What are DeFi Tokens?
Known as DeFi tokens, these digital assets find their existence within the decentralized finance world. Different tokens fulfill different roles within DeFi platforms, standing by to facilitate or govern financial transactions, or to incentivize them. They are mostly built on blockchain networks such as Ethereum and usually have some form of interaction with a given DeFi protocol or dApp.
DeFi Token Types
DeFi tokens can be divided into sub-categories, with their utility and purpose being the criteria. Let's take a look at the principal categories:
Governance Tokens
Governance tokens allowed stakeholders to vote on key issues regarding the relevant DeFi protocols or platforms. For instance, testing whether protocol upgrades, changes in fees to be applied or alteration of the overall rules pertaining to the platform is involved. Governance tokens include UNI for Uniswap, and MKR for MakerDAO.
Stablecoins
Stablecoins are DeFi tokens pegged to a traditional currency, such as the US dollar, to reduce volatility. They retain a relatively stable price, making them good for trading or as collateral for loans. DAI, USDC, and Tether (USDT) are examples of popular stablecoins.
Liquidity Provider Tokens
Those who bring liquidity to various DeFi protocols such as decentralized exchanges (DEXs) or lending platforms receive this token. Liquidity providers are therefore rewarded for their services, usually in the form of extra crypto tokens. SUSHI (from SushiSwap) and COMP (from Compound) are examples.
Utility Tokens
Utility tokens pay for services or transactions within the DeFi ecosystem or grant access to particular functions within decentralized applications. LINK from Chainlink is an example of a utility token used to pay for oracle services on DeFi platforms.
How Do DeFi Tokens Work?
Before a DeFi token is created and governed, there are smart contracts behind them; a smart contract is a self-executing contract wherein the terms are embedded directly within the code. Such contracts function on blockchain platforms such as Ethereum so that transactions remain secure, automatic, and transparent without having to use an intermediary.
Generally speaking, how do DeFi tokens work in the ecosystem?
Token Minting
In most cases, DeFi tokens are issued through an Initial Dex Offering, wherein tokens enter the market for the first time. Investors may buy these tokens with crypto-assets such as ETH or USDT, and this capital is usually allocated for the development and upkeep of the DeFi project.
Token Trading
Once issued, the DeFi tokens can be traded on decentralized exchanges (DEXes) such as Uniswap, SushiSwap, and Curve Finance. Here, users exchange tokens from their own wallets and do not place trust on a centralized authority for their trade. This exchange often includes the pairing of DeFi tokens with other tokens: usually with stablecoins or tokens of a major cryptocurrency like Bitcoin or Ethereum.
Staking and Rewards
Staking is an important function of many DeFi tokens. Users stake their tokens in a smart contract, locking them away for a specified duration. In return, they are rewarded with more tokens. This mechanism secures the DeFi platform and provides some passive income to the user. There are some risks involved with staking, such as impermanent loss or a protocol failure.
Borrowing and Lending
In numerous DeFi token lending protocols, users lend their tokens to earn interest. Borrowers get to borrow tokens by putting up their own assets as collateral. DeFi platforms lend and borrow tokens in the capacity of Aave and Compound.
Common Use Cases of DeFi Tokens
DeFi tokens come in handy in different financial applications in the DeFi ecosystem. Here is a brief compilation of some of the popular ones:
Decentralized Trading
DeFi tokens run decentralized exchanges (DEXs) that allow users to trade cryptocurrencies without relying on centralized intermediaries. By putting in liquidity at these DEXs, users support exchange efficiency and get compensated with transaction fees. For example, the UNI token is a DeFi token used in Uniswap, one of the world's largest decentralized exchanges.
Users are able to trade a myriad of tokens on these decentralized platforms, often at fairly smaller fees compared to centralized ones. Since DEXs rely on smart contracts, users keep full control of their funds throughout.
Yield Farming and Staking
Yield farming is the process wherein users provide liquidity to DeFi platforms against rewards. This includes lending one asset to another, providing liquidity to a DEX, or staking. Yield farmers are rewarded by earning yield usually in DeFi tokens such as COMP, or YFI (for Yearn finance).
Yield farming can be very profitable, but it does come with risks such as risks that arise from holding volatile assets and that of impermanent loss.
Lending and Borrowing
One of the applications of DeFi tokens that has acquired tremendous popularity is lending and borrowing through decentralized platforms. These platforms enable users to earn interest on their assets or go for a secured loan. Aave and Compound are a couple of major platforms that allow users to lend and borrow an asset using DeFi tokens as collateral.
DeFi lending has many benefits; some of these are:
- Lower fees are charged compared to traditional financial institutions.
- Access to global markets. Anybody anywhere in the world who has access to the internet may participate.
- Transparency in terms of smart contracts, where the loan agreements are automatically enforced.
Insurance
DeFi platforms are also considered in creating insurance products of a decentralized nature where users pool their resources to hedge against risks such as weather and flight delays. Nexus Mutual stands an example of the platform where users can buy decentralized insurance products through DeFi tokens.
Ready to Dive into DeFi?
DeFi tokens are attempting to transform the financial landscape by offering an entirely decentralized, transparent, and accessible alternative to the traditional means of finance. From trading, lending, governance, staking, and more, they offer new means for the market to earn, invest, and participate in finance. However, some risks come with any emerging technology, such as volatility and security of the platform. The users should always do some due diligence and understand these risks before entering the world of DeFi to have a safe and better experience.
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Token cannot exist without cryptocurrency, but cryptocurrency can without token.#Cryptocurrency is a kind of virtual currency that uses cryptography to ensure the security of transactions and control the issue.
— Cryptounit Blockchain Official (@CryptoUnit_en) February 4, 2022
A #token is a means of payment in a particular blockchain. pic.twitter.com/pbPRnBk75x