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Tokens and NFTs: what they are and how they work

Tokens and NFTs: what they are and how they work

Tokens are often associated with cryptocurrencies, assuming they are the same thing. Meanwhile, NFT is so much talked about, but hardly anyone knows what it is and what it is used for. Both tokens and NFTs have their own features, distinguished from cryptocurrencies by their intended purpose. Let's talk more about them.

What is a token?

Broadly defined, a token is a representation of something in a specific system. For example, it can be a monetary unit, a voting right, or even a bid. There are many roles assigned to a token, depending on the system it belongs to, which is designed to perform specific functions. At the same time, the token is not limited to a single task.

As historically known, a token is a money surrogate (a substitute). Tags, stamps, and coupons issued by private companies to replace small coins fall under the definition of a token.

The concept of a token in the cryptocurrency field is defined according to certain peculiarities. You should understand that cryptocurrency is a digital asset that runs on its own blockchain, it is decentralized, and all transactions in the network are verified.

A token is not a cryptocurrency and has none of the properties listed above. The key differences between a token and a cryptocurrency are the following:

  • can run on any blockchain;
  • centralized or decentralized release.

Simply put, a token acts as a virtual marker confirming ownership of a particular asset. It can have a real monetary value, or it can be linked to the value of a real asset. The latter involves the concept of a tokenized asset. For example, a token is linked to shares of a company, which means that buying the token itself will represent the current rate of the security during exchange trading, but you won't own it physically.

Types of tokens and features of their use

Depending on the purposes and tasks of use, all tokens are divided into several types:

  • utility-tokens;
  • security-tokens;
  • tokenized assets;
  • non-fungible tokens, or NFTs.

Utility-tokens

Utility tokens are referred to as service tokens because they are virtual coins to be used in a specific system or application. They do not have their own blockchain and are usually based on the ERC-20 standard in the Ethereum network.

The purpose of such tokens is for conducting transactions in the system. They serve as a form of reward payment or price for the sale of in-house goods and services. Utility-tokens are similar to the gold coins in any computer online game, which can be bought with real money or earned by completing tasks. Further, you can spend them on buying in-game bonuses.

Service tokens can be traded on an exchange, which makes them similar to cryptocurrencies. Buy, sell, and hold transactions make tokens a full-fledged investment tool.

When a new blockchain-based startup enters the market, it is necessary to finance its launch and further development. In this case, you can make use of an ICO and issue a certain amount of utility tokens. When investors purchase them, they are granted rights to use the company's product, such as early access and/or other privileges. Thus, the startup gets the necessary amount of investment using the service tokens while maintaining its autonomy as an authored product.

Security-tokens

Security tokens are the equivalent of securities, only in digital form. They certify ownership and entitle their holders to exercise investment interests (e.g., to receive dividends or a share of profits, the right to own shares, etc.). All rights are specified in the smart contract, and tokens are placed on the exchange for further trading.

The main feature of these tokens is that they are backed by real securities, so they are equal to financial investments. Companies that issue Security tokens are obliged to comply with regulatory requirements and file the relevant reports.

Such tokens solve the ICO's key problem related to the lack of compensation guarantees if the project fails or turns out to be fraudulent. Meanwhile, the use of a special investment strategy SAFT (Simple agreement on future tokens) makes it possible to use tokens for hedging (insurance) risks.

Security-tokens eliminate the intermediate link in the interaction between the startup company and the investor: there is no need to deal through a bank or other intermediary organization.

The main advantages of this type of token include the following:

  • 24/7 market availability;
  • shared ownership;
  • instant transaction execution;
  • reducing transaction costs;
  • reducing transaction costs;
  • simplifying the process of exchanging and trading these tokens.

A token belongs to the Security group if all four conditions are met:

  1. The fact of investment of funds is recorded;
  2. Profit is expected;
  3. Investments are allocated to an ordinary enterprise;
  4. Profit depends not on the investor, but on the actions and efforts of the counterparty or third party.

At the same time, issuing security tokens involves high costs for the issuing companies, and also implies a high entry threshold, since only accredited investors can access them.

Tokenized assets

As mentioned above, such tokens are blockchain-based and their value is pegged to the rate of a real asset, which can be stocks, commodities, indices, and more. Owning a tokenized asset does not mean you own it in physical form.

Non-fungible tokens or NFT

NFT is a unique token, available in a single copy and with no analogues. All rarity and limitation properties are transferred to blockchain, thus creating digital versions of collection items.

For example, the 2017 high-profile CryptoKitties game was the world's first NFT. The point of the project was to raise digital kittens, each character had unique and distinctive features. One of the users bought such a kitten for 600 ETH, which amounted to more than 2.4 million dollars at the exchange rate of 2021.

Key features of NFT:

  • uniqueness, cannot be replaced by analogues;
  • all NFTs can be compared to a flight ticket - there is an apparent similarity, but each has its own number and destination;
  • they are best suited for creating art, creativity, and collecting items;
  • they can be used to digitize an ID card, document confirming ownership of any valuable object or real estate;
  • NFTs are based on Ethereum blockchain, with ERC-721 token format;
  • purchase and sale on the secondary market through exchanges (cryptocurrency exchanges) are available.

A big case of the NFT transaction was a painting created by the artist Beeple called "The First 5,000 Days". It was sold as NFT at auction for $69 million.

Some of the world-famous NFTs are:

  • the Kings of Leon album;
  • works of the controversial graffiti artist Banksy;
  • football and basketball cards.

Tokens in the NFT category have varying degrees of rarity, whereby their issuance is limited in order to maintain the high value of the asset. They are also undivided, meaning the NFT exists in its entirety, you cannot send or sell a quarter or half of a token.

All NFTs feature a guarantee of authenticity, while the blockchain allows you to track the entire history of their ownership.

Today, any object or item, be it a picture or an audio recording of any celebrity whistling, snoring, laughing, can become a non-fungible token. The created content is digitized and turned into an NFT.

Historical background

The first experiments with NFTs started in 2013, when the Bitcoin blockchain scripting language was used.

In 2015, it was possible to launch the first full-fledged project called Etheria, which was presented at the Ethereum developers conference in London.  

In 2017, the NFT smart contract based on the Ethereum blockchain was created. Gaining popularity, the Ethereum network opened all the possibilities for the development and non-fungible tokens. This blockchain had a built-in function to create and store tokens, which was so lacking in the Bitcoin system.

In the same year, American studio Lavra Labs launched the CryptoPunks project, which allowed buying and selling unique cartoon characters. The project was based on the Ethereum blockchain.

In 2018, Decentraland, a blockchain-based virtual world, emerged and grabbed the spotlight. Using ICO, the project attracted 26 million dollars, and its internal economy of the project was already estimated at 20 million dollars, where the NFT contributed a lot.

In 2020, the market of non-fungible tokens started actively growing, reaching a capitalization of $250 million, while the tokens themselves were created from real art and creative pieces. So, in 2021, the first painting to become an NFT was the work of the controversial street artist Banksy called Morons.

Many people claim that NFT is just a hype, but fully justified, as the owners of cryptocurrencies invest millions of dollars in a new trend.

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