Here, we will take a detailed overview of the advent of Ethereum and Smart Contracts.
Of course, no technology is perfect and not even the bitcoin blockchain was flawless. Even after Satoshi Nakamoto gracefully stepped out of the limelight, others were still hard at work refining the technology that he started.
Remember that just like traditional currency, the value of bitcoin depends on the perception of the crowd (i.e. perceived value). This perceived value is held relative to the perceived value of goods and other currencies as well.
Since its inception, bitcoin is still the most versatile of all the cryptocurrencies that has ever been made. More merchants are recognizing it as a form of currency and use it in the exchange of goods and services. In fact, bitcoin is traded in global markets as well.
Some of its well-known advantages include the following:
- Greater liquidity
- An increasingly wide acceptance among mainstream businesses
- Makes international transactions a lot faster compared to traditional currencies
- Lower transaction fees
- Secured privacy for the coin owners
- Transactions are open to the public providing greater transparency
- Independence from governments and other regulating bodies
- It has a built in scarcity
However, even though it does have a lot of advantages, it does have several drawbacks as well. Here are some of the known downsides of using bitcoin:
- Exposure to specific kinds of fraud and scams
- Involvement in the black market
- Susceptibility to increased price volatility
- No utility for refunds and chargebacks
- Has potential negative impact on the environment
- Has a tendency to be replaced by other cryptocurrencies that are superior
Analyzing the Greater Potential of Blockchain Technology
A lot of experts in the information technology sector saw the potential of blockchain technology. They saw that its use case far exceeded what it was originally designed for—simply put the technology behind bitcoin (i.e. blockchain) had more benefits to give other than provide a method for facilitating cryptocurrency.
Experts analyzed the technology that was developed by Satoshi Nakamoto and company. The used the same method that was applied to internet development. What they found out surprised them to a great degree.
They found out that blockchain technology introduced a radical change to the internet that we are using today. That is why there are those who say that blockchain is the new internet.
Experts understood that blockchain required its very own platform and that you can build applications on top of that platform. You can think of it as how the Windows operating system was built on top of the original Disk Operating System (DOS). And Then with Windows built using DOS as the foundation, you can create more powerful applications.
That was the potential of blockchain technology as it was envisioned and designed by the developers of bitcoin. However, as they explored these possibilities further, they found that the bitcoin blockchain didn’t have what it takes to completely live up to its true potential.
In other words, the original bitcoin blockchain needed to be redesigned for a full upgrade with better features and functionality could be achieved. One of the ideas that came along at the time, the period of which was somewhere around 2013 to 2015, they found out that the blockchain that they had at the time didn’t allow for smart contracts.
To put it simply, they could not fully automate the system. What they wanted was a blockchain system that could simulate human behavior.
And Then Came Vitalik Buterin
Vitalik Buterin is credited for the invention of Ethereum, which you can say is the next level of the bitcoin blockchain. He is a programmer of Russian-Canadian descent. What he wanted was for blockchain to facilitate a level of scripting that allowed for artificial intelligence to be included in the system.
He saw that the current blockchain technology of the day didn’t have the capability to scale up. So, in 2014 he put together a team to create an even better type of blockchain. They based their design from the old one and then added newer features that couldn’t be accommodated before.
This project was known as Ethereum.
This was the next revolutionary step in the world of blockchain technology. What they worked on allowed for a vast number of potential applications that couldn’t be realized with the limitations that were imposed on the original bitcoin blockchain.
The ethereum blockchain allowed blockchain technology to act like a platform—like an operating system as it were. This new feature was made possible with the addition of what is known as the virtual distributed machine.
This new type of blockchain allowed programming code to be added to the blocks contained in the blockchain. Remember that when Satoshi Nakamoto first launched block zero, he was able to include lines of text within the block itself.
This means a block can contain data. What Buterin and his team did was just to expand on that idea. Why would your blockchain only contain transaction records and text when it can contain so much more? The idea was splendid—this means that with the newer blockchains you are not just distributing blocks of data, you are sending out virtual machines that have executable code in it.
These newer blocks can run applications. This new technological advancement in blockchain gave way for conditional transactions to be made. This was a feature that was totally absent in the bitcoin blockchain. It allowed the blockchain itself to determine whether a condition has been met before funds can be released.
The new ethereum blockchain paved the way for the development of what is called the Turing complete smart contracts. These smart contracts had decision making capabilities thus giving it somewhat human like capabilities and behavior.
Another feature that was added along the way was for the ability to make micro-payments. This feature allowed businesses and parties to a transaction to make small value transactions.
This allowed blockchain technology to accommodate and scale different sized businesses and transactions. Scalability is now introduced into blockchain technology with the advent of Ethereum and other similar blockchains that were powered by virtual distributed machines.
Now, blockchain technology can better accommodate businesses from coffee shops to large factories. Applications can now be run on top of the blockchain which will eventually give way to other useful features.
Tokenized Digital Assets
Ethereum also introduced tokenized digital assets. Tokenization is the concept of turning real and actual things into an equivalent digital asset. Now, that might sound like some sort of sci-fi mumbo jumbo, but it isn’t, really. Allow me to elaborate on that a little bit.
So, as an example, let’s say you have a farm that is worth a couple of million dollars. It includes a large farm lot that is several hundred acres. It has a couple of huge barns that houses hundreds of cows, sheep, pigs, rabbits, horses, and other farm animals.
Unfortunately, circumstances in your life required you to sell your farm. You are in desperate need of money but selling your farm the old fashioned way will take too much time and you need the money fast.
You don’t have time for filling out the tons of paperwork, submit your property to be listed in some broker’s offer list, sift through different offers from a lot of potential buyers, haggle for the price—yes they will haggle, choose the right offer, close the deal, and do the other steps as well.
That process just takes too long and as it was mentioned earlier you need the money—and fast. A faster way to get things done is to use tokenization, which will convert your farm into a tokenized digital asset.
Not only will it expedite the process, it will also allow you to sell only a portion of your farm and allow you to keep the rest of the property for yourself. Tokenization allows you to partition the entire property into small sections or portions that represents a portion of the whole price of the entire property.
Remember that your farm has lots of cows? With the help of tokenization, you can classify each cow to represent a portion of the entire property—let’s say 1% of the entire value of the farm. Each cow in this instance represents a token.
Let’s say your property includes a small hill at one of the edges of the entire lot. That hill can be represented as a separate token, which will amount to a portion of the entire value of the farm.
Of course, you can’t digitally print a cow and then sell it virtually on the internet. Now, that is pure science fiction with the idea of digitizing real matter. Let’s dip into a bit of the technicalities involved so you can understand how tokenization works—it’s not that complicated, trust me.
To create tokens that will represent each part of the value of the entire property (i.e. the farm and everything in it), you will need to develop an algorithm that you can implement in a blockchain.
This algorithm will be used to define the features of each of the tokens that will be included in your tokenized property. It will identify the name of the asset, its value, denominations, quantity, and other features.
Once you have the tokens defined using the appropriate algorithm, the next step is to get these tokens out into the market so they can be sold off to potential interested buyers. To do that, you need a platform that will support the algorithm in your blockchain—this is called a smart contract.
So, for instance, you chose Ethereum as the blockchain and platform that will be used to get your property out on sale. What you will need next is a text editor (like MS Word for instance), an ethereum wallet (something that you can create once you sign up for ethereum), and a template for a contract (this you will use to sell the different tokens or different items included in your farm). The contract of course will spell out the conditions for payment, the cost of the item being sold, and how the items will be delivered to the buyer, along with other details.
Once all of that is prepared, your tokens are now out in the open market and can be viewed by potential buyers. These are technically known as ERC-20 tokens. What that means is that they are tokens that are facilitated and powered by the ethereum blockchain.
Everyone participating in that blockchain is your potential market. They will see your offer and they will also see the supply and demand for similar offers. Now, do take note that the actual value of your property and your tokens will rise and fall, just like what happens in other markets. This rise and fall in prices is due to the law of supply and demand.
What you can see here is the creation of digital representations of your real property. Let’s say someone wanted to buy two of your cows. They will enter the deal through the blockchain. Certain conditions need to be fulfilled, such as the payment of money and your delivery of the cow to the buyer. Once those conditions are released then the conditions in the smart contract will be fulfilled.
If you default in the delivery then you won’t get funds released to your bank account. The funds will be returned to the buyer’s account. No deal will be initiated as long as the buyer doesn’t send money to the blockchain. As you can see, this system provides layers of protection for you the seller and also the buyer.
Is Tokenization A Totally New Concept?
Honestly, the concept of tokenization isn’t really new. However, it does represent a modern twist to the original idea. The original idea is securitization, and it is a financial and trading practice that has been around even before the advent of cryptocurrencies and blockchains.
You might already be familiar with the securitization. This is actually the process where different contractual debt obligations are pooled. Examples of these obligations are credit card debt, auto loans, and mortgages.
The related cash flows from these obligations are released to a third party investor that collateralizes these debt obligations. In other words, these financial institutions give a security to the creditor. These instruments also collect from different types of debt obligations.
Do you remember the financial crisis that happened back in 2008? Yep, that was caused by the accumulation of collateralized debt obligations.
Tokenization vs. Securitization
So, securitization caused a financial crisis, now you may be thinking if tokenization can also cause ethereum to crash as well. That is a truly interesting question and it is a valid one of course since no one wants to put their property into something that can eventually leave them bankrupt.
The biggest difference between securitization and tokenization is that tokens are contained inside a blockchain. But that idea may still seem too abstract, right? So, let’s dig in a little deeper.
A token is merely a representation of the actual asset. In our previous example, it is a cow. Sometimes it can represent money that you owe, which is a riskier type of token. Well, the fact of the matter is that there are different kinds of tokens.
Let’s go over each one of them:
Currency Tokens: these are the most common types of tokens. The most common example of which is bitcoin. Each currency token is built in their own blockchain. That means they don’t necessarily have to be built on ethereum.
Unlike other tokens, currency tokens do not base their value on real assets like cars, cows, barns, and other physical objects or properties. Their value is perceived, just like any other type of cryptocurrency and this value is fueled by the distribution of the said currency.
Let’s say that the current price of a bitcoin is $5 (it’s actually worth a lot more than that nowadays)—it’s just for the purpose of this example. Now, how much is the cost of a cup of Frappuccino? Let’s say it is also $5. You can use your currency token (i.e. your bitcoin) to purchase one cup of Frappuccino. That is pretty much the most basic example of how you use a currency token – aka your cryptocurrency.
Utility Tokens: this is a bit more difficult to explain. A utility token gives you access to certain services or products. But it isn’t current access—it is future access. In other words you haven’t used it yet.
On top of that the product or service that you have purchased hasn’t been developed or produced yet. These tokens give companies time and money to develop their products and services that they can give you at a certain date.
For instance, a property developer can sell utility tokens for a condominium that he is developing in a more prominent part of town. He can sell them now so that his customers can reserve their condominium units that are scheduled to be finished in about a year from the sale date.
The property developer expects to have the place ready for occupancy at the said date and he will get the additional funds so he can proceed with the construction of the said properties. On top of that he can already secure his profits in advance.
Sometimes people treat utility tokens as some kind of future investment with the hope that the token will increase in value over time. Note that these tokens aren’t designed to be that way. There is no guarantee that the value of the product or service that you expect to obtain in the future will increase in price or value.
Security Tokens: now, if you’re interested in making investments with tokenization then this is probably the one that you’re looking for. Security tokens are more of a straightforward investment compared to the other types of tokens that have been discussed thus far.
So, how do you know if a token is designed to be a security token which is something that you can use for an investment? To do that, you need to do what is called a Howey Test, which is the same test that is applied the by SEC to determine potential investment assets.
Ask the token distributor if the token is being sold as a form of investment. You should also ask the profits that should be expected from the investment that you will make.
You should also ask if the profits that will be made for the benefit of a third party or just the distributor/promoter of the tokens. If the answer to all of these questions is yes then the token that you are analyzing is a security token, which you can invest in.
Now, to illustrate this, let’s go back to the farm, cows, and other stuff that was being sold—our example earlier. Let’s go test if the farm and its components are a kind of security token.
First question: is the token (e.g. farm lot, tractor, cow, etc.) being sold as a type of investment? Well, we can say that the farm lot is an investment since it can be used to earn a potential income, right? The cow may also count as an investment since you can resell it for a higher price.
Next question, is there a profit that is expected out of the sale of the said property? Of course there is—no one will want to sell a farm or other property on a losing bargain. Well, unless they’re desperate for cash that is.
In the case of our example, the farmer still wants to make a certain profit out of the sale, so yes. Last question: is the deal for the benefit of the farmer or some other party? The answer is yes—the farmer wants to sell the farm or at least a part of the farm and make profit as well.
So, the answer to whether the farm is a security token is yes. It is an investment. You can buy into it and expect a profit to be made from that investment. Let’s say you buy the entire farm, so you can use that investment to make a living—your new farm becomes your new cash flow vehicle.
What are the Downsides of Tokenized Digital Assets
Tokenization sounds good and it looks like a secure way to ensure that the trade of assets, services, and investments are protected. However, just like anything that was ever designed by man, even this technology has downsides.
General Acceptance of Governments Around the World
The biggest downside of tokenization at the moment is the fact that it is very hard to regulate. However, the concept behind tokenized digital assets is that it should be compliant to all local regulations wherever it is created.
The sad news is that not that many governments are ready for it just yet. It looks like using notarized agreements that are conducted through blockchain technology and utilizing smart contracts isn’t enough to assure government leaders the security that this technology can provide.
Remember that there is supposed to be an underlying asset that is represented by the token that is being exchanged. However, going back to our previous example of a farm being sold, what would be the actual value of your token if the farm gets destroyed by a passing tornado?
A blockchain won’t be able to determine that, right? The investor should be afforded certain protections and regulators should be empowered to enforce the said protection. Unfortunately, that part of tokenization technology is still in the works.
Of course, the concern for investor protection is a valid one, which is why governments are that keen on jumping into the blockchain and tokenization bandwagon. But the good news is that there are companies that are already working towards that goal.
One good example of this is Standard Tokenization Protocol, a company that is working to ensure that token products and technologies are compliant with regional and local laws in certain parts of the globe.
They are currently working on something called an on-chain validator. This technology is said to comply with anti-money laundering laws and know your customer laws in different countries. It is also said to be compliant with digital identity management.
The company reports that they can do all of that and still keep everything within the blockchain, which is the main goal for the effort—switch everything to the side of the new internet.
However, do take note that this is still all in the making. The blockchain technology that they are developing still needs to get a test run in the real world. That means they need to implement it to real life conditions and that there should be a government somewhere in the world that will be willing to work with them to ensure that the blockchain becomes 100 percent operational.
Legality of STOs
Another downside is the fact that securities exchange commissions around the world still don’t see tokenization as something that can be legalized as a form of security investments. The selling of security tokens that are totally legally compliant is called an STO or security token offering.
An STO, simply put, is a way to raise funds using blockchain. These STOs facilitate tokenization in their respective platforms. STOs didn’t have a solid track record and still needs to be worked out especially when it comes to records and investments.
Back in the day there was an ICO boom (or initial coin offering). You can compare an ICO to an IPO or initial public offering, which happens when a company enters the stock market and is offered to public trade for the first time.
The ICO fund raising model was actually very inclusive—anyone can actually jump in and make investments. However, the SEC intervened, and for good reason. In a very short amount of time millions were being traded in that ICO and the SEC didn’t like the idea of millions of dollars getting traded without any regulatory control.
It’s not that they were dictators who were hungry for control. What they were really concerned about was the possibility of money laundering and fraud when such forms of trade are performed and considering the large amounts of funds being traded; it is possible that somewhere along the way, people may be defrauded of their money.
There were some authorities within the ICOs that tried to get past some legal loopholes. They alleged that they weren’t trading security tokens but they were actually utility tokens—remember the difference?
Of course the SEC didn’t accept such an explanation. No you can’t play that card, especially with the government. Well, they applied the Howey Test, and sure enough, the ICOs were trading security tokens and they were eventually shut down.
Tokenization and using ethereum or some other blockchain that makes use of smart contracts for securities and other investments are still in the works. There are a lot of legal loopholes that need to be worked out. It is an emerging industry and it is another step in the evolution of blockchain technology. We will still have to see what will happen to this segment in the not so distant future.
