Digital Tokens: 5 Revolutionary Ways They Are Transforming Transactions

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 used.

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 organizers, 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 digitize 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 generalizations 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 tokens, but may also be recorded on other blockchains.

Owning a digital tokens

We can be more specific and use the term crypto asset. Ownership of any crypto asset, 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, crypto assets are like bearer assets—if you hold the private key, it is yours.

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.

Online banking

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 crypto asset, 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.

Categorizing Tokens

New tokens are emerging almost daily. Their properties vary. While segregation and separation are difficult, I currently think of tokens in three categories:

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 use types 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.

CONCLUSION