What are ERC-20 tokens?

ERC-20 tokens are sets of 'fungible' digital tokens that live on the Ethereum network. Fungible here means that each token in the set is indistinguishable from every other token in the set. This is analogous to how one US dollar is effectively indistinguishable from every other US dollar (at least in the digital realm). When it comes to ERC-20 tokens, each set is differentiated by a ticker symbol like ABC or XYZ. There may be, for example, a set of 1 million ABC tokens, and another set of 10 million XYZ tokens. The barrier to entry for creating ERC-20 token sets is low (it's really just a matter of deploying a relatively simple 'contract' to the Ethereum network), so the number of sets is measured in the thousands. For this reason, most sets actually have very little value. Some, however, are worth billions.

ERC-20 refers to a technical standard that defines a common set of rules such as how the tokens can be transferred, how transactions are approved, and the total supply of tokens. The ERC-20 standard arose from a 2015 proposal that was merged into the Ethereum protocol via an Ethereum Improvement Proposal (IEP-20).

Interacting with ERC-20 tokens requires the use of ETH. For example, if you want to send 100 ABC tokens to Alice, you'll need to attach a small amount of ETH to pay for the transaction.

Read more: What is gas and how do fees work in Ethereum?

ERC-20 tokens are created by deploying smart contracts. The logic of smart contracts allows for some interesting use cases, even just for the creation of a set of tokens. For example, consider a contract written such that it can receive a maximum of 1000 ETH (that is, a total of 1000 ETH can be sent to the contract), and for every one ETH sent into the contract, the contract automatically 'mints' and sends 100 ABC tokens back to the sender. This would "create" 100,000 ABC tokens and distribute them amongst anyone who sent ETH to the contract. It's worthwhile noting that this process has similarities to an initial public offering of stock, where shares in a company are issued and distributed to people who have purchased them with dollars.

We can also specify other details in the contract. For example, we can say that 10% of the ETH received in the contract is immediately sent to Bob's Ethereum address. In this example, Bob might be the CEO of the ABC token "project." People sending ETH to the contract, then, are effectively paying Bob to do work on ABC token's protocol in the hopes that the value of ABC token will rise in the future thanks to Bob's initiative.

There are a huge variety of ERC-20 tokens. Some, like in our example above, represent financial assets that are arguably similar to a share in a company. Note that this feature means such tokens may be considered securities by financial regulators, potentially subjecting the issuers to a range of legal obligations depending on the jurisdiction.

ERC-20 tokens can also be used to represent things like loyalty rewards and reputation points. Imagine, for example, an online travel agency that issues points to users every time they make a booking through the platform. These points could be used to pay for future bookings. They could also provide holders with additional benefits like VIP service, a share of the fees generated by the booking platform, or even a say in how the platform is governed. Importantly, the points (tokens) could also be traded with other people, a feature that endows them with value beyond just the ecosystem in which they were created.

Finally, ERC-20 can be used to represent physical objects like gold or real estate. However, when digital tokens are used to represent physical objects, maintaining the connection between the two presents difficulties.

Consider the example of ERC-20 tokens that represent US dollars - as in one of the most-used and most widely distributed ERC-20 tokens, Tether (USDT). Holders of Tether tokens, which go by the ticker symbol USDT, have a claim on US dollars that are held in the bank accounts of a company called Tether Limited. The value of 1 USDT has so far reliably mirrored the value of 1 'real' US dollar, however, since the bank accounts of the company behind USDT exist outside of the Ethereum network, participants must rely on traditional auditing practices to verify the existence of the 'real' dollars. This reliance on a third-party that exists outside of the code-driven world of the Ethereum shared computer, makes it harder to guarantee 'truth.' Thus, there's always the chance that participants will lose confidence that Tether-the-company does, in fact, hold sufficient dollar reserves - a circumstance that may result in a situation where 1 USDT is not worth the same as 1 US dollar.

Despite the challenges, the fact of USDT tokens living on Ethereum endows them with a certain utility beyond 'real' US dollars. Specifically, you can easily move them around (including across borders), trade them for other tokens, or even send them to a smart contract that allows you to earn yield on them. For these reasons, the growth in adoption of USDT and other Ethereum-based US dollar tokens has been rapid.

Read more: What's Decentralized Finance?


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