In the previous piece, we read about the fundamental differences between internet protocols and blockchain protocols and how tokens are a breakthrough innovation that aligns the interest and participation of the network while allowing the creator of the protocol to bootstrap the network.
We extend further on the topic of ‘Tokens’ and explain how tokens are a breakthrough for not just protocols but also for applications built on top of protocols, from the lens of a user and break them into different types.
In case, you missed the previous read, I highly suggest covering that before you continue with this topic. You can click here to directly open the previous write-up.
For others, let’s dive in.
For most people, tokens are just a financial application like shares in the traditional world that appreciates or depreciates in value. That’s what I also thought earlier. Looked at Bitcoin or Ethereum as pure financial primitives.
But I was wrong and so are you if you hold the same thesis. The programmability of tokens unlock a whole new world of equity, utility, culture and ownership, along with its open network design which makes it revolutionary.
There are inherently 2 kinds of tokens which encompass the blockchain world -
1. Fungible tokens
2. Non-fungible tokens
Fungible Tokens
Let’s look at the textbook definition of fungible tokens -
’being something (such as money or a commodity) of such a nature that one part or quantity may be replaced by another equal part or quantity in paying a debt or settling an account, capable of mutual substitution, readily changeable to adapt to new situations’ - Merriam Webster
In layman terms, think of Fungible Tokens as tokens that have the same characteristics or attributes which are mutually interchangeable. Nobody cares or tries to differentiate between 2 fungible tokens. This is a finance term but if explained in laymen's terms, it’s easier to comprehend.
In real-life examples, think of fungible tokens as the cash that you hold or the shares that you hold.
The 100 rupee note that’s held by you and the 100 rupee note that’s held by me serves the same purpose. The shopkeeper doesn’t care which note you are using to pay him, as long as he gets his 100 rupees. Both are interchangeable.
Similarly, the Tesla shares held by you and the Tesla shares held by me are the same aka interchangeable.
Correspondingly, when you buy a fungible token of let’s say Ethereum or Bitcoin or any other application, the token you own and the token I own are the same. They don’t differentiate from each other - if the token goes up in value, both our tokens go up in value and otherwise.
What makes tokens revolutionary is their nature of programmability.
Ethereum allows programmability of fungible tokens using the ERC20 contract where developers can write their own snippets of code to decide the functionality of the token.
There are 3 kinds of fungible tokens, which are predominantly used across most or all blockchain applications.
1. Utility tokens -
In layman language, these tokens unlock functionality in a smart contract.
Example - tokens that are used as collateral to take out loans from decentralized finance applications like Aave, Compound act as utility tokens. The smart contract allows only specific reliable tokens to be locked as collateral for anyone to take out loans on Defi applications. Thus, if you hold any of these tokens, you unlock yourself to a new banking world where you can borrow money without any centralized authority.
Another example of a utility token is that of a social token.
’Social token’ is a broad term that can be used to represent personal tokens (formed around an individual), community tokens (formed around a community), and creator tokens (formed around a creator). This is the part where finance and culture intersect.
These tokens are used for like-minded folks to join an exclusive club. Friends with Benefits (FWB) is the most popular community of Web3 artists, operators, and thinkers, which is an early example of a social token where the users are required to hold 60 FWB tokens to join the club, which primarily runs and functions on Discord. As of 1st June 2021, the value of one FWB token stood at 5 USD. Today it’s worth 95 USD. As the club becomes more vibrant and sought after, demand soon surpasses supply and token prices soar as there is a limited supply. FWB for instance only has a supply of 1,000,000 tokens - around 55% of the total supply is circulating and the remaining 45% is locked for use by the DAO for future operations.
Another example of a social token is that of grammy award winning artist, RAC who launched $RAC social token which gives his supporters early access to a private Discord group and get rewarded for being early hardscore supporter of RAC. As RAC community gets more sought after, the early supporters enjoy the upside of token + other benefits designed by RAC for his community.
2. Equity tokens -
Equity tokens encourage participation in a network. They are rewarded for providing a scarce resource to the network. The best example of a utility token is Uniswap, which is a decentralized exchange that works in a different format than regular centralized exchanges.
They don’t depend on order books and bid and ask style trade executions. They rather let anyone create a liquidity pool with an equal ratio of 2 tokens (eg. Eth + USDT). The pool is then used to execute transactions done by traders/users for the same pairs eg. if anyone tries to exchange Eth to USDT or USDT to Eth, the trade is executed from the liquidity pool created by LP providers. The liquidity pool providers then get paid in Uniswap tokens for each trade in proportion to the share of the pool. Centralized exchanges charge traders with maker and taker fees for services offered by them, whereasUniswap charges 0.3% for each trade, which goes to the liquidity providers in full.
The LP providers on Uniswap earned $211.18mn in total last month.
The video below fully explains how Uniswap works, in case you want to learn more about why it’s such a disruptive Defi primitive.
Now that we learned about utility and equity tokens, let’s learn about the third type of token which is used to govern networks.
3. Governance tokens -
Governance tokens are equally or probably more important as it represents ownership in a network through vote share. It gives the holder the power to cast votes in important decisions related to the application. Governance tokens democratize decision-making for crypto native protocols vis-a-vis traditional companies where decisions are taken behind closed rooms by the founders and investors. This is what makes the user of a protocol, the owner of the protocol as they use the protocol and hold the token to define the future shape of the company.
Example of governance token - ENS (Ethereum Name Service) recently announced that they will turn into a DAO (Decentralised autonomous organization) and will airdrop the ENS governance tokens to early holders of users with a ‘.eth’ name.
For anyone who is unaware of what ENS is - just how DNS points you to an IP address in the traditional world, ENS points you to an Ethereum address in the crypto world. It represents your digital identity in the Ethereum universe.
The airdrop value ranged from $5000 to $90000, depending upon the level of participation by the users. These users can use the tokens to vote for each proposal made by the community and have a say in the future of ENS or delegate voting rights to another person, who they trust and/or one who aligns with their values. Delegating voting rights imply giving your voting power to another person (doesn’t imply you give away your governance tokens to them; you get to keep your tokens but transfer the voting responsibility to another person). For most crypto applications that haven’t launched a token yet and have plans to progressively turn into a DAO and be run by the users, it is quite inevitable that they will soon airdrop their governance tokens to early users.
For anyone who wants to go down the ENS rabbit hole, the video below is a good starting point.
This sums up our explanation of fungible tokens.
TLDR;
1. Equity tokens - used to incentivize users who provide a scarce resource
2. Utility tokens - used to unlock functionality in a smart contract or is used as an access pass
3. Governance tokens - used to represent ownership in a business in proportion to the number of tokens you hold.
Note that each token can hold one or more of the above functionality. Example -
1. Uniswap is both an equity token + governance token
2. Compound is both a utility token + equity token + governance token
3. FWB is a utility token + governance token
4. ENS is just a governance token, as of now.
Non-fungible tokens
Non-fungible tokens, on the other hand, are tokens that have unique and distinct characteristics. The textbook definition of non-fungible tokens are -
’a unique digital identifier that cannot be copied, substituted or subdivided, that is recorded in a blockchain, and that is used to certify authenticity and ownership (as of a specific digital asset and specific rights relating to it’ - Merriam Webster
In a real-life application, think of non-fungibility as your table, your laptop, your apparel, the food you eat, your husband/wife/girlfriend/boyfriend, your dog, your sandwich, your goods, etc.
All of them are non-fungible i.e. distinct or non-interchangeable.
Every time you consume any of the above, you are either consuming a unique experience or you are using an offline good that has a unique marker that differentiates it from another. None of them are interchangeable.
Correspondingly, non-fungible tokens imply that every token is unique and distinct from the other, which is stored on a public blockchain.
The earliest example of an NFT is that of Crypto Punk, the image that you see below.
Crypto Punks are24x24 pixel art images, generated algorithmically, which live on the Ethereum blockchain. There are exactly 10,000 of them, each with their own ostensible personality and unique combination of distinctive, randomly generated attributes.
The floor price of a single Crypto Punk today stands at ~$400,000 and the highest Punk ever sold is Punk#3100 which has been sold for $7.8mn.
CryptoPunks have singlehandedly paved the way for a new industry that we see today which is the Crypto art movement and has inspired a new generation of art collectors and connoisseurs.
Three years ago, in 2017, Matt Hall and John Watkinson, founders of New York-based software company Larva Labs, created a quirky art project called Crypto Punks which posed a series of questions - could a few lines of code translate to a feeling of meaningful ownership?
It was a crazy non-conceivable idea until a year back, but as it stands today, it has made a conceptual leap to a multi-billion dollar industry that we see as NFT’s today.
We will find out more about this in the next edition.
Please take out a moment to rate the above newsletter. Your feedback encourages me to work on my blind spots and improve my writing style.
Awesome Average Poor
Until next time,
Abhishek Anand.