Tokenization is the process of replacing valuable or sensitive information with a meaningless string that can only be deciphered by a trusted entity. See how this is done with credit cards in our previous blog.
In blockchain, tokenization denominates a process, where something of value is represented on the blockchain in the form of a transferable token that can be used to redeem the value it represents at a later date.
Tokens vs. Coins
We talked about the difference between coins and tokens in our beginner’s guide to cryptocurrency.
A coin is an asset that is native to its own blockchain. Coins can be used to transfer money, as a store of value and as a unit of account. Coins are used in a similar manner to money, although some specific use cases exist for certain coins. For example, Ether (ETH) is used to fuel transactions on the Ethereum blockchain, NEO (NEO) is used for staking and to earn dividends, and owning enough Dash (DASH/DSH) can be used for voting on upgrades of the Dash blockchain.
Tokens on the other hand are created on existing blockchains. Examples of blockchains that allow the creation of tokens are Ethereum (ERC-20, ERC-721, ERC-1155), XRPL (IOUs or Issued currency), and NEO (NEP-5).
Tokens usually have a single-use case like unlocking features of decentralized applications (dApps), paying for fees on transactions, or representing physical things like energy or other assets.
Tokenization on Ethereum
Tokenization is the process of digitally representing an existing real asset on a distributed ledger. By using smart contracts the cost of issuing and managing tokens can be reduced, streamlining transactions and speeding up execution.
To better understand this part of the article, it’s important you know the basics of Ethereum. Please check our first part of How Do Cryptocurrencies Differ From One Another article to learn more.
Early stage capital building
The Ethereum blockchain enables issuance of tokens via smart contracts. In 2017 we saw a surge of ICOs (Initial Coin Offering) selling tokens as initial investments into new ideas. The tokens were distributed in exchange for Ethereum and in some cases even for assets on other blockchains like BTC and XRP.
Many ICOs were released in a short time in 2017 and many of those projects had shady operations or underdeveloped ideas. This robust and simple way of gathering initial capital fell victim to speculation and fell under heavy regulatory pressure in early 2018. ICOs have been virtually nonexistent since then even though the technology performed well.
The ICO experiment was successful in that it tested one important and unique ability of the Ethereum blockchain - the issuance of custom tokens.
Decentralized Finance (DeFi) has been around for longer than most blockchain users are aware. One example is Augur with its decentralized betting platform (also known as Prediction market or Decentralized oracle) that has been around since 2017.
More recently, new use cases like Decentralized exchanges, Lending and Derivatives have popped up on Ethereum. DeFi, through the process of tokenization, enables automated audibility, open access and privacy to its users.
The DeFi movement strives to bring something more to the blockchain, like financial applications. These DApps (decentralized applications) run on public networks that need no permission and allow financial transactions without trust and need for a central coordinating party. DeFi is blockchain-agnostic, which means that it is possible on any blockchain that allows smart contracts. Most use cases that exist right now are being developed on the Ethereum blockchain.
On the XRPL, Flare is exploring new ground by developing their own blockchain with consensus and distributing Spark tokens to XRP owners. Prediction markets and lending could be the first DeFi categories offered on this new chain.
Tokenization on the XRPL
The XRPL is built to allow issuance of IOUs which can represent any value on the XRP Ledger, be it FIAT currency like U.S. dollar or euro, cryptocurrencies like Bitcoin or commodities like gold. It is not called tokenization but the principle is the same.
An IOU is an abbreviation for “I Owe You” and stands to acknowledge some form of debt. On GateHub for example BTC and USD are issued to users as IOUs at a 1:1 rate on the XRPL. These IOUs hold the value of their underlying asset due to the fact that they are redeemable with the issuing gateway. Here is a deep dive into IOUs on the XRPL by Thomas Silkjaer.
The idea is pretty simple. Assets are secured by a trusted entity (on the XRPL these are called gateways and GateHub is a gateway) and IOUs are minted on the Ledger. Every IOU represents a particular volume of the asset and can be used to transfer value or be traded for other assets on the Ledger. The process is reversible and the pin between the two is always retained. That means that the original asset will get unlocked again once the IOUs are terminated.
Trust lines are used to establish connections between trusted entities. Note that anyone can issue a currency on the XRPL so make sure to only establish trust lines with entities you know and trust like GateHub.
Transactions on the XRPL are faster and cheaper than most blockchains so transferring value via IOUs is cost and time effective. The only drawback is that only the issuing gateway will redeem its IOU.
Tokenization on blockchain serves a variety of use cases from capital building to advanced financial instruments and reducing transfer costs and time.
Smart contracts on blockchain have the power to support improvements to traditional finance but have probably not seen their peak yet. Some limitations, like transaction costs on Ethereum network which have skyrocketed due to DeFi traffic, do exist.
The recent developments on Ethereum blockchain with DeFi and Flare’s project are opening up a string of exciting possibilities. We can’t wait to see what that means for the industry as a whole.