Tokenisation

Summary

Use tokens on the blockchain to represent transferable digital or physical assets and services.

Context

The concept of tokenisation has emerged centuries ago with the first currency systems. Tokenisation is a means to reduce risk in handling high-value financial instruments by replacing them with equivalents, for example, the tokens used in casinos. Tokens can represent a wide range of goods that are transferable and fungible, like shares or tickets.

Problem

How to represent a digitalised assets as an authoritative source of the corresponding assets?

Forces

  • Risk – Handling fungible financial instruments with high value is risky.
  • Authority – Tokens should be the authoritative source of the assets.

Solution

A digitalise token on a blockchain is the authoritative source of the physical or logical asset, i.e., a token is generally used to track title over the physical or logical assets. The process of creating and managing tokens is referred to as tokenisation. Blockchain provides a trustworthy platform to realise tokenisation by recording the verifiable title transfer from one user to another. There are different ways to implement tokenisation using blockchain.

Naive tokens on a blockchain (e.g., BTC on Bitcoin and ETC on Ethereum) can be used to formulate a value system where the tokens represent monetary value or physical assets. Transactions on blockchain record the verifiable title transfer from one user to another. However, native tokens on a blockchain cannot undergo complex condition checking before transferring the ownership without the support from smart contracts, e.g., Bitcoin scripts vs Ethereum smart contracts.

A more flexible way is to define a data structure in a smart contract to record the assets and their ownership. The tokenisation process starts from an asset (e.g., money). A token is then locked under the custody of the token smart contract (or its physical owner like a bank) and gets represented in the cryptographic world through a token. The ownership of the digital token matches the ownership of the corresponding physical/logical asset. The reverse process can take place by which the user redeems the token to recover the value which is sitting within the token smart contract or its physical owner like a bank. By using smart contracts, complex conditions can be implemented and associated with the ownership transfer. For example, a smart contract can enforce an atomic swap between two tokens or an escrow transfer between a token and another asset can be enforced without the mediation of a third party. Token standards such as ERC-20 and ERC-721 provide smart contract templates to enforce fungible and non-fungible tokens in Ethereumand sister blockchains, respectively, by instantiating reference implementations such as OpenZeppeline.

Benefits

  • Risk – Tokenisation reduces risk in handling high-value financial instruments by replacing them with equivalents.
  • Authority – Blockchain and smart contracts provide a trustworthy infrastructure to provide authorised tokens for the corresponding assets.

Drawbacks

  • Integrity – The integrity of the tokens is guaranteed by the blockchain infrastructure. But the authenticity of the corresponding physical/digital asset is not guaranteed automatically.
  • Standardisation – The majority of the existing financial smart contracts on Ethereum uses the tokenisation pattern. Given the popularity of this pattern, ERC-20 has become the de-facto fungible tokens standard that describes the functions and events that a token smart contract has to implement.

Related patterns

  • When a token is no longer needed it can be destroyed using the burned token pattern.

Known uses

  • Coloredcoin is an open-source protocol for tokenising digital assets on the Bitcoin blockchain.
  • Digix and Perth Mint use tokens to track the ownership of gold as a physical property.