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This chapter is from the book

This chapter is from the book

Understanding Digital Asset (Token) Fungibility: Opportunities and Challenges Related to Token Valuation and Blockchain Ecosystems

Since the early conversations about crypto assets and blockchain, there has been a significant change in attitudes toward crypto assets and the industry’s willingness to work toward solving the issues regarding the trade, payment, and movement of (digital) goods and money. Some of the industry’s focus has centered on the economic viability of solutions, business models, and governance, and the fundamental tenets of blockchain and its correct use in use cases, such as the following ones:

  • The payments landscape: Retail, wholesale, interbank, and cross-border issues.

  • The relevance to GPI Phase 3 and blockchain’s role regarding Nostros Vostro.

  • Stable coin and digital fiat: Payment innovation, payment velocity, and emerging business models.

  • Innovation in B2B products, such as accounts payable, accounts receivable, and B2B money transfers.

Although we are building a value network that can transfer value with embedded trust and transparency, in many cases the value is created by using the principles of crypto economic models (mining, minting, or simply induced value) or, in the case of permissioned networks, by introducing asset tokenization. You should understand the primary drivers of value in a blockchain network, which inform the understanding of the core tenets used to evaluate the economic value of blockchain entities. The drivers of valuation include the following possibilities:

  • Tokens that are driven by crypto economic models, which are themselves driven by supply and demand and the utility of the network.

  • Non-fungible tokens (NFTs) that have an intrinsic value, such as identity, diplomas, and healthcare records. Such tokens are simple proof-validations of the existence, authenticity, and ownership of digital assets.

  • Fungible tokens that are valued by the total of economic activity in the network (cryptocurrency); their utility (smart contracts and transaction network processing); their assigned values, as in stable coins and security tokens; and so on.

At this point, we must define and understand tokenized value. Many different token types and classifications exist, all of which share one thing in common: They represent and digitize value.

Defining Fungibility

In economics, fungibility is “the property of a good or a commodity whose individual units are essentially interchangeable.”6 That definition has implications for the blockchain world, owing to its reliance on tokens and their economic models. In this section, we explore two fundamentals of token-based systems:

  • The token evaluation model

  • Token fungibility and asset exchange mechanisms

The Token Evaluation Model

The token evaluation model determines the value of a systemic asset. Put simply, if we choose to engage in economic activity such as transaction processing and use the asset as a currency, or if we use tokens as a utility or security, we must know what the asset or token is worth!

Considerations for evaluating the economic values of blockchain companies include the following:

  • Business solutions:

    • Problem domains: What is the business problem that we are solving? What is the industry landscape? What is our evolution through innovation?

    • Addressable markets: What is the overall cost of problem domains? For example, what is the cost of the problem itself or industry subsegments?

    • The regulatory and compliance landscape: The regulatory landscape can help or impede the adoption of new technology-led business models.

    • Competitive frameworks and alternatives: How are the other framework entities trying to solve the issue with or without DLT or blockchain?

  • Technology design and architecture:

    • Consensus design: This approach leads to trust systems and the economic viability of the blockchain network.

    • Blockchain tenets: Shared ledgers, crypto elements, smart contracts, and security elements are foundational concepts.

    • Blockchain deployment infrastructure: The cloud, geo-specific deployment, technical talent (or access to it), service level agreements (SLAs), and other components must be defined for the network.

  • Monetization strategies:

    • Token-based models: Operation fees are used to write to the blockchain-powered business network’s distributed database.

    • Tokens as a medium of exchange: Participating entities lend or sell tokens as a step-through currency.

    • Asset-pair trading: This practice monetizes margins.

    • Commercialization of the protocol: Technology services include the cloud and software, lab, and consulting services.

The Power of Networks

We can extrapolate the power of networks and the exponential power of co-creation models to create new business models and produce economic value.

Token Fungibility and Asset Exchange Mechanisms

You must understand token fungibility and asset exchange mechanisms to understand the duality of transaction processing—that is, exchanging the (digital) value of things that are worth trading. With fungibility and asset trading, every crypto asset is confined to its network of origination. Without a measurable and defined valuation model, it is impossible to determine the real value of these crypto assets or tokens, regardless of their classification, which implies that the exchange is a speculative value. It is difficult to create a sustainable economic ecosystem or marketplace based on speculation.

Various approaches to dealing with asset exchange have been proposed that provide businesses with fungibility and asset exchange models:

  • Centralized exchanges: Centralized entities that do not use or conform to the decentralized nature of blockchain technology. The business model is based on an intermediary that provides specialized exchange services for crypto assets.

  • Decentralized exchanges (DEXes): DEXes address the disintermediation of centralized exchanges, which remove cost and friction while specializing in exchanging services for crypto assets. DEXes adhere to a decentralized model and enable peer-to-peer exchanges. For example, atomic swaps and atomic cross-chain trading entail the exchange of one cryptocurrency for another cryptocurrency without a trusted third party.

  • Cross-chain transactions: Transactions between various token types that ensure that the integrity of assets (and transactions) is preserved when the token or its definition moves across networks.

  • Asset bridging: Like cross-chain transactions, asset bridging addresses the issue of a token that remains confined to its network due to its creation, validity, and life cycle. With technology such as asset locks, the bridges ensure that locked assets are not traded and do not change ownership.

You must determine the value of a systemic asset for a simple reason: If we choose to engage in economic activity, such as transaction processing by using an asset as a currency or by using tokens as a utility or security, we must know their worth. Fungibility and subsequent asset trading bring an interesting dynamic to the crypto asset world, because every crypto asset is confined to its network of origination. Without a measurable and defined valuation model, it is impossible to determine the real value of these crypto assets or tokens, regardless of their classification, which implies that the exchange would be just a speculative value. As noted earlier, it is difficult to create a sustainable economic ecosystem or marketplace based on speculation. The industry has adopted various approaches to enabling asset exchange, thereby providing a fungibility and asset exchange model that supports a more concrete market structure—one not based solely on speculation. The challenge lies in defining the correct evaluation model and choosing the correct option to enable token fungibility and facilitate exchange. Great opportunity can be found in technological advancement and the resulting business opportunities, such as first-market advantages and enabling new industries and business models.

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