Due to decentralization, security, immutability, Blockchain is considered to be the perfect technology for managing all types of digital assets. But with such interchangeable tokens, this would not be possible. Such tokens work fine for cryptocurrencies, and in fact, fungibility is the fundamental feature of any currency.
Such tokens are built in such a way that each fraction of a token is equivalent to the next. For instance, Bitcoin, the most popular cryptocurrency, is fungible, which means one Bitcoin is equal to one Bitcoin, and it’s equal to all other Bitcoins. Such tokens are assumed to be interchangeable and divisible too.
In simpler words, these are types of cryptographic tokens that are basically identical or uniform and can be interchanged with other fungible tokens of the same type without any issues.
Fungible tokens relate to the things we use every day, and it applies to real-world as well as digital assets.
Non-fungible tokens are special tokens that are unique and non-divisible that represent unique, real-world assets, collectables, or promises for memberships and benefits. They are unique in the sense that they cannot be split or exactly changed for other non-fungible tokens of the same type. You can consider NFTs as tokens with no fungibility that offer remarkable opportunities to represent real-world assets such as real estate, intellectual property, patents, art, cars titles, stocks and equity.
Fungible vs. Non-Fungible Tokens
Now, as we have understood what the two types of tokens are, let’s understand the fundamental differences between the two related to the utilization in certain use cases regarding financial instruments and representing assets.
As we already mentioned, such tokens are interchangeable and can be exchanged with any other token of the equivalent kind. Fiat currencies are fungible. For example, $50 notes are interchangeable with other $50 notes. Similarly, one Bitcoin value can be exchanged with other Bitcoin, which makes no difference for holders. Unlike Fungible tokens, non fungible tokens tokens are non-interchangeable as they cannot be replaced with the non-fungible token of the same type.
These tokens can be divisible into smaller units, and one can get any number of units, and it does not matter to holders as long as the value remains the same. Non fungible tokens cannot be divided or fractionalized. The assets they represent can be fractionalized, however.
Another important aspect to consider between fungible assets and non fungible assets is the content each holds or stores. Fungible tokens like Bitcoin store value, non fungible tokens store data like a title to a property or a stock certificate tied to an owner. Non fungible metadata contains unique properties that cannot be forged or altered and can take advantage of the benefits of immutability of records.
All fungible tokens of each type are identical in specification, and each token is identical to each other. Each non fungible token is different from all other tokens of the same type.
Most fungible tokens have standard aspects to their token economics or “tokenomics”. Issuance of the initial token (fair launch or pre-mining/initial offering), determining the total token supply, circulating supply, and max supply, the market cap of the token, and determining the inflationary or deflationary models. These are all essential to understand when fungible tokens are issued for use.
However, the tokenomics of non fungible tokens are far simpler since they typically represent something that already exists or an asset: ownership of a real world asset, a benefit offered to a limited community, or membership by a company or private party. The tokenomics become very simple and are based on the contract terms of who is issuing the offering of fractional ownership, benefits, or membership. NFTs themselves have standalone value and don’t depend on tokenomics of other tokens.
Characteristics of Security Tokens
The emergence of the security token offering or “STO” has created a significant impact on traditional financial markets. If a token is used to raise capital it will always be considered a security. Security tokens are just like any other token or digital contract; they are a representation of a security investment contract stored and tracked on the blockchain. Security tokens will also require laws, compliance, regulations, and technology to determine how they are bought, sold, and traded by the investors, along with how they are managed or governed by the companies issuing them. STOs are able to be a real asset that has its direct valuation associated with external and tradable sources. A real estate investment contract, a financial derivative product, revenue share agreements, or issuance of debt or equity are all examples of STOs in the future.
Why Raze believes Non Fungible Tokens (NFTs) are appropriate for raising capital
In addition to digitizing equity, the timing is here for many companies to consider diversifying their fundraising options by considering the tokenization of revenue shares, debt offerings, and unique fundraising instruments like SAFEs and SAFTs agreements. How a company does this is critical to its success of both the offering to their potential investors and the ongoing management or governance of this offering.
Issuing a fungible token as a security offering or a utility token to the marketplace with defined tokenomics may make sense to many new Web3 companies, however it is unrealistic and not practical for much of the private markets. In addition, there is a strong case to be made that most investment contracts and security offerings are too complex to always just default to the issuance of a fungible security token, especially in private placement opportunities.
Issuing compliant and regulated token offerings as securities create major hurdles for companies. The moment a company issues a token with tokenomics they have to maintain, they begin to act like, smell like, and behave like a public company. Now most of the efforts, focus, and strategy for the board and management is about the token price and tokenomics. Also, the introduction of bad actors or “pump and dump” whale investors can create chaos and catastrophic effects on the company if the token is public and available on any DEX or crypto exchange.
The Benefits of Non Fungible Tokens
Non fungible tokens offer vast benefits. NFTs structured as security offerings can and should be considered when offering investors a return on their investment. With the advent of blockchain technology, the digital world has taken one step closer to resembling the physical world. Digital objects now have characteristics that make them unique, ownable, and tradable, giving rise to a new age, the internet of value. Until now, most of these new digital objects have expressed themselves in the form of digital currencies, but the next evolution of digital objects is here that can represent real assets such as equity or stock ownership in a company, revenue share contracts, LLC memberships, royalty contracts, and even debt instruments.
The following aspects make non fungible security tokens scalable in the next financial revolution:
NFTs can be programmed with specific metadata and contract terms per NFT that can offer additional utility beyond a fungible token. Since security tokens should be able to represent a wide variety of real assets that already exist in the physical world, they by their very nature have infinite possibilities of terms and conditions under an investment contract.
For example, how does a company offer benefits, terms, conditions, contract expirations, distributions of benefits payments using fungible tokens? These conditions need to be hard-coded into the token.
Using a non fungible also enables the tracking and administration of unique instruments such as revenue share tokens with a smart contract and blockchain to fully automate record keeping and distributions in a fully integrated financial blockchain verified environment.
Non fungible tokens can handle any investment vehicle already developed and any in the future. The investment contract terms, the return on investment for the investor, the identity of the investor, the privacy of the investor, and the ongoing governance of the securities can all be managed by non fungible tokens because of the flexible nature of the vehicle and protocol.
Proof of Ownership, KYC/AML, and Privacy
The old days of issuing stock certificates were replaced by digital securities years ago. However, investors need and desire to still have an easy, secure, safe, and private way to hold and manage their investment contracts, shares in a company, fractional interest in a property they own, and other complex ownership vehicles that represent investments or securities. Non fungible tokens can serve as a superior “container” that can easily hold, connect, and reference any complex or simple investment contract along with connecting the owner while maintaining privacy since they serve as a far better way to store data vs. just represent value. Fungible tokens present a problem. Since all of them are the same and do not care who owns them, they create issues with future verification of investors, transfer of those tokens to any other wallet, and trading of those tokens to anyone in the world.
The conflicting goals of ensuring both the privacy of the holder of the security token and the identity of the holder is unique. Companies must know who their investors are, must maintain records of every transaction, must ensure restricted securities are not prematurely sold or transferred to other parties, and file with all regulatory authorities in their jurisdictions. Conversely, they should offer the ability for investors to maintain privacy on the blockchain and ensure their security tokens can be held and maintained in a decentralized manner via a wallet.
Most current KYC and AML practices can be costly, complex, and nearly impossible to maintain for companies. Non fungible tokens solve this by ensuring the investor upon minting their token must go through a simple KYC/AML verification to gain access to the security contract and then can receive a digital representation of the agreement they just made after exchanging their currency for investment. Companies can also issue NFTs to represent their investors since each investor should be a unique person or company. Once the mint has occurred, the security can then be stored safely and privately in the investors decentralized wallet. No names or identities are revealed in a public nature on the blockchain but only wallet addresses. However, the company issuing the security token has all the investors information and can use it for verification in the future when issuing returns and distributions. In order to claim future distributions or any promised return from the issuing party, the smart contracts can be programmed and automated to each holder of the non fungible token with key metadata tied to it for verification.
Compliance & Governance
The automated compliance of security token issuance has not achieved commercial acceptance or scalable adoption yet and is years away. Therefore, companies wanting to issue their own security offering have to go through two parallel compliance processes for regulatory and compliance approval. This process can be just as expensive and challenging as going through a traditional IPO process. However, non fungible tokens can represent a traditional security offering process because the security NFT itself is not the tradable security that will be listed on an exchange or DEX for immediate issuance and trading.
The NFT, in the use case of a security, actually is a representation of a traditional security offering including, but not limited to: any Regulation D private placement (including exemptions), traditional LLC membership agreement, revenue share agreements, SAFE and SAFT instruments, debt financing vehicles, and more. In principle, NFTs may also be used for crowdfunding and Reg A+ offerings in the future too. The reason this is possible is that the company goes through their standard regulatory steps with legal representation and simply uses non fungible tokens to offer the traditional investment offering, receive the preferred currency for payment (including accepting crypto), execute and bind a contract, verify investor identities, and issue proof of this entire transaction process recorded on the blockchain with permanent history all while maintain privacy for the investor. Furthermore, each contract term can either be unique to each investor or the same for a group of investors which is impossible using a fungible token.
Compliance is critical in this process to ensure the issuer is protecting the rights of the investor vs. just its own interest. Traditional investment contracts handle this already so there is no reason to re-create or change that process just because you are trying to use blockchain to improve or leverage other benefits. Some of the benefits of using a non fungible in relation to compliance and regulation include:
- Control the issuance and transfer of restricted private placement offerings.
- All activity is tracked on the blockchain allowing for more transparency.
- Potential to eliminate traditional intermediary roles and reduce cost of management and compliance of private placement offerings while imposing necessary and critical restrictions for compliance.
- Potential to develop a positive model to work with regulators to meet regulatory goals of transparency and disclosures to investors by developing real time verified financial and material information. Company information may be verified via decentralized disinterested trust-less blockchains and such verified records may be integrated with dynamic smart contract NFT’s to automate revenue sharing and dividend payments and disclose material information to investors.
The rights of the investor are at the foundation of why regulatory bodies exist. Companies must continue to go to great lengths to protect their investor communities, especially in less regulated markets like the private placement world. Non fungible tokens can provide companies the ability to offer their investors and shareholders voting rights, legal assurances, clarity on claims for dividends or revenue shares, and proper corporate governance including managing the cap table.
Fragmentation of Protocols
Theoretically, any company can quickly create a fungible security token (assuming they go through the proper regulation channels) and issue it to private investors. However, the explosion of tens of thousands of “alt coins” or coin offerings has created fragmentation that makes it nearly impossible for a private company wanting to raise capital to consider issuing a security offering to their private investors. They may have to begin competing with every fungible token issued since investors have a vast array of options to consider when investing in fungible tokens. Even though the security token offering may be private in nature and have limited supply, it’s still on the blockchain and the tokenomics and future value may be compared to every other token issued to the public markets.
Documents & Contracts
NFTs are linked to signed investor agreements that in their nature are unique for every investor. How does a company issue investor agreements tied to securities that are executed by unique people and then tied to their security tokens? Non fungible tokens make this process far simpler by incorporating the investment contract execution process inside the minting of the non fungible token. In addition, each investment contract can be tied or stored in the metadata of the non fungible token and kept as a history for the company. Since non fungible tokens are unique in nature, they are perfect for companies to enter into contacts with investors promising a future return for their investment. The minted token by the investor technically represents a unique investor, signing a unique contract, with a company. The company may issue one or more of the same contracts and return terms to investors but that investor signing the contract and investing represents a unique agreement between the investor and issuer. The minting of a non fungible token can now handle the contract execution process, the history of that unique contract signed, and the future enforceability of the contract terms.
Using fungible tokens assumes the ownership interest of that assets have simple and consistent terms of ownership for each entity involved in the transaction. Using a fungible token assumes Owner A of the asset has the same rights, agreements, amount of ownership, and contract terms as Owner B. The amount of fractional equity or shares that represent ownership of that physical asset is one consideration but the unique terms in the ownership contract is another.
For example, let’s say an owner of a real estate property wants to fractionally sell part or all of his property but he wants to offer unique instruments, rights, and contract terms to sell that property. How does the property owner do this with a simple fungible security token? The equity ownership rights could be sold using a fungible token which makes it easy to issue shares of that property. How are the unique contracts handled with each owner?
What if investor A wants to own 30% of the property with the ability to also make a percentage of the rental income generated on the property? A standard LLC agreement with addendums would easily handle that but there would be no way to tokenize or represent that on the blockchain in its entirety – until the non fungible token. .
Now the owner can leverage a non-fungible token model and issue one or more NFTs. The owner can easily handle everything related to the transaction including the unique contract terms with that one investor, any ownership amount, proof of ownership on the blockchain, handling of acceptance of the preferred currency paid by the investor (including the history of this transaction since it’s on chain), and allows for future distributions owed to the investor since they will have their NFT inside their private, decentralized wallet.
Platforms and “The Middle Man”
The current state of security tokens for private placement offerings has created a vastly different marketplace for investors than the public exchanges to trade crypto currencies that may be treated as securities or commodities. Today, a handful of security token platforms exist that allow companies to to issue fungible security tokens but they are all acting in silos and are not working on a common standard. If companies begin using non fungible tokens to represent their investment contracts (which are securities), they depend less on these platforms and can simply continue to offer investors private opportunities, in a compliant way, to raise capital.
Additionally, using non fungible tokens has the opportunity to replace or eliminate the need in some cases for certain entities that were created out of past regulatory developments. The need for their duties does not change but certain aspects such as intermediaries or custodians of digital securities no longer become as important since each investor should be holding their digital security in their decentralized wallet which is all tracked on the blockchain.