Ethereum is a growing platform for developing Dapps (decentralized apps) and smart contracts. While it is mostly known for its cryptocurrency ETH like Bitcoin (BTC), Ethereum is actually also a platform for crypto-based markets and applications. While the platform has its own native cryptocurrency Ether (ETH), its real promise lies in providing an ecosystem for decentralized applications and finance.
Ethereum tokens are native to the Ethereum blockchain and they are used to interact with Ethereum-based decentralized applications (Dapps). Tokens are an important part of the Ethereum ecosystem but they are often confused with other cryptocurrencies or coins. Ethereum tokens have many functions which can be hard to grasp if you are not familiar with how Ethereum and decentralized finance (DeFi) work.
We prepared a guide to explain what Ethereum tokens are and their significance for the Ethereum blockchain. If you are interested in exploring Ethereum-based assets, read on to find out more about how they work.
What Is Ethereum And How Is It Different From Bitcoin?
Ethereum is a popular open-source blockchain platform for building and running decentralized applications (Dapps). What makes Ethereum different from other blockchain-based cryptocurrencies is the breadth of its vision. Most cryptocurrencies are simply digital assets you can invest in and trade through crypto exchanges. These digital currencies can be used to purchase goods and services, at least in theory. However, even though cryptocurrencies, and especially Bitcoin, are regarded as the cornerstone of decentralized economies, in practice they are often adjacent to existing systems. For example, Bitcoin is a decentralized currency without third-party supervision or regulation, but in order to buy, sell and trade Bitcoin you need to use centralized exchanges. In other words, the goods and services you can purchase with crypto are still centralized.
Ethereum offers to revolutionize the application ecosystem by allowing developers to build apps that run on its peer-to-peer network and blockchain. Blockchain-based decentralized apps can provide more autonomy and privacy to users compared to traditional centralized apps like Google or Facebook.
The Ethereum blockchain houses several decentralized autonomous organizations (DAOs), decentralized exchanges, decentralized finance apps, prediction markets, and games.
Let’s explore some of the most important components of the Ethereum ecosystem that distinguish it from other cryptocurrency blockchains.
Smart contracts lie at the foundation of what makes Ethereum so special. Essentially, a smart contract is a self-executing automated agreement between multiple parties that is defined by its code. While traditional contracts are recognized and enforced through authorities such as courts, notaries, or other legal experts, smart contracts require no third-party supervision. A smart contract consists of logically arranged if/then operations. When the requirements written into the code of the smart contract are fulfilled by the parties engaged, the smart contract will be automatically executed.
Since the smart contracts are based on the Ethereum blockchain, the contracts are permanent and immutable. Once executed, a smart contract can not be revoked. This is great for preventing fraud, but it can cause some headaches if there is something wrong with the smart contract’s code.
Decentralized Applications (Dapps)
Decentralized apps are applications that run on decentralized platforms, like blockchains. The Ethereum blockchain is one of the most developed and popular Dapp platforms thanks to its Ethereum Virtual Machine (EVM) that allows developers to test their apps in a safe environment.
Dapps are built on top of the Ethereum blockchain and they run on its peer-to-peer (P2P) network. The Ethereum blockchain works as an operating system for Dapps, and unlike traditional applications that run on private servers, the data is distributed among the network’s participants.
Dapps take advantage of Ethereum’s smart contract facilities. This means that rules of the applications are handled by pre-given definitions and decisions, and developers don’t own the data collected by the apps.
Dapps on the Ethereum network are programmed with Ethereum’s programming language Solidity.
Dapps have many real world use cases, including games, social media sites, and finance.
Decentralized Finance (DeFi)
Decentralized Finance takes its name from the decentralized nature of blockchain technologies. DeFi applications are simply Dapps for financial goods and services. DeFi applications aim to remove intermediaries such as banks and government agencies from financial operations and streamline services through decentralization.
The Ethereum network houses many DeFi applications thanks to smart contracts. DeFi applications on the Ethereum network allow users to borrow loans, make investments, loan their crypto holding for interest, and engage in many other financial operations.
What Are Ethereum Tokens?
Ethereum tokens are different from Ethereum’s cryptocurrency Ether (ETH). Ether is the Ethereum blockchain’s native digital currency. Ethereum tokens, on the other hand, can be designed by anyone using the Ethereum platform. Ether is usually used to pay the transaction fees when users trade tokens or interact with Dapps through tokens. Let’s look at how tokens differ from coins before moving on to what makes Ethereum tokens special.
What Is the Difference Between Crypto Coins and Crypto Tokens?
Crypto coins and crypto tokens are both cryptocurrencies, but they have different properties. The main difference between a token and a coin lies in whether the digital currency has its own dedicated blockchain.
When we think of cryptocurrencies, we often think of crypto coins like Bitcoin and Litecoin, digital currencies that have their own blockchains. These digital assets are designed for making online transactions and rapidly transferring funds from one party to another.
Creating a crypto coin requires building a blockchain, which can be a difficult task for many people. Even though there are several altcoins with their own dedicated blockchains, the necessary technical skills (and the business acumen) to create and market a crypto coin from scratch make it a tougher venture compared to creating tokens on existing blockchains.
Crypto tokens don’t have their own blockchains. They are built on existing blockchains, and they run on the existing blockchain networks. Tokens are also cryptocurrencies, but they have many functions other than making payments. They are mostly used to interact with Dapps on the blockchain.
Tokens are much easier to create than coins. Anyone who knows Ethereum’s programming language Solidity can create a token on the Ethereum platform as long as they comply with Ethereum token standards.
What Is The Purpose of Ethereum Tokens?
We know that Ethereum has its own cryptocurrency Ether. So why are there so many Ethereum-based tokens and what is their purpose? This is a crucial question and answering it is a bit complicated.
The short answer is that Ethereum tokens are used to interact with Dapps on the Ethereum blockchain. A common analogy used to explain the purpose of tokens is arcades. In an arcade, you exchange currency for tokens to be able to play the games. Ethereum tokens are sometimes compared to these tokens to explain why you need them to interact with Dapps. This is a misleading analogy that doesn’t really explain the purpose of tokens.
The long and more accurate answer is that Ethereum tokens have many purposes. The two main types of tokens are utility tokens and security tokens.
Utility tokens are divided into two categories: usage tokens and work tokens. Some Dapps charge their users usage tokens for their services. Work tokens, on the other hand, give their owners the right to join the Dapp’s management and vote on decisions regarding the application.
Security tokens are similar to stocks and bonds. Owners of security tokens can profit from the performance of the Dapps and they are usually entitled to many other benefits, such as voting power. These are essentially security assets that are regulated by the Securities and Exchange Commission (SEC).
Dapp developers can create their own tokens on the Ethereum network. These tokens can be used for several functions, including using the app or having voting rights on the app.
One of the reasons why there are so many different tokens on the Ethereum network is initial coin offerings.
What Are Initial Coin Offerings?
Initial Coin Offerings (ICO) are the cryptocurrency equivalent of Initial Public Offering (IPO). Dapp startups create specific tokens for their Dapps and sell them to investors to raise money for their ventures. They are a form of crowdfunding to bring in liquidity.
ICOs, DeFi, and Ethereum tokens are tightly interwoven. The DeFi boom in 2017 is usually attributed to several successful ICOs in which startups collected millions of dollars from early investors.
The problem with ICOs is that they are not regulated by any authority as long as they sell utility tokens. Security tokens are classified as securities by the SEC and they are tightly regulated. On the other hand, utility tokens are often regarded as vouchers or coupons and are not necessarily considered securities (though the SEC can still open investigations depending on the nature of the ICO and the business).
It is very easy for anyone to create a token and facilitate ICOs and since the market is completely unregulated, scams and failures account for a big part of the landscape. The most common token scams are pump-and-dumps, also known as “pulling the rag” in the DeFi community. These are often fake companies that have a strong social media presence. They work with influencers to hype up their Dapp and token, only to liquidate their assets once its value reaches a certain threshold, leaving investors high and dry. These scams are often advertised as great opportunities and they take advantage of the FOMO (fear of missing out) mentality to raise their profiles.
Since ICOs have raised billions of dollars by selling utility tokens, developers constantly try to tokenize their apps in order to be able to participate in ICOs. However, not all Dapps are suited to tokenization and prioritizing tokenization over usefulness can spell death for any Dapp no matter how much they raise with ICOs..
How to Use DeFi Apps and Ethereum Tokens Safely
The Ethereum blockchain is known as the world’s first programmable blockchain. Developers can write smart contracts to automate financial operations that are otherwise monitored and executed by third parties. Ethereum’s capability to program smart contracts and run applications on top of the blockchain network makes it one of the biggest marketplaces for Dapps. Many startups have taken advantage of the features Ethereum offers in order to develop their apps and connect with investors and customers.
Tokenization allows startups to offer initial coin offerings to raise money for the development of their products. Since initial coin offerings can only be made for utility tokens, many developers try to fit tokens to utility schemes. Investors who purchase tokens hope that the startup will be successful and the tokens will gain value as the Dapp develops. Even though utility tokens are not strictly for investment, this is nonetheless how most people see them.
Unfortunately, the popularity of ICOs and the get-rich-quick tone that surrounds some tokens have created a risky environment for investing in Dapps and tokens. A research paper identified 355 instances of crypto pump-and-dump scams during seven months between 2017 and 2018.
Stock market manipulations like insider trading and pump-and-dump scams are illegal activities and they are investigated by the SEC. However, there are no regulations for cryptocurrencies so these scams are not even illegal.
If you want to explore the vast universe of Ethereum tokens and Dapps, make sure you pick a transparent team with open-source code and a white paper that clearly outlines their goals. Remember that if an offer sounds too good to be true, it is probably not legit.
Ethereum Token Standards
The Ethereum community set certain standards for developing tokens on the Ethereum blockchain so that different tokens on the platform can be traded seamlessly and used for different Dapps. These are known as ERC (Ethereum Request for Comments) standards. All Ethereum tokens are built according to ERC standards, though there are a few different ERC types. These standards define how new tokens are created, total token supplies, how token contracts work, and guarantee the functionality of the token.
What Are ERC20 Standard Tokens?
ERC20 tokens are fungible tokens that fit the criteria set by the ERC20 technical standard. Ethereum Request for Comments (ERC) is the name of the protocol for updates to Ethereum. ERC20 identifies the specific update that led to the creation of standards for fungible tokens.
ERC20 is the universal standard for creating fungible tokens in the Ethereum blockchain. These are the most popular tokens on the blockchain and there are several thousand ERC20 tokens in circulation.
A fungible token can represent anything on the Ethereum blockchain. All ERC20 tokens are interchangeable and can be traded with each other. Each unit can be replaced by another unit. This makes ERC20 tokens ideal for users who wish to explore different Dapps.
Developers can produce their own ERC20 tokens to be used for specific Dapps and sell them through ICOs to fund their ventures.
While most ERC20 tokens like Augur (REP) or Maker (MKR) are native to Ethereum, native tokens of other blockchains like BNB of Binance Smart Chain can also be ERC20 tokens.
What are ERC721 Standard Tokens?
ERC721 standard tokens are non-fungible tokens (NFTs). Unlike fungible tokens, which are interchangeable, NFTs are unique. NFTs can’t be replaced by other tokens. They are usually used to represent ownership of unique assets, like art works and collectibles.
NFTs first gained popularity with the CryptoKitties game in 2017 and their popularity surged in 2020 when several artists started to offer NFTs of their works. Some famous NFTs include Twitter’s first ever tweet by Jack Dorsay and the viral Charlie Bit My Finger video.
A Few Words Before You Go…
In many ways, this is still the beginning for Ethereum and the project could evolve in many directions. Ethereum’s introduction of smart contracts and its initiative to open up a decentralized market for applications may have started a new era for the internet and decentralized finance.
A key component of the Ethereum ecosystem is Ethereum tokens. Ethereum tokens can be bought with Ethereum’s native currency Ether, and they can be used for different purposes regarding Ethereum Dapps. Ethereum Dapps use the blockchain’s smart contract capabilities in order to run decentralized operations.
Many Dapp startups offer initial coin offerings to raise funds to develop their projects. If the projects are successful, the owners of these tokens can take part in the management of the project or benefit from those tokens in other ways. However, it is important to investigate carefully before investing in tokens, since the market is still young and vulnerable to scammers.