A Deep Dive Into Tokenization
People often use the word tokens without knowing what it really means — what happens when something is tokenized?
Table of Contents
- What Is Tokenization?
- Blockchain and Tokenization
- Benefits of Tokenization
- What Is a Security Token?
- What Is a Security?
- How Are Security Tokens Created?
- What’s the Difference Between Cryptocurrency Coins and Tokens?
- The Howey Test
- What Is a Utility Token?
- Utility Tokens vs Security Tokens
- What Is a Governance Token?
Tokenization is one of the concepts that has been popularized by blockchain’s rise to mainstream recognition. In this guide, we will take a deep dive into tokenization and the reasons behind its newfound popularity.
What Is Tokenization?
Tokenization is the process of creating tokens as a medium of data, often replacing highly-sensitive data with algorithmically generated numbers and letters called tokens.
Unlike cryptocurrencies, the idea of tokenization did not originate from blockchain technology. For a long period of history, physical tokens have been used to represent real money. For instance, casino chips are used to represent money, and banknotes and coins are also used as different forms of tokens.
Tokenization in the digital world was first attempted by TrustCommerce in 2001. In looking at a way to protect the sensitive credit card details of its users, the payment solutions issued the first digital tokens (randomized numbers), which were a non-sensitive data equivalent.
Before this, online payment services would store the sensitive information of their users in servers. However, these servers were susceptible to breach from hackers looking to access this information.
When a cardholder performed an online transaction, the merchant was referred back to TrustCommerce, which would then process the information on their behalf. This both eliminated the need for merchants to store credit card details and also protected cardholders from hackers.
Blockchain and Tokenization
Issuing a token on a blockchain magnifies its usefulness exponentially. The blockchain records the issuance and maintains a ledger of every single movement of that token.
Conventional tokenized assets created multiple “tokens” for every user who accesses the file. However, a blockchain creates a permanent, immutable record of the tokens by using a distributed ledger.
When a transaction takes place on a blockchain, instead of creating a new representation of the token, the ledger accesses the token stored and updates itself to reflect the spend, thus overcoming the double-spend problem.
Benefits of Tokenization
In addition to solving the double-spend problem of tokenization, issuing a token on a distributed ledger or blockchain adds a lot of benefits to the token. Some of the benefits blockchain tokenized assets enjoy are:
- Greater Security: tokens issued on a blockchain stand to benefit from cryptography and the distribution registry to get a greater level of security. Cryptography is a method of storing confidential information in open databases. While anybody can download the database, only those with a special decryption secret key can access the information. Operating on a distribution registry means that information is simultaneously stored on multiple devices and synchronized. An update is added only when a majority of the participants reach a consensus.
- Transparency: the hallmark of a blockchain is transparency. Because it runs on an open-source code, users can view the source of the blockchain as well as transactions. This increases the confidence of its users as well as reduces the cases of fraud and asset theft.
- Fewer Intermediaries: one of the banes of the traditional financial industry has been the inexorable presence of middlemen. The intermediaries normally needed for a transaction to be completed are eliminated with assets on a blockchain. With the distributed ledger acting as a source of truth, it ensures the integrity of a transaction while eliminating intermediaries.
- Immutability: information stored on a blockchain cannot be changed, deleted or corrected by a single individual. This immutability frees tokenized assets from the possibility of money laundering, bribery or an official hacking the system.
A distributed ledger ensures that not one single entity is in control of information.
- Automation: in stark contrast to the traditional financial sector, most of the bureaucratic procedures on a blockchain can be automated using smart contracts. These algorithms can handle processes involving the exchange of valuables, such as fiat money for stocks, tokens, or real estate.
What Is a Security Token?
There’s been a lot of hype in the crypto space about security tokens, but what exactly are they, and what are they used for? To understand what a security token is, first, you have to understand what securities are all about.
What Is a Security?
The term security is used to refer to any representation of an ownership position in a publicly-traded corporation, or the ownership rights represented by an option. In simpler terms, a security is any financial asset that can be traded.
When a security has been issued to digitally represent a real tradable asset, it becomes a security token. These tokens now serve as a reference to the original asset/data. Security tokens are often simply referred to as tokens or digital securities.
Security tokens can be used to digitally represent assets of different classes including equity, fixed income, real estate, structured product, investment fund shares and commodities that are both traded and held on a blockchain (a distributed ledger).
How Are Security Tokens Created?
Security tokens are created in two ways;
- Asset tokenization: a traditional financial asset that doesn’t exist on a blockchain be digitally represented by tokenizing the security. An example would be a real-estate agency creating a digital token to represent properties or shares.
- Asset origination: for financial assets that already have an on-chain presence, tokens can be created through asset origination. These assets are referred to as “natively digital securities.” They can be created by mining or staking, depending on the blockchain.
What’s the Difference Between Cryptocurrency Coins and Tokens?
These are some of the most used, yet least understood words in the crypto industry. While many would use them interchangeably, they do not exactly mean the same thing.
A crypto coin is simply a digital coin, created for making payments. Coins are created to act like money: in other words, they represent a unit of account, store of value, and medium of transfer. Crypto coins tend to take the form of their native blockchain, like with Bitcoin (BTC), Bitcoin Cash (BCH), Litecoin (LTC) and Monero (XMR).
On the other hand, a token is a digital representation of an asset. Many crypto projects issue their tokens as a representation of an asset or the utility that it has. They usually give their tokens to their investors during a public sale called ICO (initial coin offering).
On blockchains, while tokens are valuable, they cannot be considered as money in the same way crypto coins can be. They can be used for payments because of the value they get from the project that issued them.
On some blockchains, tokens are used to hold votes by the community on key business decisions, or even technical changes to the platform, thus giving tokens more functionality than the regular crypto coins.
The Howey Test
In 1946, the Supreme Court was tasked with handling a colossal case that would change the outlook of the financial industry. The Securities and Exchange Commission vs W. J. Howey Co. case would set up the framework for the infamous Howey Test.
Howey, which was a citrus farm operating on a large expanse of land in the southern portion of Florida, had decided to lease out half of its large property to generate finance for additional development.
Purchasers of the land, who were largely speculators rather than farmers, were happy to lease the land back to Howey on the premise that they would get profits by doing so.
It was then the question of whether or not the land could act as a security. The Securities and Exchange Commission deemed this move illegal, and Howey was promptly sued for not filing a securities registration statement.
After its investigation deemed the land to be a security, the Supreme court developed the Howey Test to determine whether certain transactions qualify as investment contracts. To qualify as an investment contract, the transaction must fulfill the following criteria:
- It is an investment of money;
- The investment is in a common enterprise;
- There is an expectation of profit from the work of the promoters or the third party.
As the crypto industry welcomes more investors, the SEC has become more interested in defining and regulating the use of cryptocurrencies. As such, the Howey Test has often been applied to crypto markets, especially ICOs.
In the original case, the term “money” was used; however, later cases have expanded it to include other assets and investments that are not money.
Now, cryptocurrencies fall into this category. If the tokens to be issued by a blockchain project meets all the three aforementioned criteria, then by law, it is regarded as a security.
In addition, for a token to be classified as a security, the profits that come in from the investment must not be fully controlled by the investors. If investors fully control the profits, then the asset is not classified as a security.
What Is a Utility Token?
Utility tokens are often referred to as user tokens or app coins. If a token fails to qualify security based on the Howey Test, then it classifies as a utility token. Utility tokens simply provide users with a product and/or service.
These tokens usually act as an access point into a network. Without a utility token, you cannot access the services available on that platform. A utility token is most often issued during a crowdsale or during an initial coin offering.
Utility Tokens vs Security Tokens
The purpose of token creation can be used to tell the difference between a security token and a utility token. Security tokens are created as investments, while utility tokens are created to help fund ICOs and create an internal economy within the project’s blockchain.
The value of a security token is directly tied to the value of the company issuing it. The more valuable the company, the more valuable the security token would be. On the other hand, there is no direct relationship between the value of a company and the value of its utility token.
Utility tokens are also largely unregulated, unlike security tokens. While utility tokens may be exempted from the federal laws governing securities, it drastically increases the potential for scammers to exploit.
What Is a Governance Token?
Governance tokens are designed to give individuals governance rights over the protocol that they subscribe to, or rights over the tools and applications built atop of the protocol. These decentralized governance systems will enable functionality such as protocol level voting, proxy voting, participation in governance decision making, committee membership recruitment, and more.
Now that you know a little bit more about tokens, check out our guide to cryptocurrencies!
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