At a glance
- Looking toward the rest of 2022, capital markets organizations need to become familiar with what tokens can enable.
- At a high level, stablecoins serve as a bridge between traditional finance and DeFi; they can serve as a fiat on-ramp to DeFi and facilitate USD settlement outside of traditional banking hours.
- Organizations should pay attention to the developing regulatory environment for stablecoins and gauge reactions of the innovative first movers.
Read more articles in our spring 2022 financial services industry outlook
This is the third piece in our series on decentralized finance, known as DeFi. So far, we have the concept of DeFi and explored its technological backbone, the smart contract. In this installment we’ll explore how smart contract-enabled tokens serve an important role in the DeFi economy.
Not every digital asset needs its own blockchain; this is the core difference between a “coin” and a “token.” Coins generally refer to the native asset of any given blockchain; Bitcoin has bitcoin (BTC) and Ethereum has ether (ETH). Tokens, on the other hand, are essentially a subledger on another blockchain’s distributed ledger. Generally, smart contracts are the keepers of these subledgers.
Tokens leverage the security of their underlying blockchain, like Ethereum, to provide their own unique utility. The underlying blockchain benefits from this relationship because transfers of tokens generally require a payment in the native asset, in this case ETH. These payments in the Ethereum network are commonly referred to as gas. Whether transferring ETH or an Ethereum-based token, all transactions require a gas payment in ETH. In this regard, the Ethereum network is agnostic to the digital asset being transferred.
Because tokens leverage the core functionality and features of an underlying blockchain, it is not surprising that Ethereum, the largest and most distributed smart contract-enabled blockchain, has the largest share of tokens as measured by gross value.
It’s fair to say Ethereum also wrote the book when it comes to smart contract standards for tokens. Fabian Vogelsteller and Ethereum co-founder Vitalik Buterin introduced the token standard in 2015 with the implementation of the Ethereum Request for Comments 20 (ERC-20). ERC-20 tokens, as they are known, quickly became the market standard for token issuance, as they allowed startups to use the Ethereum blockchain to bootstrap their growth (discussed further below in terms of initial coin offerings).
According to CoinGecko’s ranking of digital assets by market cap, ERC-20 tokens represent 10 of the top 25 digital assets, with $217 billion in value. It’s worth noting that several others in the top 25 started as ERC-20 tokens before migrating to their own blockchain and coin.
The largest category of tokens is the stablecoin, a token—not a coin, despite its name—tied in some manner to the U.S. dollar. Contrary to the DeFi ethos, most stablecoins are issued by centralized entities. They are still tokens and rely upon smart contracts for execution, but their issuance and backing are centralized.
As of January 2022, the total value of USD-based stablecoins was $152 billion, according to data from The Block. In January 2021 the value was merely $35 billion. The staggering growth in stablecoins, and in some cases their questionable backing, has drawn regulatory scrutiny from lawmakers.
Regulatory issues aside, understanding the role of stablecoins in the DeFi economy is essential.
Regulatory issues aside, understanding the role of stablecoins in the DeFi economy is essential. First and foremost, stablecoins offer much-needed price stability, as their name implies. With stablecoins, smart contracts can execute in U.S. dollar terms and maintain required capital levels until settlement. Pairing a stablecoin with ETH and a smart contract, it’s possible to form pools of liquidity from which programmatic trading can occur. Additionally, at a high level, stablecoins serve as a bridge between traditional finance and DeFi; they can serve as a fiat on-ramp to DeFi and facilitate USD settlement outside of traditional banking hours.
From initial coin offering to NFT
Thanks in part to the ERC-20 token’s initial coin offering, or ICO, the unfathomable became possible. Entrepreneurs seeking to bootstrap their blockchain business dreams saw the ICO token issuance as a meaningful alternative vehicle for raising capital. By 2017, reports indicated that ICO funding hit $1.2 billion, surpassing early-stage venture capital funding for internet startups. While regulatory scrutiny over these financial products slowed the pace of ICOs, data from Crunchbase shows that over $16 billion has been raised through token issuances to date.
One limitation to the ERC-20 token is that it is fungible. A nonfungible token, or NFT, would allow each item within the token contract to have its own unique attributes. So, the nonfungible ERC-721 token standard was created. The early use cases of NFTs were nearly exclusively for the issuance of digital art and collectibles, such as CryptoKitties and CryptoPunks. While art NFTs are still very popular, NFTs are increasingly being used to represent assets in the metaverse or to facilitate play-to-earn gaming.
While sometimes whimsical, the innovation around tokens and NFTs may provide interesting financial and capital market use cases down the road. For example, a recent play-to-earn NFT game featuring 8-bit pictures of wolves has issued the first NFT that functions as a self-amortizing instrument. The financial use cases of such a novel digital instrument and the ability to trade that asset for stablecoins through a smart contract could be profound. However, until these assets are fully vetted and ready for prime time, innovation and testing in a playful video game-style environment may be what we need.
Looking toward the rest of 2022, capital markets organizations need to become familiar with what tokens can enable—namely, bridging the gap between traditional and decentralized finance. Organizations should pay attention to the developing regulatory environment for stablecoins and gauge reactions of the innovative first movers.
In our next installment of the DeFi series we’ll introduce the DeFi exchange and how tokens are traded, and explore how capital is being deployed in the DeFi economy.
Read more articles in our spring 2022 financial services industry outlook.