A gentle introduction to digital tokens

Digital tokens have come to the fore recently, firstly with excitement about cryptocurrencies such as bitcoin, then with digital tokens being used to represent different assets on a blockchain.  What are they?  How can you digitise a token?  Why is it important?

When I hear the word ‘token’ I think of round plastic things like a casino chip, or something which I can use to exchange for a beer under a specific system or in a specific marketplace.

We will explore the original usage of the phrase ‘digital token’, then take a look into the world of cryptocurrency tokens, differentiating between blockchain-native tokens like BTC on Bitcoin or ETH on Ethereum, and asset-backed tokens like IOUs on Ripple.

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DIGITAL TOKENS IN THE BEGINNING

When you enter an email address into a website to join a mailing list, you’re often asked to check your email and click on a link. The link looks something like this:

https://www.website.com/confirm_email?token=4bdebebc-135b-4748-b7ab-25b31a285df8

In this case, the ‘token’ is this string of characters which was sent to you. It’s a unique string of characters, which, when you click on it, tells the server that “yep, the guy definitely got the email, so the email account is definitely his.”.

So, the website sent you a token, and you sent it back, proving you had control of that email address.

However, ‘token’ is now being used in an entirely different way to mean other things in cryptocurrency land. Let’s explore.

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CRYPTOCURRENCY TOKENS

Cryptocurrency tokens don’t exist as a string like we saw above (if they did, they would be easy to copy), but rather they exist conceptually as entries on a ledger (a blockchain). You own these ‘tokens’ because you have a key that lets you create a new entry on the ledger, re-assigning the ownership to someone else. You don’t store tokens on your computer, you store the keys that let you reassign the quantity.

I prefer to think of these ‘tokens’ as specific amounts of digital resources which you control, and you can reassign control to someone else.

We’ll cover two types of token:

1. “intrinsic” or “native” or “built-in” tokens of blockchains
2. “asset-backed” tokens issued by a party onto a blockchain for later redemption

1. Intrinsic tokens (also known as ‘native or ‘built-in’ tokens)
Intrinsic tokens are made-up resources that have some utility.

Some of the more well known examples of intrinsic tokens are:

• BTC on the Bitcoin blockchain
• XRP on the Ripple network
• NXT on the NXT platform
• ETH on Ethereum

There are many more. See: http://coinmarketcap.com/

These ‘coins’ or ‘tokens’ really form part of the core of the blockchains, and the blockchains would not run without them. They are usually part of an incentive scheme to encourage people to help validate transactions and create blocks, or in Ripple’s case, they are there to create a small cost per transaction which helps prevent transaction spam.

How did these intrinsic tokens come into existence?

As these are not backed by anything, they can be created by software, just as easily as you can write down on a sheet of paper “I hereby create 1 billion fun-coins”. In fact if you did that, and then kept a good record of which friends you gave these to, and if you could record onward transactions as your friends gave them to other friends, you would be doing pretty much the same as what these digital ledgers do.

For the examples above:

In Bitcoin, BTC are created (‘mined’) as they go along, according to a schedule. The newly created coins are assigned to the block-maker. The total number of bitcoins increases with time. They are optionally added to transactions.

In Ripple, XRP were created at the beginning (‘pre-mined’) and shared out among key participants. Each transaction has a fee costing a small amount of XRP. These XRPs are destroyed over time, and not re-assigned to the transaction validators. The total number of XRPs in circulation goes down with time.

In NXT, NXT coins were pre-mined. Each transaction on the NXT network has a fee in NXT. The fee goes to the block-maker (in NXT this is called a ‘forger’ instead of a ‘miner’). The total number of NXT remains constant with time.

In Ethereum, ETH (‘Ether’) was pre-mined. Transactions and smart contracts need ETH to create and run, and the ETH go to the block-maker as a reward. The block-maker also gets a block reward.

Purpose.  The main purposes of intrinsic tokens seem to be:

1. Block validation incentives (‘miner rewards’)
2. Transaction spam prevention (if all transactions cost some token, it limits the ability to spam)

Although these coins have external value (you can buy and sell any of them on an online exchange for other cryptocurrencies or real money), they aren’t meant to represent anything. They just are.

2. Asset-backed tokens
Asset backed tokens are claims on an underlying asset, from a specific issuer.

Wikipedia’s History of money suggests that in the good old days, you could park some gold with a goldsmith, and receive a receipt or “I Owe You” (IOU) note from them. These notes could be transferred from person to person, and anyone holding these notes could go back to the goldsmith and claim the actual gold.

Asset-backed tokens are the digital equivalent. They are claims on an underlying asset (like the gold), that you need to claim from a specific issuer (the goldsmith). The transactions as tokens get passed between people are recorded on the blockchains, and to claim the underlying asset, you send your token to the issuer, and the issuer sends you the underlying asset.

Popular assets for these schemes are currency (USD, EUR, etc) and precious metals (Cryptocurrencies seem to attract the same crowd as gold and silver). But read the press and every day you’ll see people tracking assets on ledgers by creating a digital token that represents them. Diamonds, art, music… you name it.

How do asset-backed tokens work?
Let’s take the example of Coins-R-Us, a fictitious Bitcoin exchange, issuing Euro-backed digital tokens.

You send Coins-R-Us some money by logging on to your online banking, and making a normal EUR bank payment to Coins-R-Us’ bank account for E100. When they log in and see it, they can give you 100 digital asset-backed tokens called Coins-R-Us-EUR.

The creation of these tokens is recorded on a blockchain (whether it’s coloured coins on The Bitcoin Blockchain, or assets on Ripple or NXT, or a smart contract on Ethereum, it doesn’t really matter for these purposes). You can then send these tokens to your friends (either in return for something or as a gift), and the tokens continue to be tracked on the same blockchain.

Eventually one friend will want to convert this asset-backed token for something real. She would need to go back to Coins-R-Us, create an account with them, tell them her bank account number, and send them the Coins-R-Us-EUR that she got from you. They would then transfer her some EUR from their bank account to her bank account.

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TOKENLESS BLOCKCHAINS

In some discussions, including Tim Swanson’s excellent report on permissioned ledgers, there is the concept of tokenless blockchains.  I think this means a blockchain or distributed ledger which lacks an intrinsic token (eg Ripple without the XRP), however asset-backed tokens are likely to still be used.  The ‘tokenless’ refers to lack of intrinsic token, and not lack of asset-backed token.

You don’t always need a token.  Depending on the setup of the blockchain system, you may or may not need an intrinsic token.

In general, permissionless ledgers where anyone can add a block, need some sort of incentivisation scheme for block validators to do their job.  However in distributed ledger systems where you control the validators and block-creators, then they may be doing their job for different reasons, for example because they are contractually obligated to do so.  There’s a little more on it here.

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DEMATERIALISATION AND TOKENISING LEGAL CONSTRUCTS

Currently there is a lot of noise in the media around putting things on blockchains: shares, debt, gold, companies, IPOs, diamonds, art, decentralised organisations, wine, music, countries and so on.

Sometimes the purpose is to be able to transfer assets (or rather IOUs) quickly and easily while keeping the physical item secure in a warehouse.

Other times it’s to have a digital token whose digital ownership matches the physical journey object.  For example when I sell you a physical diamond, I also send you the digital diamond-token from my control to your control, and so the blockchain records the provenance of the diamond, like a supercharged certificate-of-origin which includes a full record of ownership.

Regarding legal constructs, especially companies and shares, I think there is a difference between tracking claims to underlying objects on a ledger, and actually legally dematerialising the object.

Dematerialising something means replacing a material object with a digital one.  For example paper share certificates have now mostly been replaced by ownership registers in databases. Some paper contracts have been replaced with pdf files.

While you can declare “this digital token represents a share of a company”, and you can send that to someone else, this has no legal bearing.  The token isn’t the share, even if you own the share in real life, and you issue the token on the back of it.  The token is something outside the law which you have invented.

Sure, as the owner of shares, you may commit to other people that if they own so-and-so token, then you will pass them certain privileges (for example if you own this token, I will pass any dividends I get (from really owning the share) to you).

However, you own the share because your name is on the share registry, the real legal share registry, not the blockchain ledger which you are using to track the digital token you have created.

This is why I cringe when I hear people saying they are creating *insert legal construct here* on the/a/some blockchain. They aren’t, any more than I can create a company by writing “I hereby create a company with 100 shares” on a napkin, without doing all the real work of legal company creation with the company register of my national jurisdiction.

Sure, if the law changed and by statute a specific blockchain became, or was deemed equivalent to the national register of companies, then yes, on that statutory blockchain, you could create a company. It will be interesting to see how laws will eventually adapt to technology.