Before talking about tokens, we must talk about fungibility. This term, rarely used in our daily lives, came to the fore when the division between tokens (fungible) and NFTs (Non-Fungible Tokens or non-fungible tokens) began.
Fungibility is a property of a good or asset whose individual units are interchangeable. In simple terms, if something is fungible, it means that each unit is equal to another unit of the same type. For example, a fifty-real bill is fungible because any fifty-real bill has the same value as any other fifty-real bill. If you exchange one fifty-real bill for another, you still have a fifty-real bill.
The opposite of fungible is non-fungible. Here, the example I always use is the Mona Lisa painting, which is in the Louvre Museum in Paris. You may have a very similar copy on your wall, but the original is in the Louvre. Your car, your apartment, and even a fifty-real bill signed by Pelé are considered non-fungible. I don't need to elaborate here for you to see that in today's world, we have many non-fungible things.
Bringing together fungibility and tokens, we have:
Tokens: They are digital units of value issued on Blockchains.
Here are all cases of fungible tokens. They represent an asset or utility and can be used for various purposes, such as representing money, shares of a company, or loyalty points.
NFTs (Non-Fungible Tokens) are a special type of token that represent something unique, unlike fungible tokens, where each token is equal to another. NFTs can represent anything digital that is unique, such as art, collectibles, music, videos, among others. Each NFT has distinct information and metadata that make them non-transferable, ensuring authenticity and proof of ownership on the Blockchain.
In the world of permissionless Blockchains, NFTs are now closely associated with digital art and digital communities, such as Bored Apes and Punks, perhaps the most well-known. But the truth is that there is an ocean of non-fungible things that can be represented on Blockchains via NFTs.
In the case of money, we will always be talking about fungible tokens, or simply tokens.
Before talking about tokens, we must talk about fungibility. This term, rarely used in our daily lives, came to the fore when the division between tokens (fungible) and NFTs (Non-Fungible Tokens or non-fungible tokens) began.
Fungibility is a property of a good or asset whose individual units are interchangeable. In simple terms, if something is fungible, it means that each unit is equal to another unit of the same type. For example, a fifty-real bill is fungible because any fifty-real bill has the same value as any other fifty-real bill. If you exchange one fifty-real bill for another, you still have a fifty-real bill.
The opposite of fungible is non-fungible. Here, the example I always use is the Mona Lisa painting, which is in the Louvre Museum in Paris. You may have a very similar copy on your wall, but the original is in the Louvre. Your car, your apartment, and even a fifty-real bill signed by Pelé are considered non-fungible. I don't need to elaborate here for you to see that in today's world, we have many non-fungible things.
Bringing together fungibility and tokens, we have:
Tokens: They are digital units of value issued on Blockchains.
Here are all cases of fungible tokens. They represent an asset or utility and can be used for various purposes, such as representing money, shares of a company, or loyalty points.
NFTs (Non-Fungible Tokens) are a special type of token that represents something unique, unlike fungible tokens, where each token is equal to another. NFTs can represent anything digital that is unique, such as art, collectibles, music, videos, among others. Each NFT has distinct information and metadata that make them non-transferable, ensuring authenticity and proof of ownership on the Blockchain.
In the world of permissionless Blockchains, NFTs are now closely associated with digital art and digital communities, such as Bored Apes and Punks, perhaps the most well-known. But the truth is that there is an ocean of non-fungible things that can be represented on Blockchains via NFTs.
In the case of money, we will always be talking about fungible tokens, or simply tokens.
1.5 Consensus mechanisms Consensus mechanisms in Blockchains are essential to ensure the validity and security of transactions. It is through them that incentives are established for Blockchain networks to operate as designed. Since we are in an environment where validators (nodes) are distributed, the alignment of interests must be total, so that these validators have interests aligned with those of the network, and this is done through consensus mechanisms.
The Proof of Work method, adopted by Bitcoin, is the most well-known. This method involves miners competing to solve complex mathematical problems using their computational power in search of a reward. This type of consensus, although one of the most secure, faces criticism due to its high energy consumption and environmental concerns, as well as limitations in terms of scalability.
Another commonly used type is Proof of Stake. In this type, validators are chosen based on the number of tokens they hold and are willing to put as collateral. The process of placing tokens as collateral for the network is known as Staking. Since it is based simply on the number of tokens that agents put up as collateral, the energy consumption issue is not relevant, but issues like concentration of tokens – and consequently validators – are present.
The Ethereum network completed its migration to the Proof of Stake consensus model in the last quarter of 2022 and is now the main Blockchain following this type of consensus.
The two consensus methods mentioned earlier are the most predominant in Blockchain today, but they are not the only ones. There are also other mechanisms, such as Proof of Space and Proof of Authority, each with its own characteristics, advantages, and challenges. However, the choice of the appropriate consensus mechanism depends on the specific needs of each Blockchain network and its goals for performance, security, and decentralization. The pilot of the Drex network, for example, will be carried out using the Proof of Authority mechanism.
1.6 Layers The concept of layers in Blockchain refers to different solutions and approaches to solve the scalability problem. By understanding the layers, we can identify how different solutions fit into the overall network structure and how they collaborate to improve the efficiency and capacity of a Blockchain.
L1 (Layer 1) refers to the Blockchain itself and its consensus protocol. Updates at this layer usually involve direct improvements to the network. Bitcoin and Ethereum are notable examples of this layer: Bitcoin has been operating since 2008 and Ethereum since 2015. Both are stable networks recognized for their security. Occasionally, significant updates may occur, such as Ethereum's transition from Proof of Work to Proof of Stake consensus mechanism in 2022. Examples of L1 include Bitcoin, Ethereum, Solana, Avalanche, Cosmos, Polkadot, and Sui networks.
L2 (Layer 2) are solutions built on top of L1, which do not require changes to the main protocol but offer transaction processing outside the main chain, alleviating congestion. The main examples here come from the Ethereum network with Polygon, Arbitrum, and Optimism, all L2 solutions of the Ethereum network and the Bitcoin network with the Lightning Network.
To illustrate, imagine that an L1 has the capacity to register ten TPS (transactions per second), and the L2 has a registration capacity of one hundred TPS, but in the case of L2, it aggregates several transactions, let's say five hundred transactions, for each one it registers on L1.
In this way, for each L2 operation recorded on L1, we have five hundred transactions recorded on L2. In terms of TPS, considering that all ten transactions on L1 are made by L2, we would have the same ten TPS on the main network and 5,000 TPS on L2. A considerable increase in terms of scalability.
This is done at the cost of a higher risk in terms of the network, since L2 'borrows' the credibility, consistency, and security of L1, but at the same time has its own mechanism of aggregating transactions and registering them in groups on L1, which generates more risk.
To deal with these problems, 'rollups' are used, with Optimistic and ZK Rollups being the main ones.
The first is widely used and is based on 'fraud games', meaning transactions are assumed to be correct by default and processed instantly. However, there is a dispute period during which observers can contest a transaction if they believe it is invalid. If someone proves that a transaction is fraudulent, the transgressor is penalized. This means that transfers of tokens between the two Blockchains must respect potential dispute periods. In some cases, this can reach up to seven days.
In the case of ZK Rollups, various transactions are grouped into a single proof, submitted to the main Blockchain. In simple terms, it allows many operations to occur off the Blockchain but ensures their validity through the Zero Knowledge (ZK) mechanism, which I will explain later.
ZK Rollups are indeed a promising innovation in the Blockchain space, although they are still in their early stages of adoption.
With only a few years of existence, few L2 solutions are exploring their potential. Polygon is one of the pioneers in this movement, seeking to leverage the benefits that ZK Rollups can offer in terms of scalability and efficiency.
1.7 Oracles Price Oracles in Blockchain are companies and/or protocols that provide and verify external data for smart contracts on a Blockchain network. They can act as bridges between the off-chain world (outside the Blockchain) and on-chain (within the Blockchain), allowing smart contracts to access real-world information.
In a simplistic view, they are the price providers for the Blockchain world. These prices can be linked to both on-chain assets and off-chain assets. An example is an application that depends on the temperature of a certain location, which can be provided by an Oracle. Another example relates to the real price of a certain asset (e.g., ETH) traded on numerous platforms, sometimes with on-chain transactions (via DEX), sometimes not (via CEX).
The main functions of Oracles involve verifying the authenticity of data, securely providing it at intervals required by the user – or by the asset – automatic updates, and triggering the execution of Smart Contracts.
When we talk about tokenization, Oracles are a crucial piece, as they play the role of providing reliable and updated data that are essential for the automatic and accurate execution of smart contracts.
1.8 Web3 And we arrive at Web3, which will be the next step in the development of the internet, which will have, among other aspects, the function of money implicit in it. All of this via tokens and Blockchain networks.
While Web1.0 was about reading and Web2.0 focused on reading and writing with the addition of user interactivity and participation, Web3 is about value and decentralized exchange, enabling peer-to-peer interactions without intermediaries.
In Web3, users have complete control over their own information, identities, and transactions. This contrasts with Web2.0, where large tech companies hold and control much of the user's data and information.
An easy example refers to logging into a Web2.0 structure, typically done via Google, email, phone number, or something similar. In a Web3 structure, this login is done via your public key from a Blockchain network.
Another fact is that in Web3, money is already incorporated into the network. It is part of the infrastructure, and we do not need anything external to it. For example, to pay for this or that book you bought, there has always been the need for an intermediary to do so: a payment gateway, a credit card, a bank account from where you made the PIX, and so on. In Web3, you use a token registered on the Blockchain that is transferred from you to the seller of the book without the need for any intermediary.
Payment is direct and peer-to-peer (just like the transfer of bitcoins on the Bitcoin network). And with an advantage over what we see in Web2.0: it is possible to determine, via Smart Contracts, that the transaction of transferring your tokens only happens if the transaction of transferring the tokens for the book you purchased is also executed. Both at the same time or neither. This is already a reality on the Ethereum network today. What is not there (yet) are tokens for everything (financial assets, real estate, etc.) to enable transactions, and a regulated environment.
This feature of having the payment method already incorporated into the platform, in the case of Web3, is only possible because of the ability to have self-custody of the tokens represented by this network. The person in possession of the public key pair (like our bank account number in the network) and the private key (like the password for transactions in the network) is the holder of all the tokens recorded on a Blockchain network.
In the context of Blockchains, the private key is a fundamental piece that ensures that only the wallet owner can access and perform transactions with their funds. On the other hand, the public key is used to generate a wallet address, allowing other users to send tokens to that wallet.
It is crucial to understand that while sharing your public key is safe, your private key must be kept absolutely secret. If someone has access to your private key, they will have total control over your funds on the respective Blockchain. Another important aspect is that there is no customer service center to call to retrieve the private key. If you lose it, the access to the tokens on your public key remains there, but they can never be moved again.
With great power comes great responsibility. If, on one hand, these Blockchain functionalities, which pave the way for this Web3 world, bring the possibility of having everything under our direct control without intermediaries, on the other hand, they also bring a huge responsibility.
1.9 Tokenization Tokenization is the process of converting rights over an asset into a digital token on a Blockchain. It can be used to represent traditional assets such as real estate, shares, works of art, or even intangible assets like intellectual property.
All of this is possible due to the creation of Smart Contracts and the subsequent token standards originally defined on the Ethereum network.
Among the various advantages of tokenization, two deserve special mention:
1. Divisibility and accessibility: As we tokenize our apartment, for example, it can have a token representing each square meter of it, or that investment requiring a huge initial amount being divided into thousands of tokens that can be purchased by various people. It is no coincidence that the Securities and Exchange Commission (CVM), in a 2023 decision, placed the use of regulation and crowdfunding as one of the guides for token issuance in Brazil.
2. Operational gains: Tokenization brings enormous operational gains compared to the systems currently used. Be it in the ease of settlement and transfer, or in the security, transparency, and immutability of data that assist in future audits. Think of the cases of transferring vehicles or real estate today. Or even in purchasing a public bond in the Direct Treasury. The operation of this could be greatly facilitated if these assets had tokens representing them on a Blockchain network.
And here I haven't even mentioned the fact that they can be available for transfer 24/7 (24 hours a day, 7 days a week) on these networks.
But tokenization also brings several challenges, such as:
1. Legal security: The challenge of how to legally ensure that a certain token pertains to a certain asset. Perhaps easier for assets that are already in the digital world; still, regulations in Brazil and around the world are still trying to find a solution for everyone. The issue that permeates the discussions has much to do with classifying them as securities or not, and the application of rules for the conception and distribution of securities.
2. Which network to use: Today there are several public permissionless Blockchain networks (e.g., Ethereum, Avalanche, Polkadot) and a multitude of open-source networks and solutions to set up public permissioned Blockchain networks (R3 Corda, Ripple and Stellar networks, Hyperledger Besu, etc.). Although Ethereum is a few steps ahead of permissionless public networks, or DLTs, even within it, the discussion about which L2 to use is important.
Ultimately, what lies behind this discussion also relates to the possibility of interoperability among these networks.
3. Security and custody: Like any technology based on Blockchain, tokenization is not free from security risks.
Ensuring that tokens are secure against hacks and fraud is fundamental. Should we centralize the custody of tokens or leave them with the users? The answer involves not only the network structure but also the behavior pattern of the users, as well as the need for education so that everyone understands the responsibilities and risks of the solution.
4. Pricing: Determining the value of a tokenized asset can be challenging, especially when there is no established market or when the underlying asset is highly volatile. Price Oracles are the way to go in this regard, but they still have a lot to develop to fully address the two previously mentioned scenarios.
5. Education and UX (User Experience): Here I don't know what comes first, but this book aims to help the former. There is a significant need to educate investors and the public about what tokens are, how they work, and the associated benefits and risks, while UX in Web3 still has much to improve. Perhaps just the UX could solve it? I don't know. What I always say is that almost no one knows exactly how TCP/IP mechanisms – which are the basis of the internet – work, but everyone uses them.
UX solved this usability issue in the case of the internet; will it also solve it in the case of Blockchain?
Although it seems I emphasized the challenges more than the opportunities in this segment, it is important to highlight that when we address the transformation of currency, we will explore these opportunities more deeply.
In any tokenization process, money, or the token that represents it, is the first asset to be considered, given its essential function as a medium of exchange for other assets.
Imagine a scenario where automobiles and real estate are tokenized, but not money. How would we proceed to sell or exchange these items? Would we revert to a barter system? The answer is ambiguous: no and yes. In a constantly evolving world, the likely scenario is that we will not revert to barter.