The current era is observing a momentum gain in the platforms and tools utilized to increase commerce-related activities in cyberspace. In the pursuit, the main catalyst has been tokenization, which refers to the specific objects and interactions that might be programmed to give back the values and norms of a community. It can also be understood as a digital legal mechanism by the aid of which individuals can imbue digital and physical properties with programmed rights.
1. Security Tokens
Different token types abide by different laws and regulations. While mapping the designing, maintenance, and launch of a token, one must see whether or not the token is a Security Token or a Utility Token. This factor will determine the blueprint beginning from ideation, to launch, from the cost to the processing compliance, etc.
What is a Security Token?
A security token is analogous to owning a stock or an equity interest in an asset. They act as security instruments and thus demand a precise set of precautions/protections for the issuers and investors.
The ‘Howey Test’ is a test used by the U.S. Securities and Exchange Commission (SEC) to evaluate if a given digital asset belongs to a security under ‘The Howey Test analysis’ of ‘investments contract’. In relation to this test, an asset would be identified as a security if there is a reasonable probability of profits that might be derived from everyone’s effort. It also applies to any contract, scheme, or transaction whether or not it involves any of the characteristics of a typical security.
One condition that was much talked about was that if the network over which the token is to function is decentralized, then the assets may not represent an investment contract. This resolves that the more centralized a community is, the more the risk that sales of a crypto-asset are considered to be security sales.
Fundraising and Security Tokens
Security tokens prove to be beneficial for raising funds for investment or democratizing ownership of a project. Security tokens are often issued through a ‘Security Token Offering’ or an STO, each of which comes with a different limit on the raised amount, the jurisdiction of the place of offering, the filing requirements, and the investor’s requirement.
Location of Issuing
To decide if a token is a security, it must be known that regulators would apply laws based on the citizenship of the individual participants. The details here comprise the details of the token buyer, the issuer of tokens along with the token investors.
Examples of Security Tokens
A few examples to demonstrate the use of security token includes:
- Props Network: Props launched a security token for accredited and non-accredited investors under Reg CF through a Token Debt Payable by Assets (DPA)
- Vevue Media: Launched a security token for a Wyoming Corporation for international investors and gave them non-voting preferred equity shares
- Curzio: Launched security tokens for accredited investors under Reg D in the US and international investors under Reg S
2. Utility Tokens
Utility Tokens are the inverse of security tokens. They do not require registration as a security with the SEC. These tokens display a specific value for a specific purpose, to its holders. For instance, one can employ utility tokens to reward regular customers, give special discounts, or to make non-financial decisions/choices with a non-financial interest.
No-Action Relief is a mechanism designed by SEC that allows projects to submit requests so as to obtain assurance if their conduct falls upon a shady regulation area, where clarity is lacking. A No-Action letter is then issued by the SEC if the request is successful, detailing the reasoning for the final decision. The idea however seems almost non-practical as the system still isn’t able to identify or classify the tokens as securities.
Examples of No-Action Relief
A few cases under the No-action Relief include:
- Pocketful of Quarters (POQ): They created a token to solve the problem of the inability of using gaming credits/coins in certain online games
- TurnKey Jet: They’ve created a token to resolve coordination issues by providing Token sales for air charter services through a private blockchain network
Examples of Utility Token
Utility token doesn’t require any prior registration. Instances for utility token consists of:
- Filecoin (FIL): It is an application that permits its users to pay FIL so as to store their files over a network. Whenever a file is added to a network or is retrieved, at the same instant, the miners who store these files, get the FIL.
- Basic Attention Token (BAT): Another application designed to earn BAT for users using Brave Browser, in exchange for their attention. Moreover, creators with quality content are entitled to earn BAT, and it is also paid to advertisers to get a better run over the ad expenditure.
Security Token v/s Utility Token
Security tokens entail registration with the SEC, along with an agreement with the local securities law. Any kind of token is initially created as a ‘Utility’ token, which may over time become a ‘Security’ token if they are treated as a security.
3. Non-Fungible Tokens (NFTs)
Non-fungible states that a token is unique, and cannot be exchanged with goods of a similar kind. Its value is always specific, and the commodity is always singular in existence. The projects that brought NFTs into the mainstream were ‘Cryptopunks’ and ‘Cryptokitties’. Another factor that accelerated the growth was the marketplaces: SuperRare and OpenSea.
Behaviour of NFTs
NFTs are digital assets and cannot be replicated. They can be used to identify a digital entity such as an image, text, etc. NFTs are classified as unique since they are uniquely encoded with smart contracts on a blockchain network, which makes their ownership and details immutable. The token standards of NFTs contain fundamental features, like ownership, transfer, and simple access control. For this, the best one can put to work is the ERC-721 standard. Additional features, like royalties, might also be employed/purchased, depending upon the type of NFT, one is minting.
Formats of NFTs
There are several formats in which NFTs exist. A few of them include:
- Music – ‘Ultraviolet’ by 3LAU
- Digital Artwork – ‘Everydays: The First 5000 Days’ by Beeple
- Video Clips/GIFs – Lebron James Kobe Bryant Tribute Dunk
- Avatars and PFPs – CryptoPunks and Bored Apes
- Metaverse – Decentraland
In digits, art-based NFTs make up about only 10% of the market, while collectibles and games account for about 80% of the total NFTs.
The NFT marketplace is an area for buyers and sellers to connect. This involves a two-step procedure: the first one, wherein creators list their NFTs for sale in the primary market, and after this, the collectors can trade it amongst one another, in the secondary market. Different marketplaces work differently. They’ve their own set of NFTs for sale, payment methods, the permitted blockchain networks, and certain inclusive protocols. The popular ones are:
- OpenSea – General Collectibles
- AirNFTs – Gaming
- NBA Top Shot – Sports Collectibles
- SuperRare – Digital Art
The greater the popularity of an NFT, the higher the willingness to bid a claim for its ownership.
Value of an NFT
NFTs allow its creator to bypass third parties and grant direct access to its customers. It also helps the creators to collect royalties, a fraction of all secondary sales of their creation, in an entirely automated way, which is otherwise not a possibility in the traditional art world. Each time their work is sold in successive transactions, they will obtain a percentage of the sale price, and their earnings for their work will continue.
Use Cases of NFTs
The current applications of NFTs are:
- Membership: Memberships can be created by certain gated communities, in the form of NFTs, to create scarcity and demand.
- Ticketing: NFTs can be used as tickets/programmable cash to attend an event., and enhance connections between the artists, event organizers, and audience.
- NFT-as-a-Service: NFT can be employed to provide specific services.
- Physically–backed NFTs: NFTs can be used to represent or be in existence, by being attached to a physical item to provide traceability and transparency.
- Real Estate: Although yet to be legally established, NFTs can be used to verify ownership and titles.
- Logistics: Since NFTs are created through blockchain, one can trace the movement of goods in the supply chain.
Types of NFTs
The present ecosystem of NFTs constitutes various types of “experiential” NFTs.
- Collectible NFTs: The NFTs that are scarce, and can be traded, tracked, and displayed to others. They account for about 80% of the total NFT market. They’re similar to physical collectibles, the only difference being, that they are available in a digital format. Examples – Curio Cards, Bored Ape Yacht Club, Nike Cryptokicks, Axies, etc.
- Credential NFTs: The NFTs that record exhibiting basic statistics. They include personal identity, certifications, passports, medical reports, insurance claims, or even self-sovereignty. They can be adopted to verify digital identity. Examples – 0xcert, Soul-Bound Tokens, NFT Covid-19 Vaccination passports, etc.
- Dynamic NFTs: The NFTs that are programmed for certain types of changes. They can dynamically modify their outlook and operations based on the triggers and inputs. Examples – Chainlink, Async Art, 22 Racing Series, etc.
- Fractional NFTs: It is a single NFT that is co-owned by a large number of owners. It is generally used in the financing and maintenance of an NFT project.
4. Liquidity Provider Tokens (LP Tokens)
LP tokens refer to a distinct type of reward mechanism to facilitate transactions between different types of cryptocurrencies. These tokens have gained popularity in Web3 space and DeFi (Decentralized Finance) since they aid in transactions on exchanges.
In plain terms, exchanges relate to marketplaces wherein a huge number of people buy and sell assets like currency, stocks, crypto coins, tokens, etc. Currently, exchanges can be done in two ways, centralized (traditional currency exchange) and decentralized medium.
Kinds of Exchange
On a broad scale we’ll be talking about exchanges in two systems:
- Centralized Exchange (CEX): These kinds of exchanges are similar to traditional exchanges wherein a third party is involved to facilitate traders and record buying and selling orders in a digitalized book. It is because of these orders that liquidity is further provided. CEX also exercises a little degree of control over investors’ funds. They hold over 96% of the current crypto trading exchanges and are more common. Examples – Binance, Coinbase, etc.
- Decentralized Exchange (DEX): Unlike CEX, DEX consists of algorithms on a blockchain that help to trade crypto assets between users automatically, without employing any third party. Instead of order books, DEX uses liquidity pools to provide liquidity. It is due to these pools that one asset can be converted into another without producing a sweeping change in the asset’s price. Example – Uniswap
Automated Market Makers (AMM)
AMMs refer to the protocols/ trading mechanism that excludes the participation of third parties or intermediaries or order books, as in CEX. Consequently, AMMs are utilized by DEX for aiding transactions.
An individual liquidity pool is present for every trading pair of assets wherein anyone can provide liquidity to the pool. To balance liquidity pools and avoid radical changes in the asset’s price, there are preset mathematical equations. A liquidity pool will then rebalance to maintain an equal ratio of a given portfolio of assets. After this, the price of assets is calculated on the difference between the desired ratio and the ratio at a given instant of time.
The Function of LP Tokens
Before the development of LP tokens, crypto assets were locked or staked for explicit mechanisms and continued to remain inaccessible during that time stretch. This resulted in low liquidity and lower activity in the crypto ecosystem. After the introduction of LP tokens, it became possible to generate bigger pools of liquidity for assets subsidized by users, augment the liquidity of the market, and financially incentivize LPs through the issuance of LP Tokens in exchange for the service they offer. Therefore, LP tokens resolve the issue of locked crypto liquidity, within a DeFi ecosystem.
When tokens are traded over DEX, slippage is the difference in price when a transaction is submitted and when the transaction is finally confirmed over a blockchain. It occurs due to differences in the confirmation time of different blockchains, in various places. It can also be caused due to low liquidity if the liquidity pool becomes imbalanced and cause price spins.
Initial DEX Offering (IDO)
An IDO is a token offering like ICO, STO, and IEO. It is a new fundraising model in which a new project or start-up raises funds against their new tokens through a DEX. Herein, LP tokens are locked for new tokens provided by the project or start-up.
Yield Farming is a kind of investment strategy. In this, investors shift their assets between different liquidity pools so as to maximize their returns or interest rates. In the aspect of LP tokens, liquidity lenders can grow their interest rates for these tokens in a yield farm. One such way to do it is through ‘Staking’, which is a form of yield farming.
Governance tokens are a sort of ownership token that refers to tokens provided by the developers to users for making decisions governing a future protocol. These tokens can be used to help different types of voting:
- Executive Voting: for continuous evaluation of proposals
- Quadratic Voting: to assist a community to buy more votes for a typical problem
- Ranked Choice Voting: for proportional representation
- Holographic Consensus: approval by a small, representative group present in a larger organization
With the help of governance tokens, organizations can also choose from several different methods to allocate votes, like:
- Company Model: one vote per share
- Membership Model: one vote per person
- Reputation Model: a hybrid of company and membership models Governance tokens also permit organizations to add incentives like staking to voting so as to increase or limit participation for the profit of the organization. These tokens can also be applied to facilitate voting by both on-chain and off-chain mechanisms.
The development of these tokens has increased the number of digital business models like Decentralized Autonomous Organizations (DAOs), Cybernetic Organizations (cybOrgs), etc
Potential of Governance Tokens
Governance tokens can be used for:
Legal Integration: It will determine the degree to which legal rules for governance might be embedded into a technical architecture. This can be done in two ways, the first being the governance tokens might be used to develop a legal wrapper for an organization; and the second being the governance tokens utilized to create legally binding obligations.
Decision-making: With the help of governance tokens, organizations gain the ability to program increasingly sophisticated decision-making mechanisms. It boosts legacy voting mechanisms by streamlining the process and making it more efficient.
Behaviour: Using governance tokens, the ability to design and achieve certain behavior is one such potential, consisting of frameworks like DAOs, DACs, DAs, etc. For instance:
- Coordination DAOs: help to manage activity for a set of people without expecting returns
- Investment DAOs: community-administered groups that allow capital pooling and investment in projects with the objective of producing returns
- Hybrid DAOs: a combination of investment and coordination DAO tooling
Since the development of tokens is still in its emergent state, and new trends are still settling, testing each token as regulatory developments take place, must be the wisest decision to make. Speaking individually, the future of security tokens must be towards greater transparency. In the case of utility tokens, the picture of the future isn’t vivid and still lacks clarity as until now there is no legal consensus about the true definition of a utility token. As for NFTs, their popularity is reaching heights, and masses of audiences are showing interest in both trading and minting their respective artworks. For LP tokens, they work completely fine, and still, new innovations might be accepted if proved fruitful. In the end, to talk about governance tokens, it is still young, however, until now, has been proven to be extremely productive.