How can ERC-20 tokens enable smart contracts on the Ethereum Blockchain? – Cryptopolite

by Arthur · March 20, 2023

Welcome to the exciting world of crypto! If you are interested in the cryptocurrency space, then you have probably heard of Ethereum, the second largest blockchain network after Bitcoin. Ethereum is a platform that enables developers to create decentralized applications (dApps) and smart contracts using the Solidity programming language.

One of the most important features of Ethereum is its ability to support custom tokens, which are assets that represent value or utility and can be used in various ways within dApps and smart contracts. ERC-20 is the most common token standard used on the Ethereum blockchain, and it has completely revolutionized the way we think about digital assets. Let’s explore all about ERC-20 tokens.

Table of Contents

What is ERC-20?

ERC-20 is a token standard on the Ethereum blockchain that defines the basic functionality of a token. At its core, ERC-20 is a set of six features that a token smart contract must implement to comply with the standard. These features include:

totalSupply: This function returns the total supply of tokens.
balanceOf: This function returns the balance of tokens held by a particular address.
transfer: This feature allows a user to transfer tokens from one address to another.
transferFrom: This function allows a third party to transfer tokens from one address to another on behalf of the token holder.
authorize: This feature allows a token holder to authorize a third party to use their tokens.
allowance: This function returns the amount of tokens that a third party is allowed to spend on behalf of the token holder.

Implementing these features will make ERC-20 tokens easily integrated into dApps and smart contracts, making them versatile and useful. For example, a dApp can use an ERC-20 token as a reward for completing certain tasks or as a means of payment for goods and services.

ERC-20 tokens are also fungible, meaning that each token can be exchanged for another token of the same type and value. This makes it easy to trade and exchange on cryptocurrency exchanges.

How does ERC-20 work?

Now that we’ve covered what ERC-20 is and its basic features, let’s inspect how ERC-20 tokens work and their technical implementation, especially now that Ethereum has transitioned to Proof-of-Stake (PoS).

A developer programs an ERC-20 token as a smart contract on the Ethereum blockchain. A smart contract is a self-executing contract with the terms of the agreement between buyer and seller written directly into lines of code. Smart contracts allow trusted transactions and agreements to be executed automatically without intermediaries, making them a key feature of the Ethereum blockchain.

When a developer creates an ERC-20 token, they create a smart contract that follows the ERC-20 standard. They deploy this smart contract on the Ethereum network and users can interact with it using the Ethereum wallet.

One of the main features of ERC-20 tokens is their fungibility. Because all ERC-20 tokens follow the same standard, users can easily trade and exchange them with each other.

To create an ERC-20 token, a developer must first write the code for the token’s smart contract.

This code includes the six functions required by the ERC-20 standard, as well as any additional functions or functionality that the developer wishes to include.

The developer launches the smart contract on an Ethereum testnet, such as Sepolia, after writing the code. This process requires you to pay a fee in Ether, which is the native cryptocurrency of the Ethereum blockchain. The developer pays a gas fee to the nodes on the Ethereum network that process the transaction.

Now that Ethereum has moved to Proof-of-Stake (PoS), distribution and interaction with ERC-20 tokens has become more efficient and cost-effective. The random selection process for validators, based on the amount of Ether they hold and have staked as collateral, eliminates the need for miners to solve complex mathematical problems in the Proof of Stake (PoS) consensus mechanism. This means the network can process transactions faster and with lower fees.

A challenge with ERC-20 tokens is their scalability. Because every transaction on the Ethereum network requires paying a gas fee, high network traffic can cause fees to explode, making it expensive to transfer tokens. To meet this challenge, Ethereum is continuously improving its infrastructure and exploring new solutions, such as layer-2 scaling and sharding.

Why are ERC-20 tokens important?

Now that we’ve explored how ERC-20 tokens work and their technical implementation, let’s inspect why ERC-20 tokens are important and their impact on the broader blockchain industry.

ERC-20 tokens are important because they enable the creation and growth of decentralized applications (dApps) and decentralized financial platforms (DeFi). dApps and DeFi platforms leverage the capabilities of blockchain technology to create new types of financial services that are decentralized, transparent and accessible to anyone with an internet connection.

ERC-20 tokens are a key component of these platforms, as they enable developers to create custom assets that can be used within dApps and smart contracts. For example, an ERC-20 token can be used as a reward for completing certain tasks in a dApp, or as a means of payment for goods and services within a DeFi platform.

ERC-20 tokens also enable new forms of fundraising, such as token generation, where a project can raise money by selling its tokens to investors. This has led to a proliferation of new projects and startups, some of which have become very successful.

Another important aspect of ERC-20 tokens is their fungibility, because they are identical in terms of specifications and characteristics, and they can be exchanged for each other without loss of value or functionality. For example, one DAI token can be exchanged for any other DAI token, regardless of who owns it or how it was acquired.

This fungibility is achieved through the ERC-20 standard, which defines a set of rules and functions for creating and issuing tokens on the Ethereum blockchain. These rules ensure that all tokens created using the standard have the same properties and functionality, allowing them to be exchanged on a one-to-one basis.

The fungibility of ERC-20 tokens is important because it allows them to be used as a medium of exchange, store of value or unit of account. For example, a business can use ERC-20 tokens to pay suppliers or employees, or an individual can use them to buy goods or services from a merchant. In each case, the fungibility of tokens ensures that they can be exchanged without loss of value or functionality.

ERC-20 tokens have had a significant impact on the blockchain industry and are poised to continue playing a key role in the future of decentralized economy and applications. As blockchain platforms continue to evolve and innovate, we can expect to see even more exciting developments in the world of ERC-20 tokens.

Challenges and Limitations of ERC-20 Tokens

While ERC-20 tokens have enabled a wide range of exciting new opportunities for innovation and decentralized finance, there are still some challenges and limitations that need to be considered.

One of the biggest challenges with ERC-20 tokens is scalability. As the popularity of the Ethereum network has grown, so has the number of transactions and smart contracts executed on the network. This may result in congestion and higher fees, which may make it difficult for some users to interact with ERC-20 tokens in a cost-effective manner.

Another challenge with ERC-20 tokens is security. Smart contracts are vulnerable to a wide range of security risks, such as code errors or vulnerabilities. These risks can be exacerbated in the case of ERC-20 tokens, where values of millions of dollars can be at stake.

To help mitigate these risks, the Ethereum community has developed a number of best practices and standards for smart contract development. In addition, tools such as formal verification and auditing can be used to identify and address potential security vulnerabilities before they become a problem.

ERC-20 tokens are also subject to regulatory challenges. While blockchain technology has the potential to revolutionize a wide range of industries, its decentralized nature can make it difficult for regulators to monitor and control. As a result, governments around the world are struggling with how to regulate the use of blockchain technology, including ERC-20 tokens.

The bottom line

ERC-20 tokens have revolutionized the blockchain industry by enabling the creation of custom assets that can be used within decentralized applications and smart contracts. Their interoperability, ease of creation and versatility have led to a proliferation of new projects and startups, many of which have become highly successful. ERC-20 tokens are likely to remain an important and influential part of the blockchain landscape. They will continue to enable exciting new opportunities for decentralized economy and applications, and will play a key role in driving innovation and growth in this rapidly changing field.