What Are DeFi Tokens?

Decentralized Finance (DeFi) tokens are digital assets that are built on blockchain technology and designed to provide financial services.

Why it matters. DeFi tokens are an increasingly popular asset that provide access to financial services that are not available through traditional financial institutions and offer a more secure and transparent financial system.

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DeFi tokens are an exciting development in the world of finance and provide access to decentralized financial services that were previously unavailable. They offer a more secure and transparent financial system, and are becoming increasingly popular due to their accessibility and the growth of the DeFi movement.

What is DeFi?

DeFi refers to blockchain-based financial products and services that aim to disrupt centralized financial services and institutions—much like fintech disrupting the traditional financial industry. DeFi platforms offer access to a suite of financial services you’d normally get at a bank or other traditional financial institution.

For example, instead of sending or receiving payments and getting loans through banks, you can use DeFi decentralized applications (dApps) or protocols.

The major difference between DeFi protocols and traditional banks is that DeFi transactions are executed with smart contracts. These transactions are non-custodial—they don’t require a centralized authority’s scrutiny.

What are DeFi tokens?

DeFi tokens are cryptocurrencies created by DeFi protocols to grant their platform users access to a wide range of decentralized financial applications and services. These tokens have specialized functions to help users interact with decentralized applications.

Some of the most popular DeFi tokens include ALGO, ADA, COMP, and LINK.

There are three types of DeFi tokens:

• Utility tokens give users access to certain privileges in DeFi
• NFTs acts as symbols of ownership of digital and real-world assets
• Asset tokens represent real-world assets

So how do DeFi tokens work?

DeFi tokens work thanks to smart contracts, which are digital contracts (codes) that self-execute when certain conditions are met.

One common term used interchangeably with tokens is coins. Both DeFi tokens and coins can be used as a store of value and bought on centralized and decentralized exchanges. However, they’re different entities.

DeFi coins are cryptocurrencies created to mimic fiat currencies in the crypto space. DeFi tokens, on the other hand, are crypto-assets with a more varied utility that aren’t necessarily financial.

Tokens are designed to serve the dApp they’re built upon, while coins can have a blockchain-wide use case. For example, you can use ETH to pay for gas fees or buy NFTs on Opensea using ERC-20 tokens (tokens built on the Ethereum blockchain), while you can only use LINK on Chainlink.

What are some DeFi token use cases?

DeFi tokens use cases transcend financial application. Let’s explore them.

Governance tokens

Many DeFi protocols are partially governed by their community members who have voting rights to vote on and challenge key decisions. However, not all members are eligible to vote on governance proposals; only token holders have the power to vote. Tokens used in voting exercises are referred to as governance tokens.

Conventionally, users are allowed one vote per token. The more governance tokens you hold, the more voting rights you have. In general, larger token holders are perceived as more interested in the advancement of a project’s growth.

Maker DAO is an example of such a protocol with DeFi governance tokens. With MKR (Maker DAO’s native token), community members can vote on issues such as the interest rate and amount of collateral needed to borrow DAI.

Other popular governance tokens include Aave tokens (decentralized protocol for lending and borrowing assets) and CAKE tokens (a decentralized exchange for swapping Binance, or BEP-20, tokens).

Keep in mind that participating in governance doesn’t incur gas fees. While you can buy governance tokens, there are other ways to get these tokens.

Liquidity pool rewards

Liquidity pools are crowdsourced digital spaces (like a bank’s vault) where cryptocurrencies are locked up so traders can swap and trade cryptocurrencies, akin to real-life stocks. However, there’s a drawback: why should anyone release their funds to be used by traders?

Short answer: DeFi tokens.

Developers incentivize users (liquidity providers) with DeFi tokens to attract liquidity to their projects. Keep in mind that it’s quite risky to lock up your funds, so banks are unwilling to supply liquidity to DeFi protocols. These protocols then encourage everyday crypto investors to contribute and lock up their cryptocurrencies in order to get token rewards.

Aave and PancakeSwap are examples of protocols that offer token incentives to liquidity providers. Liquidity providers can use these tokens as governance tokens or for other purposes.

Other DeFi use cases

Developers are devising innovative ways for tokens to be more useful for holders. For example, token holders can stake their crypto for higher rewards. Aave does this nicely. They have a special module called ‘Safety Module’ which acts as a backup fund in unforeseen circumstances. Token holders can stake their tokens and earn “Safety Incentives.”

In some cases, holders can use their tokens as collateral to borrow other cryptocurrencies.

What are the risks?

The major risk involved in buying DeFi tokens is the volatility in the crypto space. The downfall of a crypto project could have a ripple effect on other projects and impact the value of their tokens. This could result in the loss of your funds or a decline in the asset’s value.

The newness of blockchain technology means protection against cyberattacks isn’t watertight. You could lose your crypto should a hacker exploit a vulnerability in a protocol’s code.

Finally, there’s the risk of rug pull. This is when developers code a smart contract while leaving room for them to cart away investor funds.