Token Taxonomies
For the first edition of this newsletter, I thought it would make sense to zoom out and begin by taking a macro perspective of the current state of token ecosystems in general. To do this, we'll take a look the history of cryptocurrency development, different approaches in token design, as well as their applications.
Where It "Began"
Before exploring cryptocurrency and the tokens that exist today, it should be recognised that there have been many previous attempts at the creation of digital token currencies that could be used as a means of exchange, prior to the advent of Bitcoin:
Whilst these experiments failed to go anywhere, they paved the way for Bitcoin - the first peer-to-peer electronic cash system, which saw the first transaction take place on 12th Jan 2009.
Since then, Bitcoin has grown to become the largest cryptocurrency by marketcap, with a globally distributed network.
Given its success and longevity, Bitcoin can be deemed as the first successful attempt at creating a digital currency that could be used as:
In many cases, Bitcoin has often been referred to as "hard money" - something which is often used to describe money that is asset-backed. As we can see below, Bitcoin not only shares many properties that are common in fiat currencies, but also commodities such as gold - but with better characteristics when compared with both.
So why start here?
Well, whilst Bitcoin was the first fully-fledged "cryptocurrency" to be created and see adoption, it inspired many others and opened the floodgates to waves of innovation that has seen thousands of different cryptocurrencies be created to-date. Given this, it easy to imagine why there are challenges with deciding how to categorise such innovations, given the diverse landscape that has emerged.
Coins & Tokens: What's The Difference?
So how can we go about evaluating and grouping different cryptocurrencies and getting a better understanding of their functions and differences?
With the rise of countless new blockchains and innovations within the crypto space, it is a constantly moving landscape and this is challenging. But with several years since the emergence of blockchains that are not just settlement layers à la Bitcoin, but also smart contract platforms - such as Ethereum - there has been have been a number of emerging categories of tokens.
But before we look at these different tokens and standards, it is probably useful to first make the distinction between "Coins" and "Tokens". Whilst "cryptocurrency" is a collective term that refers to both, with the use of these words seeming fairly interchangeable in common parlance, they are actually distinct in nature and this is one of the first nuances that should be considered. Whilst this article is more interested in exploring the token side of things, it is worth quickly covering these differences:
As we can see here, the main distinction is that coins are the native currency to their chain and will be used for paying for things such as transaction (gas) fees. Tokens on the otherhand will be created on top of any blockchain network that has smart contract functionality (i.e. can support the creation of tokens on-chain). Unlike coins, tokens have far more functionality than being an incentive to secure a network (as with coins) as they are often created to play a particular role within a protocol's ecosystem.
E.g. Curve Finance protocol's token $CRV is an ERC-20 that primarily acts as the reward for LPs that deposit funds into the protocol, but can also be "locked" in the protocol for a period up to 4 years in order to be used proportionally for governance rights/voting, for which they are rewarded with a proportional claim of 50% of the protocol's administrative fees that it collects. See more on this in my Curve Finance Deep Dive here.
Whilst crypto coins are inherently important given they incentivise the security of blockchains and are arguably strong forms of money and stores of value, they aren't as interesting as tokens - given the variety of different use cases - hence spending the majority of this article focusing on the latter.
So Coins & Tokens Are Different - But What About All The Different Types Of Token?
There are a number of different ways tokens can be classified and we'll explore a number of these dimensions to see how they compare. But, firstly let's take a look at what tokens actually are.
Crypto Tokens: 101
As highlighted earlier in this article, tokens are built on pre-existing blockchains that can support smart contracts as tokens are a form of smart contract - computer programmes/code that is stored and executed on blockchain networks. To understand the different token types, it's important to remember that they are smart contracts; it is because of this fact that they can take on different characteristics and functionalities.
We can use the Ethereum ecosystem and some of the different token standards within to highlight this. Of course, it should be noted that other blockchains have their own standards - the Ethereum standards are being used as they are most commonly encountered and the first to gain widespread adoption.
As we can see above, there are four major classifications of token standards on Ethereum. Whilst there are other standards as well and likely new ones that will be created in the future, these are four of the most commonly used. With each of these, we can see how tokens differ in technical composition and the consequences of this on use cases. The standards are essenitally guidelines for how tokens should be created/issued, deployed, transferred, destroyed etc. These standards are important as it is through standardising the functionality of these different token types, it makes it easier to build applications for these tokens and intereact with them. I.e. they have a set of rules that sets out what data a token should contain, how it should behave, what the token can do, as well as how a holder can interact with that token.
By looking at a few of these standards, we can explore how this works:
ERC-20: Also, known as Ethereum Request for Comment 20, proposed by Fabian Vogelsteller in November 2015, was the first token standard proposed within the Ethereum ecosystem, implementing an API for tokens within smart contracts.
This token incorporated the following mandatory functions (in order to ensure that these tokens and interactions were predicatable):
As seen from these functions, these are all focused on ensuring that these sorts of tokens can be used as a means of exchange, unit of account, and store of value. The optional functions also signal this with:
Prime examples of these tokens are stablecoins such as $USDC - i.e. an on-chain version of a dollar. Their only real purpose being as a store of value and means of exchange.
ERC-721: The ERC-721 standard was proposed by William Entriken, Dieter Shirley, Jacob Evans, Nastassia Sachs in January 2018 in order to create a non-fungible token standard. These tokens are non-fungible as each token is unique and not interchanged with another token on a one-for-one basis - constrasting ERC-20 tokens which are identical to each other in value and their underlying properties. As this standard can be used to add unique properties to the token, they have broad use cases beyond being used as a means of exchange, such as tokenising art (NFTs - such as Bored Ape Yacht Club or Punks) or decentralised identity (such as Lens).
With token standards, it is also common to find variations as well and the ERC-721 standard is a good example of a token standards receiving a number of different modifications in order to provide new functionalities to the token. This can be seen by the different ERC-721 variations below:
ERC-1155: Proposed by Witek Radomski, Andrew Cooke, Philippe Castonguay, James Therien?, Eric Binet, and Ronan Sandfor in June 2018, was designed to improve the status quo for NFTs, largely focusing on providing flexibility with its multi-token standard. This means that both fungible and non-fungible tokens can be created within the smart contract. It should also be noted that all state is found within a single smart contract, meaning that it multiple tokens can be batched transferred in a single transaction, thereby also increasing the efficiency of the tokens. This means that the smart contract's transaction and storage costs are more efficient, compared to if separate contracts were deployed for different types of tokens as a single smart contract can represent multiple tokens.
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ERC-4626: Authored by Joey Santoro, t11s, Jet Jadeja, Alberto Cuesta Ca?ada, Se?or Doggo, in December 2021 set out a new standard of smart contract. Built on the ERC-20 token standard, ERC-4626 facilitates tokenised vaults - in which assets from multiple investors can be pooled and put to work in different investment strategies. In receipt for depositing tokens into the vault, the depositor will receive other tokens in return - that are proportional to the amount deposited - representing the investor's share that is within the vault. The purpose of this new standard was to make it easier for (Decentralised Finance) DeFi protocols to manage tokenised vaults. It standardises the way protocols can interact with vaults, reducing complexity and security vulnerabilities, making it easier and more efficient for vault creators and users alike.
Beyond Ethereum
As previously mentioned, it's not just Ethereum that implements standards for tokens that are created on chain. If we look beyond EVM blockchains (blockchains that are compatible with the Ethereum Virtual Machine and conform to its standards) at a couple of non-EVM chains, we can see that other blockchains also utilise standardisation - but in slightly different ways .
Here are a couple of examples:
Solana: uses the SPL (Solana Program Library) token standard across the Solana blockchain. The standard allows for the creation, management, and transfers of tokens on Solana - just like Ethereum's standards, this ensures that all tokens have the interoperability needed to be used across different apps and protocols. It should be noted, the Solana uses a different account model to Ethereum, meaning that their token composition is different - i.e. one generic program that can be used across different data. Check this article for more on this as it's a little more complex.
Cardano: is another example of a non-EVM chain that takes a different approach to their token standardisation, through the use of Cardano Native Tokens. Unlike Ethereum, where tokens are implemented through smart contracts, Cardano's tokens are built into the ledger natively. The interesting aspect to note here is that instead of needing custom code and implementations for tokens to be created (arguably creating more security challenges and complexity), Cardano can support user-defined tokens through the native tokens framework. TLDR: tokens aren't tied to smart contracts - learn more here.
Use Cases - What Are The Main Applications Of Tokens?
Whilst in the early days, tokens had little functionality apart from being a useful tool to raise capital through the use of Initial Coin Offerings (ICOs), fast forward to today and there are multiple different use cases - as seen by the different token standards that provide the technical capabilities for these.
Below we can explore five broad applications of tokens, ignoring their technical standards and instead focus on what they are actually used for (instead of just holding and hoping number go up). It should be noted that this is not an official classification, but a mental model I use for classifying tokens and their most common applications:
Governance Tokens
Inherent to decentralising a crypto protocol, is ensuring that the governance (the control) of the protocol is handed over to the community. The main way of achieving this is through launching a token that can then be distributed to the community, thereby giving something that they can use to participate in the decision-making process of the decentralised autonomous organisation (DAO) that is consequently created. The majority of protocols will look to create a DAO, in order to live by true web3 values of decentralisation and community governance, whichever part of the Web3 space they operate in - c.f. Vitalik's writings on "Control as Liability" as to why this is important.
To emphasise the importance of governance tokens, we can see their significance in DeFi - given the majority of protocols have decentralised and are governed by their communities. This is quite a feat, given the amount of capital locked into these protocols. Enduring examples of this are protocols such as MakerDAO and AAVE with billions of dollars in Total Value Locked-In (TVL) with active community governance and regular DAO votes that manage the respective DAOs.
Payment Tokens
Probably the best application of cryptocurrency/tokens, full stop. It makes sense that payments would be one of the most common use cases of tokens, given that they share many of the same properties as "money", yet with the technical capabilities that makes them a better means of payment. This is most evidently seen with stablecoin markets and the sheer amount of settlement volume seen in recent years. Check out this WΞB3 RΞCAP article I wrote on Stablecoins, if you would like to learn more.
Utility Tokens
The broadest category of token classification, utility tokens have an array of different use cases but are commonly used to grant their users access to certain functionalities or services; whether this be voting on DAO proposals, being used to access special privileges, or because they have some other application within a particular protocol's ecosystem. But also, they are often found as a reward to users for performing a particular action. To this extent, it is easy to see how such a classification could overlap either the governance classification or the community classification and for this reason it should be recognised that these classifications are not necessarily mutually exclusive.
Examples of these tokens include:
Basic Attention Token ($BAT): a token that rewards users for using the Brave browser and viewing ads. The token can also be used for tipping content creators as well as is exchangeable like other tokens.
Filecoin ($FIL): a token that is used within the Filecoin ecosystem. Storage providers that provide storage space to the decentralised network are rewarded with $FIL; users pay for storage space and to retrieve files with the token.
Security Tokens
Probably the least mature category of token use cases - given the regulatory, legal, as well as technical challenges of bringing real world assets (RWAs) on chain - this is a category with growing interest from more institutional players as they recognise the benefit of leveraging blockchain technology as the settlement layer for different financial instruments. Given the challenges seen in some jurisdictions around securities laws, we can expect this category to become more diverse as protocols take different approaches to tokenisation, as seen in the diagram below:
Community
As seen by the NFT craze of 2021, NFTs were not just about JPEGs and digital art, but they were also significantly based around forming communities and the token providing access to that community. Whilst very much a first iteration of onchain communities, this is a rapidly growing segment of application for crypto tokens with community being core to many web3-native offerings - often still built around NFT projects. What this has unlocked, however, is also a wave of innovative and forward-thinking brands that are looking to capture this powerful new tool for interacting with their consumers and leveraging this to deepen the relationship they have through the means of new loyalty initiatives - tokens. And it's not just small brands exploring tokenising customer loyalty, but also some well known global brands from Adidas to Starbucks.
Legal Status Of Tokens
An entire article could be dedicated to this topic, particularly given the way that public blockchain networks are international in their composition, crossing multiple jurisdictions - with nodes scattered across the globe - as well as the protocols that are built on top being decentralised as a consequence of this. With these protocols often launching their own tokens, there are often questions around their legal and regulatory status - particularly with regard to which jurisdiction the tokens are issued in and the differences in treatment around the world relating to this.
If we look at the issue of legal qualification, Legal Nodes has helpfully put together this breakdown of the legal status of different token types as broad guidelines:
As we can see from this, some of our earlier classifications have been bundled together under new or similar classifications, relating to their legal status. It is unsurprising that these classifications are broadly similar, however, given that they will relate to what the token is, its functionality, and how a user will interact with it.
Whilst debates can be had around each of these categories and which tokens do/do not fall under these different headings, it should be recognised that legal treatment will vary based on jurisdiction and these qualifications are not a "one-size-fits-all". For crypto founders looking to launch a token, however, it is key that they consider these jurisdictional differences and take counsel on how best to proceed, but there are a few countries that are seen to be more favourable than others:
Closing Thoughts
The token landscape is a rapidly evolving ecosystem of new tokens and standards, as well as the laws and regulations governing them. I hope this article has provided a comprehensive summary of some of the different ways tokens can be classified, implemented, and utilised. At the end of the day, they are simply just computer programmes that function on-chain that can be used to transact, transfer data, prove ownership, demonstrate alignment with a community or other entity, as well as impact the development of protocols through voting.
2024 is setting up to be an exciting year for tokens as regulation and innovation begin to sync. Whilst it has been an educational journey for regulators and other institutions, the penny has finally dropped and the future has never looked brighter for a tokenised world.
Want to dive into more detail? Feel free to drop questions in the comments!
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All comments within this newsletter represent my own opinions and not my employer's.?Nothing within this newsletter constitutes financial advice.
Web Developer || Technical Writer || Blockchain Enthusiast
11 个月I haven't read it all; I skimmed through it. I have read some of your articles, and I believe this one, too, will provide a lot of value. I will give proper feedback once I've read through it. Nice work, Tom.