshi Nakamoto is an anonymous individual or group who is credited with creating the first blockchain(the Bitcoin Blockchain) and crypto-token through the whitepaper released in 2008

Wallet — A wallet is a software program that allows users to store their crypto-tokens by recording their public and private keys and interacting with various blockchains to carry out transactions.

Whitepaper — A whitepaper is functional document published by a team explaining the various technical aspects of some project the team is working on.