a16z: Understand 7 token categories and understand where the value of crypto assets comes from

Original title: "Defining tokens"

Authors: Miles Jennings , Scott Duke Kominers , Eddy Lazzarin

Compiled by: Deep Tide TechFlow

With the increasing activity and innovation of token-based network models, builders want to know how to distinguish different types of tokens—and which tokens may be the best choice for their business. Meanwhile, consumers and policy makers are working to better understand the role and risks of blockchain tokens in applications.

To help organize conversations, we provide definitions, examples, and frameworks to help you understand the seven categories of tokens most commonly used by entrepreneurs: network tokens, securities tokens , company support tokens , functional tokens , collection tokens , asset-backed tokens , and Memecoin . We outline them in more detail below.

Quick review: Tokens and their characteristics

Fundamentally, the token realizes true digital ownership .

More precisely, blockchain is a decentralized computer composed of a network of individual computers that maintain shared ledgers—in fact, a " computer in the air ." Tokens are data records on these ledgers that can track quantity, permissions, and other metadata. Crucially, these data records can only be changed based on rules encoded on the blockchain, which can be used to grant executable rights.

Under this precision, there are many details that have an impact on design, functionality, value, and risk: Since tokens are embedded in software, they can be programmed to represent almost anything—any digital form or property record. This means that tokens can be designed as digital store of value, such as Bitcoin, productive and consumer assets, such as Ethereum, collectibles, such as digital transaction cards and gaming items, payment stablecoins, such as USDC, and even digital stocks.

Some tokens provide holders with various rights (such as voting rights or economic rights), while others allow only product or network services. Some tokens can be transferred between users, while others cannot. Some tokens are interchangeable, i.e. all units are equivalent (e.g. dollar bills), while others are non-interchangeable, i.e. they represent unique personal assets (unique, such as transaction cards, or even Mona Lisa).

These design choices are important because they determine whether the token is a good store of value or medium of exchange; whether it is a productive asset with inherent functional and/or economic value ; or whether it is inherently worthless. The characteristics of a particular token also determine how it will be treated under applicable law.

So whether you are building a blockchain-based project, investing in tokens, or just using tokens as a consumer, it is crucial to understand what you are looking for. It is important not to confuse Memecoin with network tokens. The rest of this article is intended to help eliminate this confusion.

Token type

Network tokens

Internet tokens are essentially related to the programmatic functions of blockchain or smart contract protocols, and their value also comes from this.

Network tokens are often built-in usefulness; they can be used to operate networks, reach consensus, coordinate protocol upgrades, or incentivize network actions. The networks associated with these tokens usually (in most cases should) contain economic mechanisms that drive the value of the token. These include programmatic repurchases, dividends, and other changes to the total supply of tokens through token creation ("faucet") or destruction ("sink") to introduce inflation and deflationary pressures to serve the network.

Internet tokens can have similar trust dependencies as commodities and securities. Recognizing this, both the SEC's 2019 Framework and FIT21 stipulate that network tokens will be excluded from U.S. Securities Act when these trust dependencies are mitigated through the decentralization of the underlying network. The core essence of decentralization is that systems can run without human control (individual, corporate or management team).

Network tokens are best used to guide the creation of a new network , assign ownership or control of the network to its users, and/or ensure that the network can self-fund for continuous and secure operations. Examples of network tokens include DOGE, Bitcoin’s BTC, Ethereum’s ETH, Solana’s SOL and Uniswap’s UNI. In the context of smart contract protocols such as Uniswap and Aave, network tokens are sometimes called " protocol tokens " or " application tokens ".

Securities tokens

Securities tokens represent the digital form of securities , which can be in traditional forms (such as corporate stocks or corporate bonds), or have special characteristics such as providing profit interests in a limited liability company, a share of athletes' future income , and even securitization rights to future litigation settlement payments .

Securities usually give holders certain rights, ownership or interests, and their issuers usually have unilateral powers to influence or construct asset risks. As the SEC is expected to modernize securities laws to allow on-chain transactions, the number and type of securities to be tokenized may increase, which may increase the efficiency and liquidity of the securities market. But even if the categories continue to grow, digital securities will remain subject to U.S. securities laws

Securities tokens have been used to raise funds for commercial enterprises. Examples of securities tokens include Etherfuse Stablebonds and Aspen Coin , which are part of the ownership interest in the Aspen Rigi Resort.

Company-backed tokens

Company-backed tokens are inherently linked to and gain value from off-chain applications, products or services operated by companies (or other centralized organizations).

Like web tokens, company-backed tokens may use blockchains and smart contracts (for example, to facilitate payments). But because they are primarily related to off-chain operations, not network ownership, companies can unilaterally control their issuance, utility, and value. Like functional tokens (described below), company-backed tokens usually have their own embedded utility. Unlike functional tokens, the tokens supported by companies are speculative.

Given these characteristics—though company-backed tokens do not give holders clear rights, ownership or interests like traditional securities—they have similar trust dependencies to securities: their value is essentially dependent on systems controlled by individuals, companies, or management teams. Therefore, although the tokens supported by a company are not securities themselves, when the tokens supported by a company attract investment, their transactions may be subject to U.S. securities laws.

Company-backed tokens may become legal categories. However, they have been used primarily in the U.S. history to illegally circumvent securities laws—to attract investments in applications, products or services controlled by a company, and may act as agents of equity or profit interests in the company. Examples of tokens supported by companies include FTT, which acts as a profit interest in the FTX exchange, or the hypothetical cloud service provider issuing tokens that enable holders to access cloud services and obtain some on-chain revenue from such services. Meanwhile, BNB is an example of a company-backed token that evolved into a network token with the launch of Binance Smart Chain. Company-backed tokens are sometimes called " startup tokens ", or, given their links to off-chain applications, are called " application tokens ."

For more information on the difference between network tokens and company-backed tokens (including FTT), read “ Internet tokens vs. Company-backed tokens .”

Functional tokens

Functional tokens provide practicality within the system and are not used for investment purposes. Functional tokens are often used as currencies in the digital economy. For example, digital gold in the game, loyalty points in membership programs, or points redeemable for digital products and services.

Importantly, functional tokens are different from securities tokens, network tokens and company-backed tokens because they are designed specifically to prevent speculation. For example, these tokens may not have a supply cap (meaning an unlimited amount can be minted) and/or have limited transferability; if not used, they may expire or depreciate, or they may have monetary value and utility only in the system in which they are issued. Most importantly, they do not provide, promise or imply financial returns. Given that they are not suitable as investment products, functional tokens are generally not subject to U.S. securities laws.

Functional tokens are best suited to be used as currency in the digital economy, where issuers gain economic benefits by controlling the monetary policy of that digital economy (i.e. acting as a central bank) and maintaining stable token value, rather than benefiting from the appreciation of token value. Examples include FLY , which is the loyalty and payment token of the Blackbird restaurant network. Another example is Pocketful of Quarters, an in-game asset that did not receive SEC action relief in 2019. Robux and Start Alliance Points have not been tokenized yet, but beyond that, they embody the concept of functional tokens well. Functional tokens are sometimes referred to as “ utility tokens ,” “ loyalty tokens ,” or “ points .”

Collect tokens

The value, utility or significance of a collection token comes from records of ownership of tangible or intangible goods. For example, a collection token can be a digital simulation or representation of a work of art, musical work, or literature; a collection or commodity, such as a ticket stub for a concert; a membership of a club or community; or an asset in a game or a metaverse, such as a digital sword or a plot of land in the metaverse .

These tokens are usually irreplaceable and are often practical. For example, collectible tokens can be used as an activity license or ticket; can be used in video games (such as that sword); or can provide ownership in relation to intellectual property rights . Since collectible tokens are often associated with finished products or products and do not rely on the efforts of third parties, they are generally not subject to U.S. securities laws.

Collection tokens are best used to convey ownership of tangible or intangible goods. Many (though not all) " NFT " products fall into this category. Examples include NFTs that convey ownership of digital art or other media; profile pictures (“pfps”) such as CryptoPunks and Bored Apes, as well as other virtual fashion and branded merchandise ; game items; and account records or identifiers (such as ENS domains) .

Some collectible tokens are directly associated with physical products, either providing a digital extension of the physical product experience, such as Pudgy Penguins toys and Generative Goods collection cards, or providing a digital representation of physical goods for easy tracking and/or exchange, such as NFT event tickets and BAXUS’s vault liquor NFT .

Asset-backed tokens

The value of asset-backed tokens originates from claiming rights or economic risks to one or more underlying assets. These underlying assets may include real-world assets (such as commodities, fiat currencies, or securities) or digital assets (such as cryptocurrencies or liquidity pool equity).

Asset-backed tokens can be sanctioned in whole or in part and can be used for different purposes: acting as a store of value, a hedging tool, or an on-chain financial primitive. Unlike collectible tokens that get value from ownership of unique goods such as digital artwork, in-game items, or event tickets, asset-backed tokens function more like financial instruments, gaining value from their collateral, price-linking mechanisms, or redemption rights. However, the regulatory processing of asset-backed tokens depends on their structure and purpose. Some tokens, such as fiat-backed stablecoins, are usually not subject to U.S. securities laws. Other tokens, such as certain derivative tokens, may be subject to securities or commodities if they represent investment contracts or tools similar to futures.

There are many use cases for asset-backed tokens, including:

• Stable coins , pegged to currency or assets;

• Derivative tokens that provide synthetic exposure to underlying assets or financial positions;

• Liquidity Provider ( LP ) tokens represent claims for collective assets in the decentralized finance (DeFi) protocol;

• Deposit receipt tokens representing pledged or custodial assets.

Examples include USDC (a stablecoin backed by fiat currency), Compound’s C token (a LP token), Lido’s stETH (a liquid staked token), and OPYN’s Squeeth (a derivative token that tracks the price of ETH).

Memecoins

Memecoin is a token that has no inherent utility or value, usually associated with internet memes or community-driven movements, and has no fundamental connection to the network, company, or application.

Memecoin’s price is driven entirely by speculation and related market forces and is therefore extremely vulnerable to manipulation. Its main characteristics are the lack of intrinsic purposes (if there is a purpose, they are no longer Memecoin), the lack of practicality, and the resulting zero-sum nature and volatility. Memecoin is not normally bound by U.S. securities laws , but is still subject to anti-fraud and market manipulation laws.

For example, PEPE, SHIB and TRUMP.

Not all tokens are perfectly grouped into one of these categories—Entrepreneurs iterate and experiment with new models regularly. For example, if social and reputation tokens are not investable, they may be more like functional tokens, and if they are controlled by centralized issuers, they may be more like corporate-backed tokens. As token features change or new features increase, tokens can also evolve from one category to another, making classification difficult.

But the decisive characteristics of dividing these categories are the expected sources of value accumulation. The flowchart helps illustrate this:

(Note: The picture is translated by AI and has a certain difference from the original token definition)

Acknowledgements: We would like to thank Chris Dixon, Tim Roughgarden and Bill Hinman for helpful comments; and Tim Sullivan’s editors.

Miles Jennings is general counsel for a16z crypto, responsible for providing advice to the company and its portfolio companies on decentralization, DAO, governance, NFT, and state and federal securities laws.

Scott Duke Kominers is a Sarofim-Rock Professor of Business Administration at Harvard Business School , an associate professor of economics at Harvard University and a research partner at a16z crypto . He also provides advice on web3 strategy and marketing and incentive design for several companies; see his website for further disclosure. He is also co-author of Tokens for Everything: How NFT and Web3 will change the way we buy, sell, and create .

Eddy Lazzarin is the chief technology officer of a16z crypto. He manages engineering, research and security teams that support investment processes and work with portfolio companies to build the future of the Internet.