Oct 24, 2022
SFT Whitepaper 02 | Chapter 1: Token, NFT, and SFT
Why semi-fungibility is important to the future of our economy, network, and freedom.
Smart contract tokens used as proof of ownership have inspired endless innovations since they were first proposed by Vitalik Buterin. Token standards like ERC-20 and ERC-721 are at the cutting edge of defining and expressing digital ownership, and have fueled the multibillion-dollar crypto market.
But what if this isn’t the whole story? What if there’s an untapped market for digital assets based on a brand new token standard that we haven’t even heard of? Our goal in this book is to inform the reader that this market exists and that ERC-3525 Semi-Fungible Tokens (SFTs) will bring that market to life.
Understanding SFTs requires a deep understanding of crypto and its fundamentals. Therefore, we must go all the way back to the genesis chapter, namely, the definition of a token. As we move forward, we will discuss recent things such as fungible tokens (FT) and non-fungible tokens (NFT), and, finally, why semi-fungibility is important to the future of our economy, network, and freedom.
1.1 What is a Token?
A token represents identity, social status, ownership, rights, or value. Historically, physical tokens have been used to facilitate transactions or establish orders. In schools, children receive “stars” or badges for good behavior; military officers or soldiers wear shoulder marks that bear ranks or other insignia; and arcade gamers use coins for playtime.
With the advent of the Information Age, physical tokens became digital ones, and accessing control is a typical function of a digital token. Tapping a badge or card equipped with a chip to pass a turnstile and IBM-powered Token Ring (a data link for local area networks in which all devices are connected to a Ring and can pass one or multiple frames of data from one to another) are just a couple of examples of how our lives benefit from the use of digital tokens.
The definition of a token is never static, rather, it evolves with the technology of the day. In the blockchain era, tokens have a new meaning. In Token Safe Harbor Proposal, the U.S. SEC commissioner Hester M. Peirce defines a blockchain token as a digital representation of value or rights
(i) that has a transaction history that:
(A) is recorded on a distributed ledger, blockchain, or other digital data structure;
(B) has transactions confirmed through an independently verifiable process; and
(C) cannot be modified;
(ii) that is capable of being transferred between persons without an intermediary party; and
(iii) that does not represent a financial interest in a company, partnership, or fund, including an ownership or debt interest, revenue share, entitlement to any interest or dividend payment.
In Peirce’s definition of a token, we identify three mainstays:
1. It is a digital representation of value of rights;
2. It can be transferred;
3. It provides a full history of transactions recorded on blockchain.
Physical tokens, digital tokens, and blockchain-based tokens all share a fundamental characteristic: they serve as symbols, labels, or certificates that represent value or rights. Tokens are empowered by rules or systems of rules, and these rule-based systems can be software, network protocols, management systems, legal systems, or social conventions. The blockchain uses a different form of system: smart contracts.
1.2 Smart Contracts and Tokens
Human civilizations rely heavily on contracts. The English philosopher Thomas Hobbes (1588–1679) noted that a world without rights and contracts leads to individuals living “solitary, poor, nasty, brutish and short” lives. Contracts are legally enforceable promises. In more granular terms, they are multistep, collaborative, and consensus-based protocols that govern the rights and obligations of their parties. In a contract, the whats, the whos, and the hows must be spelled out in writing or in other forms, and the obligations that each party must fulfill as well as any consequences for failure to do so must be clearly stated. To make a contract work, we need three things: the contract itself (the totality of the terms), an execution system (the legal and/or reputation-based system that binds a contract), and a certificate attesting the contract, or the proof of contract.
(Note that popular contracts such as commercial papers, coupons, bonds, or cash notes, are so standardized these days to the point where they almost do not appear as contracts.)
By blurring the fine line between the contract itself and execution system, blockchain technology has helped to create a much more unified and efficient structure for contract creation and execution, and this structure is the smart contract. A smart contract is a set of instructions that follow a simple if/when p then q rule that is verified through a digital signature and executed on a distributed, immutable and transparent network called a blockchain. Smart contracts store and execute rules, while tokens represent ownership and rights. In this sense, a blockchain token is a proof of a smart contract. Not all blockchain tokens, however, are created equal. Among the key factors we consider when classifying blockchain tokens is their fungibility.
1.3 What Makes a Token Fungible (and Non-fungible)?
Most crypto users have used fungible tokens, but few could identify them. In order for a token to be considered fungible, it must be able to be replaced by another identical token. A fungible token is computable, which means that multiple tokens can be added together (or subtracted).
On the blockchain, fungible tokens are usually ERC-20 tokens (which stands for “Ethereum Request for Comments 20”), although a minority of fungible tokens exist in ERC-20 variants, such as BEP-20, SLP, and TRC-20. ERC-20 is the most widely used token standard on the Ethereum network, and it was proposed just four months after the mainnet went live. ERC-20 tokens can be used for a variety of things, including stock shares, loyalty points, and virtually all cryptocurrencies. Currently, ERC-20 tokens are worth over US$100 billion.
Non-fungible tokens, or NFTs, fall on the other end of the spectrum from ERC-20 tokens. While ERC-20s are interchangeable, NFTs have their own ID and metadata, which makes them unique. The ID consists of a serial number and the address of a maternal smart contract, while metadata describes the NFT’s diverse attributes. The uniqueness of NFTs makes them suitable for storing digital goods like art, domain names, sound clips, in-game items, and more.
A NFT has many advantages over fungible tokens, making it a great choice for the proof of a smart contract. Let’s take a closer look at these advantages.
Descriptive
NFTs are ideal for representing complex or simple contracts, because metadata allows a broad array of display and storage options.
Expressive
Since NFTs can display a wide range of information, they are ideal for describing contract terms (such as strike price, interest rate, maturity, and installment terms), which an ERC-20 token could not accommodate easily.
Cost-effective
The use of NFTs can significantly reduce the development, deployment, and maintenance costs of smart contracts and reduce the number of smart contracts needed to implement complex transactions.
The deployment of one new token for each component of portfolio allocation, redemption rules, and fee structures would increase the cost of running the transaction. NFTs require only a single smart contract to be deployed by the developer.
Capital-efficient
As ERC-20s support only fungible liquidity pools and are not suitable for integrating other smart contracts or expanding to other pools, this results in some DeFi protocols shackled by the inefficiency of ERC-20s. An NFT, on the other hand, allows management of multiple heterogeneous asset pools with a single smart contract, significantly improving capital efficiency.
1.4 The Semi-Fungible Token and ERC-3525
A semi-fungible token (SFT) is a type of digital asset based on blockchain technology that blends fungible and non-fungible characteristics. More specifically, SFTs combine the quantitative attributes of a fungible token and the descriptive features of a non-fungible token.
To understand SFTs, we must first consider what kind of ownership or rights they are meant to represent. An SFT can be used to represent any digital asset that has quantitative attributes and is required to be fractionalized or combined in certain circumstances. Bonds, coupons, vouchers, invoices, promissory notes, and land titles are some examples of such assets, as are futures, options, and ABS. In a financial application, using an SFT is probably most straightforward when combining a $20 bond and a $30 bond into a $50 bond.
The ERC-3525 Semi-Fungible Token Standard (approved September, 2022) is the first EIP standard for semi-fungible tokens, and it is fully scalable into a universe of use cases and functionalities. Solv Protocol, the creator of the standard, uses the ERC-3525 as a container for digital assets, in which users can package unlimited amounts and types of tokens for various purposes. A user of the ERC-3525 token could also transfer digital goods directly into and out of it freely, making it easy to repay bond issuances to multiple lenders quickly and efficiently.
An ERC-3525 token can empower a Web3 user in several ways.
1. Create advanced digital financial assets, such as CDs, checks, bonds, options, futures, swaps, insurance policies, equities, or ABS. An ERC-3525 token provides liquidity to the user, since it could be split into infinitely many pieces. Further, it provides strong visualization to make sure that the contract and any attachments are easily accessible.
Perhaps the greatest advantage of the ERC-3525 token used as a financial asset is its look-through, fund-in-fund transparency enabled by the blockchain, by which users can find out how the underlying investment assets perform through the complex structure of an ERC-3525 token.
2. Create fractionalized virtual lands, upgradeable/mergeable in-game items, virtual membership cards, gift cards, raffle tickets, etc.
3. Onboard real-world assets (RWAs). ERC-3525 tokens could embed legally binding contract documents (in PDF files, for example) and enable access through blockchain oracles to real-world information for the related assets.
ERC-3525s can be used as tokenized RWAs in a number of different ways, including tokenizing solar panels and capturing their unearned profits as well as tokenizing real estate. Users can split or merge tokens by quantitative parameters such as surface area (of a solar panel) or square footage (of a real property). As tokenized RWAs, ERC-3525s are regulator-friendly since they’re good at reducing transaction frictions, maintaining secure decentralized records, and authenticating provenance.
4. Fractionalized wallet. The ERC-3525 protocol can nest any crypto asset inside, so an SFT can act as a blockchain wallet for any digital assets, plus fractionalization and transferability.
5. Tokenize and visualize smart contracts. Every ERC-3525 token contains a full-blown smart contract that can store, send, or receive a given crypto asset if invoked. ERC-3525 can be used to also tokenize traditional contracts like trade agreements, lease agreements, or loan agreements, where relevant parties can leverage the standard for fast, automated, and foolproof contract execution.
SFT’s developers worked hard to ensure that it will be just as gas-efficient as ERC-721 — if not more. And every wallet, protocol, or marketplace that supports NFT will be able to integrate ERC-3525 assets since ERC-3525 is backward-compatible with ERC-721.
Furthermore, ERC-3525 is completely open-source to encourage collaboration and innovation. To date, protocols such as FujiDAO and Buffer Finance have begun building on-chain options markets upon ERC-3525, and Solv Protocol is the first and largest market that uses ERC-3525 tokens as fractionalized on-chain bonds to help institutions get financing and access credit markets.
1.5 Summary
In this chapter, we have first covered the fundamentals of tokens. A token is a physical or symbolic object that represents identity, social status, ownership, rights, or value. Digital tokens act similarly to physical tokens except that digital tokens can enable digitally-based access control. A blockchain token is an advanced form of digital token because it is decentralized and offers a transparent and immutable transaction history that can’t be achieved with traditional tokens.
Fungible tokens are interchangeable with each other, and non-fungible tokens are not. While fungible tokens are ideal for assets focused on liquidity, non-fungible tokens are ideal for storing and displaying unique visually-rich jpegs or gifs, or text-rich financial contracts. An SFT powered by ERC-3525 combines the quantitative attributes of an ERC-20 token with the descriptive attributes of an ERC-721 token, and is suitable for representing sophisticated contracts such as bonds, futures, lease agreements, or even smart contracts.
Understanding the intricate relationships between FTs, NFTs, and SFTs may still be tricky for some. Therefore, bridging concepts like financial NFTs may be a good place to start.
Intrigued? You can download the whitepaper here: https://sftlabs.io/
A telegram group for EIP-3525 builders: https://t.me/EIP3525_DEV
