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What is Tokenization?

To understand tokenization and the token economy, let’s first clarify the difference between the two types of cryptocurrency; tokens, and coins. Indeed, let’s first establish that even the most basic term in this industry, ‘cryptocurrency,’ is itself misleading.

A currency is, by financial definition, a unit of account, a store of value and a medium of exchange. Therefore a cryptocurrency should also have these three characteristics, plus a consideration that it is cryptographic, which means it is secured and verified using digital encryption techniques.

Bitcoin, the first notable cryptocurrency, is all of the above. However, because its creation started the industry, the term cryptocurrency is now used to describe all coins and tokens, even if many of them do not function as a medium of exchange – and therefore do not indeed qualify as currency.

For reference, Bitcoin was not the first cryptocurrency, DigiCash was created way back in the 1980s – but Bitcoin’s decentralized nature, featuring the blockchain public ledger, is what made it the first real proponent of the industry.

Now that we’ve cleared that up let’s explain the difference between coins and tokens. Although these terms are used interchangeably, the two are significantly different.

Coins vs. Tokens

Coins, generally split into Bitcoin and altcoins (everything else including Ethereum, Ripple, and LiteCoin), can be seen as actual ‘digital money’ and have their blockchain, which hosts a ledger of transactions.

Tokens can be thought of as stamps or loyalty points. They can represent any tradeable asset but reside on another blockchain, the most popular of which at the moment is the ERC20 protocol, on the Ethereum platform. The token economy is, therefore, best thought of as the interplay and exchange of these scarce digital assets, which are traded between users. Some tokens (they tend to be the good ones) are also integral to the functioning of their micro-economies too, we’ll cover this concept in more depth later.

Tokens and ICOs

Enter: the ICO (Initial Coin Offering), the cryptocurrency equivalent of the IPO (Initial Public Offering). In traditional finance, an IPO involves the sale of shares in a company, with the aim to raise funds; for example, the Facebook IPO in May 2012 which recorded a peak market capitalization of over $104 billion.

An ICO is also a means of funding, through the sale of a digital coin or token, but with some advantages, or disadvantages depending on your mindset, the first being regulation.

To issue an IPO a company must register transparent and legally-binding documentation with its local regulatory body. The legal requirements surrounding ICOs are still emerging – while it is clear that governing organizations such as the Securities and Exchange Commission (SEC) are closely watching the space in an attempt to balance innovation with consumer protection, there remains no standard outline for disclosure of information. However, anyone considering such an issuance should be following their interpretation of the regulator’s comments thus far and seeking expert legal counsel.

For an IPO, often a company will have to show a level of minimum earnings, a proven track record and a log of investment, but for an ICO the project’s product may still be conceptual. This is the reason why purchasing tokens in anticipation of widespread adoption created by the demand for the token, is very risky. There is no guarantee that the project or the ecosystem built around the token will take-off. Of course, because of the considerable promise of distributed ledger technology, ICO participants may also see demand for tokens increase. Case in point: in June 2017, the ICO for the Basic Attention Token (BAT) raised $36 million in 30 seconds; in that circumstance, the value of the tokens went on to increase significantly. The high degree of risk has led the SEC to issue some communications to retail investors, alerting them to the various risks involved.

Ownership and Democracy

The fundamental business difference between tokens and equity is the concept of company ownership including the right to a vote. The stocks bought through an IPO provide owners with a share of any future earnings the company generates, plus the chance to receive regular dividends and a vote at the AGM or shareholders’ meeting.

Tokens bought during an ICO operate more like a receipt for future services: the buyer does not receive ownership of the company but instead receives a token of ‘utility’for use within a specific ecosystem. Thus the token, a critical part of the ecosystem being built by that company, represents the opportunity to participate in its ecosystem or micro-economy. Today, most tokens are a means to access new and exciting software, for example, to generate a transaction on the Ethereum blockchain requires small amounts of Ether. If one believes demand to participate in that ecosystem will increase, then it follows demand for the token will also increase.

Tokenized Business Models

To consider tokens as simply a means of raising funds is a mistake though. Although one should always be very skeptical of projects that seem to only incorporate a token as a means of raising capital, the nature of distributed ledger technologies and business models often require a token as a unit of exchange or the fuel that powers the ecosystem. Consider that this new technology offers the means to exchange value using the internet, seamlessly, for the first time.

Tokens are much more than a fundraising activity. They offer significant network effects around a distributed technology project, and they are fundamental to the overall promise of distributed ledgers. Because blockchain products tend to be open source software, there isn’t an opportunity to sell the software in the traditional sense. Having people ‘buy the right to access it’ through unique and scarce cryptographic tokens provides a business model for open source software where one has never existed before. This supports innovation and should ultimately lead to new technologies that represent the next phase of the web.

About the author

Jason Manolopoulos co-founded Dromeus Capital Group in April 2008 and is the co-CIO of the firm. Jason leads the firm's investment activities is a member of the Firm's Executive and...

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