The notion of tokenization on blockchain caught the world by storm when one such token, representing a collage, was sold for 69 million dollars!
The word “tokenization” has several connotations to it, depending on the context in which it is being used. Very simply put, a “token” is a representation of an entity, often referred to as an “asset”. This asset can be physical or digital. With the advent of IT systems, these tokens are created and managed in a digital format. But what does tokenization mean in context of blockchain, and what is the mystery behind tokens managed using blockchain technology?
Native Tokens in Public Blockchain Platforms
Blockchain technology came into existence with the invention of Bitcoin, which is a platform that allows exchange of cryptocurrency in a trustless manner. In public blockchains, such as Bitcoin, Ethereum, etc., the cryptocurrency (e.g. Bitcoin, Ether, etc.) is referred to as the native token of that platform, which has multi-fold uses:
- Transfer of Value: The most common usage of this native token is its exchange between the users on the platform in a decentralized manner. First, each user needs to create a wallet and buy these tokens, via a cryptocurrency exchange, using their fiat currency. By using the wallet, the user can send and receive tokens through the blockchain network.
- Incentivization: Since public blockchain are completely decentralized, there is a built-in mechanism to validate each transaction and arrive at a consensus to achieve this trustless transfer of value. But this consensus mechanism requires computation power that must be spent by the validator nodes in the blockchain network. Hence the native token is also used to incentivize the validators in the form of transaction fees. This ensures that validators have the financial motivation to participate and validate the transactions.
- Preventing Attacks: Public blockchains can be accessed by anybody, and, thus, opens doors for both legitimate and rogue users. To prevent misuse each transaction has a cost associated with it which needs to be borne by the user submitting the transaction. This transaction cost is deducted from the native tokens linked to the user’s account in their wallet. Thus, malicious users will be thwarted from posting fake transactions or generating DDOS (Distributed Denial of Service) attacks. A part of this transaction cost is used to incentivize the validators.
- Investment Vehicle: One of the economic reasons of introducing the native token is to raise money by inviting crowdfunded investments. In the cryptocurrency world, it is called as ICO (Initial Coin Offering), which is like an IPO (Initial Public Offering) in the stock market. The “coin” here is the native token whose value is decided by the demand-supply gap, and market perception of the functionality provided by the blockchain platform and potential of its adoption. This price of this native token is usually measured in USD and is highly volatile, but is an attractive investment option by the millennials.
- Decentralized Governance: This is enabled by allocating a percentage of native tokens to the blockchain node operators so that they can vote and collaboratively decide on the roadmap of the public blockchain network in a democratic and decentralized manner.
Hence, there is a very specific purpose and usage of native tokens in public blockchains, which is quite different from the typical concept of tokenization.
Asset Tokenization using Blockchain
A digital representation of an asset can be termed as tokenization, and this representation can be achieved through a variety of mechanisms. Some of the key aspects of this digital representation are:
- Uniqueness – If the same asset can be duplicated and it cannot be represented in uniquely then all other functionality around that token will be susceptible to misuse and misrepresentation. For example, fake or duplicate representations can enter the value chain, which defeats the purpose of creating the tokenized version of that asset.
- Non-repudiation – The origin and validity of the digital representation always needs to be guaranteed.
- Ownership – Establishing the current ownership of the asset and enabling transfer of ownership is also key aspect of token management.
- Monetary Value – if the asset holds a monetary value, then it should be a reliable and effective way of specifying it and linking it to universally-supported digital currencies.
Creating a unique representation of a physical asset is the most challenging aspect because translating the attributes of a physical asset into a non-duplicable and repeatable digital representation is not always foolproof. Technology options continue to evolve, becoming both accurate and cost-effective, to derive a unique digital representation of an asset. Once the asset’s unique representation is determined, blockchain becomes one of the top technology choices to manage that asset for the following reasons:
- Blockchain provides a decentralized model through which transactions and their related states are immutably persisted, or recorded, by leveraging a transparent consensus mechanism. Therefore, the token representing a physical / virtual / digital asset on blockchain can act a source of truth and provide irrefutable evidence of the transaction’s existence, which can be verified at a point of time to prove its authenticity and prevent fraud.
- Each transaction submitted to blockchain is signed by the concerned party, which is used to authenticate and establish the provenance of the asset, throughout its lifecycle. Any changes to the asset state are recorded as a new transaction on blockchain, which makes it non-repudiable.
- Token ownership on blockchain is established through a signed, timestamped entry, and an automatic audit trail of ownership changes is established as blockchain as an append-only ledger that maintains the historic state-change transactions. This feature is useful in resolving ownership disputes and double spending of the same asset.
- Blockchain platforms that support smart contracts provide flexibility, not only defining the data structure of the token, but also associating a monetary value with it. This monetary value can be managed via the smart contract logic, just like any other state changes related to asset’s metadata.
- For blockchain platforms that support a native token, the asset’s value can be pegged to crypto tokens. Thus, the asset’s monetary value will be linked to the native token’s cryptocurrency value (such as that of Bitcoin, Ether, etc.). The implication of such an approach is that the asset token is susceptible to the volatility of cryptocurrency markets.
- Wrapped tokens is another concept where the base crypto currency is tokenized on a different blockchain platform, which more scalable, cost-effective and interoperable. For example, WBTC (Wrapped Bitcoin) and WETH (Wrapped Ether) help in the cross-chain exchange because WBTC can be created by following Ethereum tokenization standards and vice-versa.
Thus, blockchain provides different techniques for managing the token’s lifecycle which is governed by the type of token being created. There are three broad categories in which these tokens can be classified:
- Fungible Tokens – any asset token that be sub-divided and exchanged. For example, digital currency or cryptocurrency can be bought or sold or transferred to the nth fraction.
- Non-Fungible Tokens (NFT) – any asset token that has unique ownership and can’t be subdivided. For example, a piece of art or a house or car.
- Hybrid Tokens – any asset token that is semi-fungible, such that it holds the characteristics of an NFT but still be divided in certain conditions. For example, a larger piece of land can be divided to have multiple owners
Each token type has certain behaviors and constraints associated with it, which are enforced through smart contracts on blockchain. There are several blockchain platforms that have token SDKs (Software Development Kits), which aid developers in managing the token’s lifecycle right from its creation till it is retired or marked as consumed. This ensures a decentralized and transparent processing of the tokens that makes token trading marketplaces built on public blockchain an attractive proposition.
Can asset tokenization be managed without blockchain? A simple answer is “yes” because tokens are used to digitally represent an asset. But how reliable or trustworthy is that representation? Can the ownership of that token be irrefutably proven? Is the provenance and traceability of the token available in a transparent manner? Blockchain certainly caters to all these requirements and thus brings in a unique value proposition that would excite the startup-savvy millennials, as well as traditional enterprises. It is imperative to achieve standardization in token taxonomy and vocabulary so that token interchangeability and interoperability between different blockchain platforms becomes seamless for the end user.