The moment you think you got it figured, you’re wrong.
One of the most important properties that let cryptocurrencies function well as money is the limited supply. If someone was allowed to print coins from thin air, it would be very poor money and would essentially be worthless.
But would they really be completely useless? These cryptocurrency-like things are called tokens, and they aren’t that useless. In this chapter, we’ll look at how they can enable more accessible fund raising, improve gift cards or enable peer-to-peer derivative trading.
What are tokens?
Tokens are essentially cryptocurrencies, except there’s a single entity with the power to create coins. Tokens retain the other useful properties of cryptocurrencies such as counterfeit resistance, transaction irreversibility and double spend protection.1
They achieve this by operating on top of an existing cryptocurrency. You might think of it as the issuer marking some coins with additional information, specifying what kind of token they are. (Technically tokens can be implemented in many different ways, but this is the core idea.)
The most popular class of tokens are probably the ERC20 tokens, implemented on top of Ethereum. USD Coin, Coinbase’s stablecoin backed 1-to-1 by USD, is example an ERC20 token. Binance Coin, used for the bonus system on the cryptocurrency exchange Binance, is another.2
Initial coin offering
The most famous—or infamous—use of tokens is for an Initial Coin Offering (ICO). It’s similar to an Initial Public Offering (IPO), which aims to raise funds for companies or projects. In return for giving them money you’ll receive a token as a sign of participation. ICOs are mostly unregulated and are easy for anyone to participate in.
One of the benefit of ICOs is that they’re very easy to setup, and with the right tools it can be done in a few seconds. This is also a downside as there are countless of ICOs that function only as pyramid schemes with the only purpose of finding greater fools to dump on.
Although ICOs are mostly associated with scams (and rightfully so I’d say) there might be some usefulness here. What you’re really doing is donating money to a cause you believe in, and hope you’ll get a good outcome.
Does it sound insane? That’s really no different from how Kickstarter works, where it’s very popular to pledge money for an interesting board game project and you wait for months or years and hope you’ll get something in return.
Why would you want a token for this? The benefit would be that anyone, anywhere, could participate and that participation could be done anonymously. And it all takes place on a platform where you have a guarantee that you can sell your token if you lose faith in the project (since properly implemented not even the issuer can prevent token transactions).
People use gift cards all the time, but they’re not always that great. How do you verify that they’re valid, and haven’t already been used? How do you do that in stores, when you’re choosing which one to buy, and how do you verify digital gift cards?
For example, let’s say you walk into a store and want to buy a gift card. How do you know it’s not fake, or haven’t been used? Luckily there’s a code on the gift card, which you can enter into a website to verify if it’s still valid. Okay! It’s valid, so you buy it and walk out the store.
Unfortunately for you, the store clerk has already written down the gift card code, and shortly after you leave the store he decides to use it up, making your gift card useless. Physical gift cards, the one you hand in to a store when you use them up, don’t really have this problem, but this is unsolved for digital gift cards.
This problem, of how to transfer ownership of a code, is really the same double spending problem that cryptocurrencies pioneered a solution for. And tokens inherit this property, allowing you to buy a token based gift card and be absolutely sure that it’s unspent and that you’re the only one who can spend it.
It’s quite difficult for us humans to truly understand very big numbers, because we don’t have anything to relate them to. For example, what’s the difference between $1 billion and $1 trillion? I know that the latter is 1000 times more, but that’s just a number and I have difficulties to truly understand how large the difference is.
I think visualizations can help us compare large amounts like these, so here’s one where the small box corresponds to $100 billion and the big box corresponds to $1 trillion. (Although they may look small, the amounts are still huge.)
I bring this up just to say one thing: the value of derivatives is absolutely huge. Money, which makes the world go around, is dwarfed by the value of derivatives.
But what are derivatives?
In short, they’re a bet on the value of something. A derivative is a contract that derives its price from fluctuations of the underlying asset. This commonly include bets on stocks, bonds, currencies and commodities. Have you heard about futures, forwards, swaps and options? They’re all different types of derivatives.
We’ve already seen how cryptocurrencies can improve currencies, but other types of derivatives might also find some benefit from being based on cryptocurrency tokens.
Take stock trading, for example. They’re done through a stock exchange and intermediaries that manage the exchange. This is required because—like the problem with gift cards—there’s no way to transfer ownership in a secure way. But now there is; with tokens you could create a decentralized derivative market and trade them directly between two people, without the need for an intermediary to manage the trade.
If you wanted to, you could also create digital bearer shares, where the share of a security is given to whoever controls a specific token. (With typical bearer shares control is given to whoever holds a certain piece of paper.) They would protect the owners’ anonymity, since their identity is never recorded or required, and could be used to for example create a company controlled by anonymous people.
I’m not suggesting that all derivatives should just use tokens, in many cases this wouldn’t make sense and would only add inefficiencies to the system. But even if there’s just a very small fraction of derivatives that could benefit, due to the sheer size of the derivative market, tokens could still bring a lot of value.