A token means generally ‘something that can represent something else’. For instance, we talk about a token of gratitude like a bouquet offered to represent that someone is grateful. Or think of a concert ticket that represents the attendance to a specified event in the future. Another example of a token is money. These represent an amount of value. Tokens can also describe fungible tokens. Fungible tokens are tokens that are equal because they represent the same thing. Money is a good example: one euro coin represents the same value. So, money, as well as cryptocurrencies, are types of tokens that are fungible.
An NFT is a token, where the ‘N’ stands for ‘non’ and means that this type of token is NON-fungible; it’s NOT similar to another token; it’s a unique token, and one does not equal the other.
Within the financial world, tokens are a form of value represented and traded on a blockchain. Because of blockchain technology, we can make tokens that are digital representations, which are non-fungible. That makes it possible for anything in the real world to be represented by an NFT on the blockchain, being our house, the clothes we wear, or the piece of land we own. Everything can be represented digitally, art included. The most critical part of this process, however, is the conversion from physical to digital. Someone has to vouch that a token really represents e.g., the plot of land. This needs to be (verifiably) backed up by legal reality. So, here we see that there is counterparty risk. With digital art, this problem doesn’t exist, because there is no physical component. Most of us started hearing about NFTs in 2021, especially those representing (digital) art. Digital art has been one of the first NFT use cases – maybe because before blockchain anyone could copy and claim to own digital pieces of art. However, because of their unicity, they can be used as identity verification means (Decentralised Identifiers, or DIDs) or as medical records (doctors can issue NFT birth certificates upon birth, and that NFT would represent the lifelong identity that they can use for all their medical records). However, the widely used case for NFTs is the gaming industry (digital collectibles such as those in ‘Play-to-Earn Games’ like Axie Infinity, are a common use case). Also, the supply chains can benefit from these developments – many goods and items, particularly those in the food sector, have a problem when it comes to verifying their provenance, the contents within the packaging, and the source of supply. NFTs may be tied to a product via the blockchain, giving it a tamper-proof NFT identity.
Cryptocurrencies, tokens, NFTs, and anything that is created and stored digitally, is identifiable and discoverable, and has or provides value is considered a digital asset.
These (together with a user’s digital identity) play an important role in supporting the metaverse. Early in its evolution, the metaverse is a seamless convergence of our physical and digital lives creating a unified, virtual community where we can work, play, relax, transact, and socialise.
A key point is that there is not only a virtual world but many worlds, which are taking shape to enable people to deepen and extend social interactions digitally. This is done by adding an immersive, three-dimensional layer to the web, creating more authentic and natural experiences via shared virtual worlds accessible through technologies such as virtual reality (VR), extended reality (XR), and augmented reality (AR).
Based on interoperability, these spaces aim to become a large and interconnected ecosystem where people can move freely (by using their digital identity) and take their digital assets with them. To move tokens and digital assets in the virtual world we need some protocols that are part of decentralised finance (DeFi). Digital assets and DeFi are together loosely known as web 3.0. According to 11:FS’ report on web 3.0, web 3.0 is built on the primitives of crypto, but it talks more about the business models and economic opportunities.
Decentralised finance (DeFi) refers to a set of newly emerging financial products and services that operate on decentralised platforms using blockchains to record and share data. These products and services are conducted without a trusted central intermediary such as a bank, and they include payments, lending and borrowing, trading and investments, capital raising (crowdfunding), and insurance.
Over the last two years, the DeFi landscape has evolved into a large network with integrated financial instruments and protocols. According to The Block, cumulative revenue on DeFi protocols surpasses USD 4.5 billion as of March 2022, making it one of the most promising developments in the financial world. The protocol is defined as rules or standards that govern a specific task or activity. DeFi protocols are specialised autonomous programs that have been designed to address issues related to the traditional finance industry and they aim to introduce more financial instruments. So far, DeFi protocols have formed an integral part of a complex ecosystem with numerous notable tokens and projects, and due to the substantial rise in the value of DeFi protocols, many startups in this area see plenty of opportunities.
DeFi protocols are primarily designed for borrowing and lending applications in the financial sector.
An example of DeFi protocols is Decentralised exchanges (DEXs) that give traders an easier way to complete crypto transactions. As DeFi protocols run according to a series of smart contracts, these exchanges can attract large amounts of liquidity, often bringing yields for investors. To assess decentralised finance (DeFi) protocols, metrics such as the total locked value (TVL) have been created. In a DEX, experts can measure the total locked value (TVL) by adding up all the assets deposited in the exchange. Many of today’s traders use this measure to understand a system’s strength and potential. By counting all the coins currently staked within a protocol, TVL reveals the total supply underlying the system.
DEXs often replace traditional exchange order books with liquidity pools and automatic market makers (AMMs – which are a special algorithm codified in a smart contract that calculates the exchange price for every swap), that pair buyers and sellers depending on order prices and volume. These are pools of cryptocurrency assets that remain under the exchange's surface, waiting to clear any buy or sell order. The funds in the pool come from investors who deposit money to profit from transaction costs payable to pool users.
The most common financial activity throughout the DeFi ecosystem is lending. Similar to traditional lending institutions, some holders deposit their funds into a protocol to make a profit while others need currency in the short term borrowing from the pool of funds while posting their locked assets as collateral. As a result, the system increases the fluidity within crypto markets and creates new opportunities for everyone involved.
Another increasingly common phenomenon within the DeFi ecosystem is derivatives. These products give experienced traders a way to manage synthetic assets, produce future contracts, and boost overall yields from their complex investment portfolios.
Liquidity pools are the crypto funds that have been locked into a DeFi protocol through smart contracts. They are created through deposits, giving investors within a protocol the leeway to draw from a pool of accessible funds. Because they involve the direct and immediate locking of assets within a protocol, they can be measured within the parameters of crypto TVL.
To take part in DeFi protocols, traders must stake a certain amount of their crypto assets. Via yield farming, once these assets are staked, investors can earn profits through returns on them.
This article concludes our three-part series explaining the crypto space. If you want to test your crypto payments knowledge, check out Part 2 of this series.
As we have tried to be concise and stir your curiosity around the crypto industry, please keep in mind that the information we provide is a synthesis of the main concepts surrounding this industry. For a more comprehensive understanding of these topics, we suggest you do some further reading. You can find some links with resources below:
The Cryptocurrency Revolution: Finance in the Age of Bitcoin, Blockchains and Tokens, by Rhian Lewis
Layered Money: From Gold and Dollars to Bitcoin and Central Bank Digital Currencies, by Nik Bhatia
Digital Gold: Bitcoin and the Inside Story of the Misfits and Millionaires Trying to Reinvent Money, by Nathaniel Popper
Binance Academy
Chainalysis Academy
Ethereum Portal
This editorial was initially published in our Crypto Payments and Web 3.0 For Banks, Merchants, and PSPs Report. The first edition of our report aims to provide a go-to payment resource of crypto terms and concepts for those interested to understand the basics of crypto payments and their long-term impact. Furthermore, it shares practical examples of cryptocurrency-enabled ecommerce and banking services and presents the latest developments in the regulatory landscape. Also, it reveals what are the most innovative companies in this space, that are building the crypto rails.
Feel free to download your copy here.
About Mirela Ciobanu
Mirela Ciobanu is a Lead Editor of the Banking and Fintech domain at The Paypers. She is actively involved in drafting industry reports, carrying out interviews, and writing about the digital assets industry, the regtech space, digital identity, fraud prevention, and payment innovation. Mirela is passionate about finding the latest news on crypto, blockchain, DeFi, and fincrime investigations and is an advocate of the need to keep our online data/presence protected. As a writer, she aims to always get the best obtainable version of the truth. She can be reached at mirelac@thepaypers.com or via LinkedIn.
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