DeFi tokens: A simple guide for beginners
Discover the cryptocurrencies that provide utility to DeFi applications.
Defined as a sub-category of cryptocurrencies, decentralised finance (DeFi) tokens are used within applications that seek to decentralise traditional financial services. Although a fairly new sector, the tokens have quickly attracted the attention of many investors. It may be why you have found this article today.
In this guide, we will explore what DeFi tokens are, outline their use cases, describe the most popular ones on the market and the risks involved. Let's dig in.
What are DeFi tokens?
Each DeFi token is developed for use within an associated decentralised finance application. DeFi applications mirror conventional financial concepts, such as exchanges, lending, borrowing and insurance. Tokens are usually built on the same blockchain that hosts the DeFi application.
Built on the blockchain, DeFi tokens have the same seamless transferability and transparency as all other cryptocurrencies. However, unlike cryptocurrency coins that help secure a blockchain network, DeFi tokens are used in decentralised applications that are built on top of an existing blockchain. Each DeFi token holds a unique purpose within the associated DeFi protocol.
Different types of DeFi tokens
There are 3 types of DeFi tokens. These include:
- Fee tokens
- Governance tokens
- Collateral tokens
Fee tokens are simply DeFi tokens designed to facilitate the collection of fees generated by a DeFi protocol. Each DeFi protocol implements specific fees and processes for collection. For some, stablecoins are accepted. Others employ a native DeFi token.
Governance tokens are DeFi tokens that give holders governance rights. They represent voting power within DeFi protocols and enable holders to influence daily operations and future development. Most tokens issued within DeFi applications fall into this category.
Governance tokens represent the foundation of decentra. They effectively represent the "De" in DeFi. By encouraging community participation, holders of such tokens can actively participate in the development of the sector.
Collateral tokens are tokens that are used to stabilise a DeFi protocol. If there is a shortfall on a borrowing platform due to user loans being liquidated, any gaps can be covered by collateral tokens. As a result, price is pegged to the stability of a DeFi protocol. The tokens are vital for protocols where cryptocurrencies can be used as collateral or where synthetic assets are created.
List of popular DeFi tokens
UNI is the primary token of Uniswap, which is one of the leading decentralised exchanges (DEXs). The token was built using the ERC-20 token standard, which means that it is compatible with the Ethereum blockchain.
UNI tokens were launched in September 2020 as a means to reward Uniswap users. The tokens entered the market trading at $2.94. After a development period, holders of the tokens can now use them to vote on upgrades on the protocol. Investors can also stake their tokens on the exchange to earn extra interest on their investment.
At the time of writing, according to coin aggregator Coinmarketcap, UNI holds a price of $18.19 with a 24-hour trading volume of $392,957,848.Uniswap
LINK is the native token of Chainlink, one of the most widely used decentralised oracles in the cryptocurrency industry. The decentralised oracles provide real-world data to decentralised finance applications. LINK is another ERC-20 token compatible with the Ethereum blockchain.
LINK has existed since 2017 but the Chainlink application has only gained interest since the DeFi summer of 2020. As a result, LINK's price has increased dramatically over the last 12 months. While holding a price of less than $1 for several years, LINK's value reached $52 in 2021.
MKR is the governance token of MakerDAO, arguably one of the first-ever DeFi applications. MakerDAO was built on the Ethereum blockchain and offers users the ability to access crypto-backed loans. By depositing cryptocurrencies users can access loans distributed in the US dollar stablecoin DAI.
MKR tokens have grown in popularity due to their requirement in the management of the stablecoin DAI. At the time of writing, DAI holds the 23rd largest market cap of all cryptocurrencies. If DAI performs well and remains pegged 1:1 with the US Dollar, the stability is often reflected in MKR price.
Since launching in 2017, the MKR token has remained below $1,500. With increased interest in cryptocurrencies and increased use of the DAI stablecoin last year, DAI increased to an impressive all-time high of $6,000.MakerDAO
COMP is the native token of Compound, a leading and popular decentralised cryptocurrency lending platform. The token was launched in June 2020 and has become a popular investment option in the DeFi sector. The token gives holders voting rights to the Compound protocol and is used by the application to distribute rewards to those lending.
As one of the younger DeFi tokens, COMP has not experienced such extreme price movements. It spent the majority of 2020 consistently below $200. However, with increasing interest in the DeFi sector COMP reached an all-time high of $800 in 2021.Compound Finance
AAVE is the native token of Aave, a cryptocurrency lending platform that is similar to Compound. The DeFi platform was first introduced in the cryptocurrency market in 2017. At the time it went by the name ETHLend and implemented LEND as its native token. In 2018 ETHLend was rebranded to Aave, with all LEND tokens transferring to AAVE.
Aave's open-source protocol is built on the Ethereum blockchain and, therefore, AAVE tokens have been built based on the ERC-20 standard. The token has enjoyed a bullish market for the majority of 2021. Holding AAVE provides users with discounts on the lending platform and allows them to vote on the development of the platform.Aave protocol
Risks of using DeFi tokens
A risk that all cryptocurrencies share is price volatility. DeFi tokens are highly volatile and can experience significant price movements over a period of hours.
Price volatility is a key reason why many investors remain cautious of cryptocurrencies. As easy as it is for one to make money in the market, it is also easy to lose huge sums. The lack of inherent value is one reason why cryptocurrencies are so volatile.
DeFi applications rely heavily on smart contracts. These are automated digital contracts that are programmed by developers. If there is a coding mistake or exploit in a smart contract, digital assets can be lost in the DeFi ecosystem.
In April 2021, a hacker took advantage of a vulnerability that had been present in Uranium v2 contracts, resulting in a loss of $57 million. The hacker exploited a coding error in the platform's balance modifier logic. Similarly, in May 2021 a hacker exploited Rari Capital smart contracts by "tricking" them into allowing hostile contracts to gain access to funds stored in its vault. The hack resulted in an $11 million loss.
Flash loans are an innovative DeFi feature that allows users to borrow without depositing collateral. The feature facilitates opportunities such as arbitrage, self-liquidation and collateral swapping. However, as beneficial as flash loans are, they have quickly become one of the most common features that hackers target to directly or indirectly steal funds.
DeFi is an innovative sector within the cryptocurrency industry and DeFi tokens are a crucial part of the system. By facilitating fee collection, providing governance rights and offsetting collateral, tokens provide many advantages to the financial products on offer. They have already proven popular among cryptocurrency investors, with many solidifying a position within the cryptocurrency market. While not risk-free, the tokens have the potential to help revolutionise the finance and banking sector.
Pros and cons of cryptocurrency lending
- Accessibility. DeFi tokens improve accessibility to a broad range of financial services.
- Increased transparency. DeFi tokens could create new standards of transparency and access in the financial sector.
- Automation. Combined with smart contracts, DeFi tokens help the automation of DeFi applications, which can greatly reduce the costs for financial services.
- Governance. DeFi tokens often provide holders with governance rights to a platform. This places the development directly into the hands of loyal users.
- Price volatility. Like all cryptocurrencies, DeFi tokens are highly volatile. Significant price swings can occur within hours.
- Security risks. There is an inherent risk when using DeFi applications, which transfers across to DeFi tokens. If an application is exploited, the value of an associated DeFi token would be affected.
- No regulation. The DeFi sector is an unregulated industry. There is no insurance in case applications fail or funds are lost.
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