Lesson 2: TOKEN DEFINITION AND CHARACTERISTICS

Before we move forward, it’s important to make the distinction between coins and tokens. Both
represent value and can be traded for one another and often the terms are used interchangeably.
The main difference is that coins operate on their own blockchain, while tokens operate on another
coin’s blockchain. Therefore, coins are used as currency within the network and their value reflects
the value of their native blockchain. Tokens on the other hand, are not only a medium of exchange,
but also represent digitalized value that is not limited to purely economic terms. They could
represent ownership of a security or commodity, the right to access services or products, right to
contribute work, copyright, governance functionality, voting rights, digital identities etc.

As DLT is evolving at a fast pace and token use cases are expanding, it’s not easy to give an exact
definition that encompasses all the properties of tokens. Freni, Ferro and Moncada (2022) define
tokens as quantifiable representations of decentralized and disintermediated trust,

Tokenomics, a portmanteau of “token” and “economics”, can be described as the field that studies
the value proposition of a project and how that value is captured in its respective tokens. It involves
determining the token supply and demand drivers. Considerations include token emission and
burning mechanisms*
, token distribution, vesting schedule and investor incentives. The nature of
DLT allows for consistent alignment of investor behavior with the project’s goals, through
Tokenomics utilization.

Over the last few years, many businesses and startups explored the value proposition of DLT and
started building projects utilizing it. The team behind a blockchain based project usually designs a
token to complement it, then releases it to the public through an Initial Coin Offering (ICO).

An ICO, similar to an Initial Public Offering (IPO), is a way for the team to raise capital through retail
investors, in order to finance its operations. Investors are motivated by the potential value
appreciation of the token, its exchange for services offered within its ecosystem and participation
in governance. At the same time, the project experiences a network effect through a positive
feedback loop where users, investors and developers increase along with the token’s price.

The main difference between IPOs and ICOs is the regulatory environment in which they are
issued. IPO is a lengthy and expensive legal and compliance process that includes, but is not limited
to, a minimum earnings threshold, a good business track record and a prospectus that includes all
IPO details that are relevant to an investor. In contrast, ICOs are mostly uncharted territory,
regulatory wise. As a result, ICO is a fast and inexpensive process that requires minimal resources
and exhibits low entry barriers. Those usually include a smaller team and a whitepaper loosely
describing the project, targeted at the investor. Thus, IPOs are issued mainly by established private
companies with large capital, while ICOs are issued mostly by startups aiming to reach investors
worldwide, without any of the cross-border transaction frictions that normally apply. Another
significant difference is that purchasing tokens does not grant ownership of the project or right to
dividends. Lastly, IPOs are mostly targeted at institutional investors while ICOs are mainly targeted
at retail investors and venture capitalists.

The lack of clearly defined legal and regulatory requirements, combined with its lower cost and
simplicity, has led to many ICOs being used as a vehicle for fraud, posing a higher risk to investors.
In the U.S., the Securities and Exchange Commission (S.E.C.) is assigned with the task of
protecting investors from fraudulent ICOs and determining whether an ICO token should be
considered a security, thus falling under the S.E.C.’s jurisdiction to enforce federal security laws.
The S.E.C. applies the so-called Howey Test to determine whether an ICO should be considered a
security offering. As per the Howey test an ICO token qualifies as a security if it is “a contract,
transaction, or scheme whereby a person invests his money in a common enterprise and is led to
expect profits solely from the efforts of the promoter or a third party.”

In that sense, a token could change is status of being treated as a security, once its network becomes large enough that there is no central third party whose efforts are a key determining factor in its success.

So far, the only token or
coin that has been officially declared that it is not a security is Bitcoin, which is considered a
commodity by the S.E.C.

Currently, there is no robust definition for what decentralization
means, what standards should be obtained for a project to be considered decentralized, what are
the factors that affect it, how they are quantified and what the established threshold to regulate a
token as a commodity, as opposed to a security, is. Acknowledging that decentralization exists on
a spectrum, one could argue that the decisive question is: “Are there specific people or groups of
people who, if they suddenly stopped their involvement with the project, the project would no
longer be able to function?”

Ideally, the token’s properties are determined in a way that aligns with the team’s vision for the
project and its goals. Listed below, are some of the factors that need to be taken into consideration
while designing a token:
• Economics: What will the funding of the project look like? What is the initial and total supply
of the token? What is the token issuance and burning mechanism? Will it follow an inflationary
or deflationary model?
• Incentives: What incentivizes users to hold, spend or use the token? Those include potential for
value appreciation, staking rewards, services that can be exchanged or accessed with the token,
participation in governance etc.
• Use cases: What are the use cases of the token?
• Initial distribution: How are tokens allocated between the team, private and public investors?
Will there be a vesting schedule to ensure gradual token release promoting commitment to the
project and discourage immediate selloff after ICO?
• Technical considerations: Will the token be fungible? Is it going to be released in one or more
blockchains?
The definition of a token remains somewhat abstract, so classifying them is a complex task that
depends on the scope. Adding on the differences of each blockchain, tokens have distinct
characteristics related to their technology, use cases, economics, governance, underlying value etc.
Even though commonly agreed standards do not exist, previous works have contributed on creating
token taxonomy frameworks.