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WHAT ARE DIGITAL TOKENS?

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Terminology is evolving quickly. While bitcoins and other
cryptocurrencies are all referred to as ‘digital tokens’ in a generic sense
(as in ‘a Bitcoin is a digital token’), a distinction now seems to be
emerging between cryptocurrencies, such as BTC and ETH whose coins
are tracked on their respective blockchains, and tokens which are usually
issued by an issuer during an Initial Coin Offering (ICO) and tracked
within smart contracts on Ethereum’s blockchain. The word ‘token’ can
mean different things depending on the context in which it is used191.
What are tokens? What is a digital token? Why is it important?
It is easy to understand what a ‘token’ is in the physical world. Think of
round plastic things like casino chips, beer vouchers, or fairground ride
tokens. Essentially a token is something which is issued by an issuer (the
casino, the beer festival organisers, or the fairground) and can be used in
a specific context or in a specific marketplace, perhaps under specific
conditions or timings. The token has value because the context gives it
value, but if you take the token outside the context the value decreases or
falls to zero. While a $5 casino chip is worth $5 inside a casino, it would
be worth less on the other side of the world. And fairground ride tokens
would not be worth much, if anything, outside the context of the
fairground.
But what do people mean when they talk about digital tokens? If you
digitise a beer voucher or casino chip does it become a digital token? Is a
balance in a PayPal wallet a digital token? Is a bank balance a digital
token? What’s special about a Bitcoin?
The characteristics of the different types of token vary widely, and
generalisations lead to confusion. In this section, I hope to clarify the
different types and characteristics of tokens by differentiating between
blockchain-native tokens like BTC and ETH, asset backed tokens like
IOUs, and utility tokens that can be spent on goods or services at a later
date, usually recorded within smart contracts on the Ethereum
blockchain as ‘ERC-20’ standard tokens192, but may also be recorded on
other blockchains.
Owning a Token
We can be more specific and use the term cryptoasset. Ownership of any
cryptoasset, whether it is a cryptocurrency or a token, is vested in the
person who has the private key that corresponds to the address with
which the token is associated. This private key allows that person—the
owner—to create and sign transactions releasing the token and assigning
it to someone else. In some respects, cryptoassets are like bearer assets—
if you hold the private key, it is yours193.
The rules of blockchains require that if a token is to be sent (i.e., if a
payment to be made), the transaction must include the digital signature
related to the token’s current address. This digital signature is validated
by all of the blockchain network participants. The digital signature acts as
a single point of authentication to signal that it really is the address
owner who is making the payment instruction.
With online banking, in contrast, you prove that you are you then instruct
the bank to do something on your behalf. You provide a username and
password and usually a one-time PIN created on another device—a so
called ‘second factor’. Authenticating with a username and password has
its benefits. If you forget or lose your password, you can have it reset if
you supply more proof that you are the account holder.
With a cryptoasset, transactions must have a valid digital signature. If
you lose your private key, you cannot access your asset and you cannot
have it reset. If your private key is copied the thief can make transactions
on your behalf, and you can’t stop them. In this respect cryptocurrencies
are much less forgiving than banks. Not even those who maintain the
ledger can alter the balances, because they can’t provide the necessary
digital signatures. This is different to a traditional ledger maintained by a
bank, which can be alter balances without any kind of cryptographic
proofs.
Some people say that with Bitcoin, you are your own bank. You don’t
instruct an entity to make a payment on your behalf: you are responsible
for making payments yourself.
Categorising Tokens
New tokens are emerging almost daily. Their properties vary. While
segregation and separation are difficult, I currently think of tokens in
three categories:
Native blockchain tokens, which are essential for the underlying
blockchain to work or be incentivised. Native tokens are usually the
incentive for block-creators to do their work. Cryptocurrencies are
usually native tokens.
Asset backed tokens, which represent title or ownership to some realworld
asset held in trust by a custodian.
Utility tokens, which represent a claim on a service provided by the
issuer of the token.
Data website onchainfx.com provides these categories for digital
tokens194:
Currency Tokens: Currency tokens are native blockchain assets
intended to be used as money. Networks classified as currencies
typically do not have many ‘features’ beyond those necessary to define
and transfer the native blockchain asset.
Platform Tokens: Platform tokens are required to use general
purpose decentralised networks that support a wide variety of possible
applications. Platform tokens are often used specifically to mediate use
of the platform (ie, tokens are used to pay ‘gas’ in order to access the
platform’s functionality).
Utility Tokens: Utility tokens are native to decentralised networks
that are designed for specific application types. That is, they are open
networks but designed with a specific-use-case in mind. For example,
decentralised storage and decentralised asset exchange are both usetypes
for which targeted networks (and their corresponding tokens) are
being built. The terms ‘Utility Tokens’ and ‘Protocol Tokens’ are often
used to describe the same type of token.
Brand Tokens: Brand tokens exist as tradeable digital assets for use
mostly on one company/entity’s platform. Some Brand Tokens may
evolve into more generalised Utility Tokens over time.
Security Tokens: Security tokens represent a claim on a specific
cash-flow, or off-chain asset. Networks which generate fees-for-service
that accrue to token holders, explicitly grant voting rights to token
holders, or where tokens are said the be ‘backed’ by some other asset,
such as gold or company equity, are Security Tokens.
In the section on ICOs we will discuss how tokens may be classified by
regulators as financial securities. For now, I will describe my own
distinctions between native tokens, asset backed tokens, and utility
tokens.
tokens.

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