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Not all tokens are created equal

author by Ian Woodgate March 31, 2023

Editor’s note: Ian Woodgate is a Technical Sales Engineer at Digital Asset.

What does the word “token” mean to you? Traditionally we think of tokens as something that we own—a representation of something of value in the real world. A token for lunch at a restaurant, a token for a vending machine, a token for a parking lot, and so on. Tokens may be fungible (one is the same as another and I could swap, say, 10 of mine for 10 of yours, with no impact), or non-fungible (each one is different, so they cannot be swapped without impact). The much-publicized non-fungible tokens (NFTs) are really just digital tokens that are each unique.

We are used to tokens being fairly simple constructs. Someone owns them, and you can exchange them, use them, or give them to someone else. Cryptocurrencies are a type of token, and this makes sense in that a bitcoin “token” has value and can be exchanged or given to someone else.

In the blockchain world, ERC-20 is a popular way to represent fungible tokens digitally. It is, by design, aligned to the view of fungible tokens described above. This makes it ideal for creating digital tokens that have an owner and can be transferred. For cryptocurrencies and the like, that’s great, as it’s pretty much all you need. In the financial world, an ERC-20 token is an example of a bearer instrument.

But what about financial instruments such as bonds, equities, derivatives, or complex structured products? How could we represent these as tokens? How can we manage:

  • Secure custody: accounting for the roles of custodians, issuers and registrars

  • Instrument behavior

  • Intermediated settlement

  • Elections, such as the exercise of an option

  • The impact of external observables (such as an interest rate)

  • Servicing (payment of dividends, coupon payments, corporate actions, payouts, etc.)?

If you represent a financial instrument using a bearer instrument token approach, then you still have to do most of the above stuff somewhere else (most likely off chain). That means you have to keep all of your existing systems and processes in place. So instead of making your business simpler and more efficient by tokenizing assets, you have in fact just added another layer on top. To add to the mix, you also need to think about whether or not your tokenized asset gives you what you need with regard to:

  • Privacy (as opposed to anonymity—token transactions may be anonymous if you don’t know who owns a wallet address, but they can be  seen by everyone on a permissionless network)

  • Composability with applications provided by other organizations

  • Transparent and predictable costs

  • Regulatory compliance (for example, the Fed/OCC/FDIC joint statement on crypto-assets from January 3, 2023 states: “...issuing or holding as principal crypto-assets that are issued, stored, or transferred on an open, public, and/or decentralized network, or similar system, is highly likely to be inconsistent with safe and sound banking practices.”)

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So, as ever, it comes down to choosing the right tool for the job. If you just want the functionality of a bearer instrument, then that’s great. But if your financial instrument’s requirements are more complex, then that’s where our Daml Finance library comes in. With Daml Finance, you can create tokens that give a much more accurate and complete representation of financial instruments, and it is this capability that allows you to optimize processes and simplify systems.

In the next post in this tokenization series, I will illustrate how tokens created with Daml Finance can be used to lifecycle assets “on chain,” as opposed to creating bearer instruments and managing other aspects elsewhere. We will also explore how instrument lifecycles are modeled and applied to investor holdings, and how the lifecycling approach with Daml Finance provides greater simplicity and flexibility in the application of lifecycle events to all holdings.

Also, you can watch the recording of our recent webinar on asset lifecycling, where you’ll hear more from me about how to simplify financial instrument management with Daml Finance.