As a decentralized platform that uses smart contracts to deliver transparency and immutability, Ethereum makes it easy for anyone to create new blockchain tokens. User-friendly apps automate the process, meaning knowledge of smart contracts is not required. As a result, Ethereum hosts many thousands of tokens developed for as many different purposes. But the vast majority of those tokens fall into just a handful of general categories. Understanding those categories and the role of token types in the decentralized finance ecosystem can make navigating DeFi and the broader blockchain space easier.
What Are Blockchain Tokens, and Do They Differ from ETH?
Ethereum blockchain tokens, also known as cryptographic tokens and cryptocurrency tokens, are transferable digital assets that are built on top of the blockchain. The blockchain hosts a vast number of digital assets—block explorer and analytics site Etherscan.io lists over 900 major projects based on the popular ERC20 token standard alone. Because these are built to the same open standard, they can be integrated easily with Ethereum-based decentralized applications (dapps) and DeFi protocols.
There are nearly 400,000 ERC20 token contracts on the Ethereum network, but only one “native” token—Ether (ETH). ETH is generated by the Ethereum network to reward miners for their work in adding blocks to the blockchain. It’s integral to the platform, as it’s used to pay the gas fees required for every transaction.
What Are the Major Token Types?
Different token types serve users in different ways, and each plays a unique role in helping the overall DeFi ecosystem function well and grow.
In February 2020, this blog provided an overview of the types of cryptocurrency tokens that existed at the time. The DeFi movement was very small then, with barely a billion dollars of total value locked (1% of today’s TVL) in various protocols. Over time, new trends in DeFi emerged and various token types, including Liquidity Provider tokens, established niches in response to evolving market needs. In contrast, utility tokens have become less popular. Although they still exist, it’s generally not necessary to hold a separate utility token to interact with DeFi services like Uniswap.
Currently, there are five major token types DeFi users are likely to encounter:
1. Transactional Tokens: DeFi’s Money Supply
A transactional token has three functions in DeFi: a means of payment, a store of value, and a unit of account. Stablecoins, including USDC, TUSD, and Dai, all of which track the US Dollar, are transactional tokens. Assets such as WBTC and RenBTC, which are backed 1:1 by bitcoin, are also transactional tokens.
2. Governance Tokens: Community Decision-Making
Governance tokens enable communities of people to leverage their power in support of the decentralized blockchain projects or DAOs (Decentralized Autonomous Organizations) that issue them. For example, holders of COMP, the governance token of Compound Finance, engage in collective decision-making for the organization through blockchain-based voting.
Governance tokens are distributed in a variety of ways, including through direct sales to the community, airdrops to platform users, or as rewards for providing liquidity to DeFi protocols. They are also available for anyone to buy on the secondary market via centralized and decentralized crypto exchanges.
3. Utility Tokens: In-App Payment Currencies
Utility tokens function a little like local currencies—each is used as a form of payment within a specific ecosystem. For example, the Basic Attention Token (BAT) was created by the developers of the Brave browser and is used to buy advertisements and pay audiences for viewing those ads on the browser. Publishers and creators are rewarded with a share of revenues (in the form of BAT) from ads hosted on their sites. Users can tip publishers in BAT for uploading content they appreciate.
4. Liquidity Provider (LP) Tokens: The IOUs of the DeFi Space
As DeFi enthusiasts have found ways to benefit from the deep liquidity available in the space, Liquidity Provider (LP) tokens have become more important and widely used. LP tokens act as vouchers used to redeem digital assets that liquidity providers lock in liquidity pools in an Automated Market Maker (AMM), a type of decentralized exchange. Those providers earn trading fees from users exchanging tokens against the locked assets. AMMs have become popular in the DeFi space, thanks to a user-friendly approach to trading the assets they offer.
When a liquidity provider locks their assets in a pool, they receive a number of LP tokens equivalent to shares of the pool they own. For example, if Alice locks 1 ETH and 4,000 Dai in an ETH/DAI liquidity pool and she’s the first depositor, she might get 1 LP token in return, which represents her 100% share of the pool. If Bob comes along and locks 2 ETH and 8,000 Dai in the same pool, he receives 2 LP tokens because his share is twice as much as Alice’s. Now, each LP token represents one-third of the pool, or 33.33%.
A liquidity provider can use the LP tokens to redeem their pooled assets at any time. LP tokens can also be used as collateral in some DeFi dapps.
5. NFTs: An Emerging Form of DeFi Collateral
An NFT (non-fungible token) is a unique, indivisible token that represents ownership of a single digital or physical item. NFTs have gained particular traction in the digital art and collectibles scenes, and are slowly being integrated with DeFi apps.
NFTs generally use the ERC721 token standard, rather than the ERC20 standard used by most DeFi tokens. However, just like any other Ethereum blockchain token, NFTs can be transferred and traded on the open market, and have value determined by supply (verifiable scarcity) and demand. NFTs can also be used as a form of digital collateral on a small but growing number of platforms.
Ethereum Token Types: Many Parts of a Vibrant DeFi Whole
Thanks to Ethereum’s open infrastructure, common standards, and composability, different blockchain token types can be readily plugged into decentralized applications and protocols. What’s more, as the DeFi space continues to grow, new use cases could emerge to spur even more distinct token categories.
To explore how DeFi is changing the face of financial services, visit www.MakerDAO.com.