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What is a blockchain token? 5 functions in DeFi

January 4, 2022

7 min

What is a blockchain token? 5 functions in DeFi

Cryptocurrencies are not just a means of exchange. With crypto, it is as if the currency were a flexible and intelligent piece of software with countless possibilities and utilities. Let’s break down all types of cryptocurrencies and tokens.

What is a token on blockchain?

Tokens are a type of cryptocurrency. The two main types are tokens and coins.

Coins are currencies that are natively based on their own blockchain, and usually aim to have the classical function of means of payment. A typical example is Bitcoin.

Tokens on the other hand are often on a layer 2 blockchain, or are based on a blockchain but only have their functionality within a certain application or app.

Tokens express the “programmable” part of cryptocurrencies, in fact, there are many types of tokens depending on their purpose.

The most popular and longest-running blockchain for issuing tokens is Ethereum, which includes many standards for easily programming many types of tokens. The basic standard is called ERC-20.

What are the main types of tokens?

Currently, there are five main categories of tokens that we may encounter in DeFi: transactional tokens, governance tokens, utility tokens, yield farming tokens (liquidity provider tokens – LPs) and non-fungible tokens (NFTs). This is what each token is used for.

1. Transactional tokens: DeFi money

What is a transactional token used for? The name says it all: to carry out transactions, to move value. These tokens are used to facilitate liquidity transfers between different decentralised applications (Dapps), or to purchase goods and services.

“Transactional token” is often synonymous with “coin”, given their similar economic function, however, ERC-20 (and other such standards) tokens that only have a transactional function are not technically coins.

These include stablecoins, such as USDC, USDT and Dai, but also wrapped tokens such as wBTC and renBTC.

Wrapped tokens

Wrapped tokens are cryptocurrencies “wrapped” in the token standard of the blockchain in which they are to be used.

While bitcoin is native to the Bitcoin blockchain, it is not native to the Ethereum blockchain, and in fact has another type of code that is not compatible with the latter.

Since Bitcoin is not supported by Ethereum, an ERC-20 anchored to the value of Bitcoin has been created and is called Wrapped Bitcoin (wBTC). wBTC can therefore be used as an LP token (last paragraph) or in trading strategies in all DeFi protocols built on Ethereum.

Ethereum is the most common blockchain to host external cryptocurrencies, but it is not the only one. Avalanche, Tezos, BSC and Terra have also developed their own standards.

2. Governance tokens: power to the DeFi community

Governance tokens enable their owners to contribute to the evolution of a project. Community members can thus influence decisions on updating decentralised protocols, propose new ideas and even modify the governance system itself.

Governance tokens usually give access to a platform where changes are proposed, checked and voted. Since on-chain governance models are managed by smart contracts, votes are collected and processed automatically. Otherwise, there is a dedicated team that evaluates each suggestion.

The most comprehensive and most decentralised systems of governance are called DAOs, decentralised autonomous organisations.

An example of a governance token is Maker (MKR). This token allows its holders to vote on decisions related to the DeFi protocol that powers the decentralised stablecoin DAI. Or COMP, Compound Finance’s governance token, allows its holders to shape the future of the organisation. The same goes for holders of YFI, the Yearn Finance governance token.

Governance tokens are distributed in various ways; through ICOs, via airdrops or as a reward for providing liquidity to certain DeFi protocols. It is also possible to buy them freely on exchanges.

3. Utility tokens: Dapps and ecosystems

Utility tokens have, in fact, a well-defined purpose or utility; they are a bit like tokens in an arcade, i.e. they function within a specific ecosystem.

One example is the Basic Attention Token (BAT), which was created for the Brave browser. The token is used to reward content creators and those who display advertisements on the browser. Publishers and creators are rewarded with a share of the revenue (in the form of BAT) from the ads hosted on their sites. Users can also tip creators in BAT for content they enjoy.

To better understand how these types of tokens work, a very common example is utility tokens within games. While in centralised games we have money and gems that can only be spent in-game, in blockchain-based video games these tokens can also be traded in exchanges, as well as having utility in gameplay.

4. NFT: a unique case

An NFT (non-fungible token) is a unique, non-convertible, non-divisible token that represents ownership of a single digital or physical item. It is therefore the opposite of cryptocurrencies such as Bitcoin.

NFTs have become particularly popular in the digital art sector, as they allow the ownership of works to be tracked on the blockchain, but they are finding applications in different sectors, markets and also in DeFi applications.

Ethereum-based NFTs usually use the ERC721 standard token, rather than the ERC20 standard used by most tokens. However, just like any other token, NFTs can be transferred and traded on the open market and have a value that fluctuates according to supply and demand.

5. LP tokens and yield farming

LP tokens are referred to as “Liquidity provider tokens” and are used to redeem one’s own liquidity and the respective rewards locked in yield farming smart contracts.

Let’s take an example: the decentralised exchange Uniswap works thanks to the liquidity provided by numerous users, like all AMM-based DEXs. To provide liquidity, i.e. varying amounts of different tokens, you deposit them into specific smart contracts, called liquidity pools.

In return, you receive the same amount of LP tokens, with an additional percentage reward that increases over time (APY). In order to withdraw cryptocurrencies from the pool and redeem the reward, you need to use LP tokens.

Thanks to these tokens, the currencies locked up in the smart contracts correspond to a form of usable liquidity, making the entire DeFi more dynamic and liquid.

Just a virtual currency?

5 functions are more than we have ever imagined throughout history for any type of currency. To think that for each of these functionalities there are so many cutting-edge examples and projects on the crypto market.

However, all this is possible thanks to a great computer without borders: Ethereum.