How to explain tokenization to Six Year Olds (well… sort of)
What actually is a blockchain-based ‘token’? It can be tricky to wrap one’s mind around concepts such as the tokenization of financial assets, token fractionalization, and how smart contracts behave in certain scenarios, even for seasoned DeFi industry practitioners. Chances are, you haven’t been interrogated on blockchain concepts by a crypto-obsessed six-year-old, but as Albert Einstein once said, “if you can’t explain it to a six-year-old, you probably don’t understand it yourself”. With that in mind, we at ConsenSys Codefi have taken a stab at explaining the tokenization process by using an analogy to something all six-year-olds know: marbles.
So let’s start with a token:
A token digitally represents the ownership of something in a secure way, using cryptographic methods. “Something” can actually be anything: a crypto asset, yes, but also a company share, a fund share, a syndicated loan, a corporate bond, a derivative, a real estate asset, a piece of art or a luxury good.
The properties and requirements of a certain token differ depending on the use case. Choosing the right token from among the numerous options depends on the given use case.
Step 1: Selecting a Token Category
Despite the diversity of tokens, most of them can be generalized into 3 main categories, as defined in the Token Taxonomy Framework.
The first category is fungible tokens:
Fungible tokens are all identical and cannot be distinguished from each other. Each individual token is essentially interchangeable, like US dollars, company shares, or ounces of gold. This is probably the simplest and most common category of tokens, and basic use cases for fungible tokens are quite straightforward — the most common one being cryptocurrencies (such as Bitcoin or Ether).
The second category is non-fungible tokens:
Non-fungible tokens are like a collection of different, unique marbles: they represent something unique or finite and therefore are not mutually interchangeable. Non-fungible tokens (NFTs) are used to create verifiable digital scarcity, as well as representing asset ownership of things like real estate, luxury goods, works of art, or collectible objects in video games (CryptoKitties is an early example). Essentially, NFTs are used for items which require a unique digital fingerprint. NFTs make possible a whole new variety of powerful opportunities for using blockchain technology.
The third category is hybrid tokens:
Hybrid tokens are a mix of both, and therefore are a bit more complex. Each token belongs to a class (sometimes also called category/partition/tranche). Inside a given class, all tokens are the same: they are fungible. But tokens from different classes can be distinguished from each other: they are non-fungible. Using the marble analogy, hybrid tokens are like groups of different coloured marbles, identical to all and only those marbles of the same colour group. Hybrid token classes can for instance represent a fund share, a container on a ship, etc.
For any token — fungible, non-fungible, or hybrid — there are a set of pre-defined axioms or ‘rules’ dictating its behavior in certain scenarios. For more common uses of tokens, such as financial asset tokens, a set of generalized Ethereum token standards have been built (such as ERC20, ERC721, ERC1400) in order to ensure more seamless interoperability and integration with existing platforms and decentralized applications.
For example, if a company issues shares via a token that is listed upon one of those verified standards (such as ERC20, ERC721, ERC1400), they will “by design” be tradeable on any kind of Ethereum-compliant exchange (OpenFinance, Templum, TZero, etc.). Furthermore, if the asset verifies a standard, investors can then choose any asset custody solution among all Ethereum-compliant wallets (Argent, Fortis, Metamask etc.).
Step 2: Define the Business Workflow + Appropriate Behaviours
Every token, in the end, is a collection of smart contracts that dictate its attributes and functionality. The corresponding functionalities of that token are set in a standard smart contract, which can be then used by other products like different wallets and exchanges. Token smart contracts are codified rules and behaviors that follow the token throughout its lifecycle.
A token smart contract is a good starting point to tokenize a financial asset. A token on its own however, is not enough to make it a financial asset, as it still needs to be applied and adapted to a use case. In order to leverage the benefits of programmable blockchains like Ethereum, we need to set use-case specific rules and behaviors governing the asset. Then we see the magic happen.
If we see the token as a marble, asset tokenization goes beyond just the creation of marbles (or tokens). It also includes the pipeline that guides all of the movements of the marble. This pipeline is what we call the business workflow for a tokenized asset.
In conclusion, financial asset tokenization is the combination of:
a token (fungible, non-fungible, or hybrid): a digital representation defined by a set of self-evident rules interoperable with the ecosystem, and
a business workflow: a set of “use case specific” rules, that will apply to the token and dictate its behavior in certain scenarios.
The business workflow is built either by:
adding additional behaviours/ properties directly in the token smart contract (when those are generic enough), or by
creating a dedicated workflow smart contract, in addition to the token smart contract, which can be seen as the pipeline through which the tokens will evolve
Common behaviours that can be implemented in the workflow smart contract
In the end, the combination of a token smart contract + business workflow smart contract allows you to represent any kind of financial assets.
Step 3: Configuring the Governance and Roles
Once all the rules are defined (token + business workflow), it’s important to configure the smart contract by defining who is allowed to perform the different actions defined within the rules.
Different levels of control can be defined over the tokens.
Different roles can also be distinguished depending on the governance put in place.
Step 4: Choosing a Blockchain Network: Public or Private-Permissioned
The last step is choosing the blockchain network where the smart contract(s) (i.e. tokens) will be deployed. While there are many different blockchains in operation today, the main choice lies between public blockchains (like the public Ethereum blockchain), private, or private-permissioned blockchains (permissioned so that only selected participants can join the network). Depending on the functionality you need for your tokens, the decision of which blockchain network to use impacts things like:
Scalability: how fast transactions process and how low the network latency is. Depending on one’s scalability requirements (or the necessary speed of transactions), a private network might be preferred, for example (which offers faster transaction execution, but at the expense of privacy and interoperability)
Privacy: public network transactions are pseudonymous but not completely anonymous.Once someone knows the address (public key) of a token holder, he’s able to access the whole transaction history of this person. Therefore depending on the transparency requirements (such as some regulatory contexts), a private network can be more appropriate.
Interoperability: assets will be easily accessible by external platforms/exchanges if deployed on the public Ethereum network, while it will require more complex developments for integration, like cross-blockchain bridges, if created on private networks.
Do you want to play with marbles?
We hope that understanding the different kinds of tokens and capabilities of tokenization have become just a little bit clearer for you. If you’re interested in learning more about tokenized assets as a possible solution for your business, we’d love to help. ConsenSys’s commerce and finance operating system, Codefi Assets, provides the building blocks to create, issue, and manage the lifecycle of digital assets, associated markets, and digital financial instruments on public or permissioned blockchain networks. We can help simplify and customize the design, issuance, and distribution of digital assets and securities. Codefi Assets can help you issue new tokens, and encode and automate the corresponding rights and obligations of issuers and investors, on the type of blockchain network that works best for your needs.