An In-depth Study of Token Standards

Introduction

The introduction of token standards has played a pivotal role in the evolution of the blockchain industry, fostering innovation and enabling the widespread adoption of decentralized finance. From the pioneering ERC-20 standard to the emerging BRC-20, token standards have facilitated the creation, issuance, and deployment of various tokens, driving the growth of the crypto space.

By providing a set of rules and specifications, token standards ensure interoperability, composability, and efficiency within the ecosystem, allowing developers to focus on innovation rather than reinventing the wheel. This article explores some notable token standards in the crypto space, delving into their principles, development status, and their critical role in shaping digital assets’ future.

What are Tokens in the Crypto Space?

Tokens are a type of cryptocurrency that serves as a specific asset or represents a particular use on the blockchain. They are often created through initial coin offerings (ICOs) or other fundraising methods, including Initial DEX offerings (IDOs) or Initial Exchange Offerings (IEOs). Tokens can have multiple purposes, with the two most common types being security and utility tokens.

Security tokens function similarly to shares since their value is determined by a tradable external asset. On the other hand, utility tokens allow users to access products or services provided by a platform.

Differences between Crypto Native Coins and Tokens

The terms “coin” and “token” are frequently used interchangeably in the world of cryptocurrency, but it’s important to note that they have different meanings. Coins are essentially digital currencies that can be used as a form of money, while tokens can serve a variety of purposes. Additionally, Coins are native to their respective Layer-1 blockchains, whereas tokens are created on top of existing chains. To sum up, the fundamental differences between coins and tokens are as follows:

What are Token Standards?

A token standard is a set of rules and specifications that dictate how tokens operate and function on the blockchain. These guidelines ensure that different software programs, such as wallets and applications, can interact with the token predictably, without needing to understand the underlying code. Token standards differ depending on the blockchain they are built on and their intended use cases. Tokens created under different standards have varying guidelines governing them, making them incompatible. However, they can either be traded as wrapped tokens, even if they are on a different blockchain and have different standards, or through a blockchain bridge.

Wrapped tokens allow for efficient token exchange and enable the trade of different tokens on other blockchains. These tokens represent other assets on a different blockchain and are created by depositing the original asset into a smart contract, which then issues an equivalent amount of the wrapped token on the target blockchain. This allows assets from one blockchain to be used on another, creating interoperability between different decentralized finance platforms and ecosystems.

Also, blockchain bridges facilitate interoperability between tokens of different standards or smart contracts. They are often used to connect separate blockchains operating on different protocols or functionalities. Bridges facilitate the transfer of assets or data between otherwise isolated blockchain ecosystems. They typically involve smart contracts or other decentralized protocols to ensure security and trustlessness in the transfer process.

Overall, token standards follow an agreement process to be approved by the community before they can be used.

A Brief History of Token Standards

The history of token standards can be traced back to the emergence of the Ethereum blockchain and its smart contract capabilities. In the early days of cryptocurrency, tokens lacked standardization, which made them hard to integrate and manage. In 2015, Fabian Vogelsteller introduced the ERC-20 token standard on Ethereum. ERC-20 was developed for fungible tokens. However, as the need arose to represent unique digital assets like collectibles, ERC-721 was created in 2017, enabling the development of non-fungible tokens (NFTs). Since then, various standards have been developed to address specific needs in the crypto space.

Essentially, token standards have continued to evolve, playing a crucial role in the innovation and adoption of cryptocurrency.

Why Do We Need Token Standards?

As blockchain technology and cryptocurrency continue to gain popularity, several projects are being launched on different blockchains. With this rapid growth comes the need for different token standards. Token standards are crucial in the crypto space for various reasons.

1. Interoperability: Token standards promote interoperability. Without them, each cryptocurrency would exist in isolation, with its own rules and an incompatible platform, leading to chaos in the ecosystem. The introduction of token standards ensures that tokens based on the same protocol can interact seamlessly. For example, the ERC-20 token standard allows tokens to work flawlessly on a variety of wallets and platforms, creating a unified crypto ecosystem where assets can flow seamlessly.
2. Composability: Token standards foster composability, which means developers can reuse existing components to create new tokens. By adhering to an established standard, a developer can skip the arduous task of building basic functionality from scratch. This means less time spent on basic functionality and more time for experimentation and innovation.
3. Efficiency: The application of token standards promotes efficiency by easing interaction between smart contracts. Standards like ERC-20 provide essential functions such as address retrieval and tracking token balances. Developers can use tools like the Contract Application Binary Interface (ABI) to monitor token activities.

What Would Happen in the Absence of Token Standards?

The adoption of token standards has made it easier for the development and integration of cryptocurrencies. In the absence of such standards, the crypto space would face various issues, including fragmentation, security concerns, development obstacles, and limited functionality.

A fragmented ecosystem would arise, where each token would have its unique implementation, making them incompatible with each other. This would create an isolated ecosystem, hindering possible interaction between different tokens, wallets, and exchanges.

Security concerns would also arise in the absence of standard security practices. This could introduce vulnerabilities to the system, making tokens more susceptible to attacks and exploitations. As a result, risk for users would increase, hindering mainstream adoption.

Developers would face significant difficulty in creating and integrating new tokens when there is a lack of a common framework. This would stifle innovation and slow down the growth of the crypto space.

Furthermore, without standardized functionalities like transfers and approvals, it would be difficult, cumbersome, and complex to use tokens. This would limit their usability and practicality for various applications.

Therefore, the need for token standards cannot be overemphasized as they promote interoperability, simplify development, and foster a more secure and functional crypto ecosystem.

How are Token Standards Established?

Establishing token standards involves several steps, which vary depending on the project community and blockchain. The first step is to identify a specific need that is not being addressed by existing standards. This could be a desire for a new token type with unique functionalities or the need to improve interoperability between existing tokens. For instance, the ERC-20 only relates to fungible tokens, hence the need for a new token standard that addresses non-fungible tokens.

Once the need is identified, the next step is to create a technical proposal that outlines the proposed standard. This proposal document should specify the specifications, functions, and functionalities of the new standard. In the Ethereum ecosystem, “Ethereum Improvement Proposals (EIPs)” are used for this purpose.

After creating the proposal, it is then presented to the wider community for discussion, feedback, and potential revisions. This allows other stakeholders, including developers, users, and security experts to contribute their insights and identify any potential challenges.

If the proposal is approved by all parties involved and deemed beneficial after a thorough review, it will be adopted and implemented. This process may involve integrating the standard into the underlying blockchain protocol or setting guidelines that developers should follow when creating new tokens, adhering to the standard.

Finally, token standards can evolve over time based on community needs and technological advancements. Updates and amendments may also go through a similar process involved in establishing a token standard to ensure the standard remains relevant and effective within the crypto ecosystem.

Learn more about how token standards are created here.

Who is Typically Responsible for this Process?

When it comes to creating standards for tokens in the crypto space, there is no single, central authority that makes the decision. It is a collaborative effort involving different communities within the blockchain ecosystem.

First, the developers identify the need for a new standard and draft the initial proposal outlining its specifications and functionalities. Next, technical experts provide valuable input during the review process. They assess technical details relating to the proposed token standard such as its technical feasibility, security implications, and potential impact.

Community members actively participate in discussions, providing feedback, suggesting improvements, and ultimately influencing the adoption or rejection of the proposed standard. Additionally, some blockchain communities have established organizations responsible for overseeing and promoting specific token standards within their ecosystem.

Therefore, establishing token standards is a collective effort that requires diverse perspectives and expertise from different stakeholders within the cryptocurrency space. Hence, it is not the sole responsibility of any one individual or entity.

How Do Token Standards Work?

Token standards are a set of instructions that tokens must follow to operate smoothly and consistently on a specific blockchain. Essentially, they provide a set of rules that establish a common language for tokens. This includes details like the token name and symbol, the maximum number of tokens that can ever exist, how tokens are transferred between different wallets or accounts, and how users can grant permission to other applications or contracts to interact with their tokens. Token standards also promote interoperability between tokens and applications built on the same blockchain, which allows for seamless transfers and integration with dApps.

Moreover, token standards simplify development by providing a predefined framework for developers to build upon. This saves them time and resources by not having to create their functionalities from scratch. Finally, well-defined token standards can contribute to improved security by outlining best practices and potential vulnerabilities to avoid during token development.

Generally, token standards are essential for creating a consistent and efficient ecosystem of digital assets within the blockchain space. They promote interoperability, simplify development, and contribute to a more secure and user-friendly environment for exploring the potential of cryptocurrencies and other digital tokens.

Commonly Used Token Standards

Source: Crypto.com

The cryptocurrency space thrives on innovative ideas, and token standards play a crucial role in bringing these ideas to life. These standards provide a common framework for tokens to function effectively, ensuring that they can interact seamlessly with other tokens and encouraging a diverse and thriving ecosystem. Below are some of the most commonly used token standards in the cryptocurrency space:

Common Token Standards on the Ethereum Network

A graphical representation of the evolution of the Ethereum token standard

(Source: Unicorn Ultra)

Ethereum Request for Comment

The term ERC stands for “Ethereum Request for Comment.” It refers to a technical document that outlines the best practices, attitudes, creativity, and research relevant to the Ethereum ecosystem.

ERC defines application-level designs and protocols within the Ethereum ecosystem. This includes token specifications for smart contracts such as ERC-20, which typically comes with a reference implementation. Common ERC guidelines specify a fundamental set of operations for a token type, enabling apps and smart contracts to communicate with them uniformly.

ERCs play a crucial role in the development of Ethereum by defining various standards such as token interfaces, smart contract protocols, and other functionalities that developers can use when creating decentralized applications (dApps) on the Ethereum blockchain. These standards ensure interoperability and compatibility between different projects and tokens, allowing them to interact seamlessly within the Ethereum network.

ERCs are proposed, discussed, and refined within the Ethereum community by developers, researchers, and stakeholders. Ethereum smart contract programmers are responsible for creating ERC-related documents outlining the rules and regulations that every Ethereum-based token must follow. They also examine these materials periodically and offer feedback to help improve them. Once an ERC is finalized and accepted, it becomes a formal standard, guiding the development and implementation of dApps and smart contracts on the Ethereum blockchain.

There are various ERC standards, each serving a specific purpose. Some of the well-known ERC standards include:

ERC-20

Source: Kaleido

ERC-20 is the most widely used standard for tokens that are based on the Ethereum blockchain. It lays down specific requirements that all Ethereum-based tokens must adhere to as a technical standard for creating tokens on the Ethereum blockchain. These tokens can be created using the simple ERC-20 interface and reused by various applications like DeFi. ERC-20 is a fungible token standard, which means that each token or fraction is identical and indistinguishable from the next. For example, the US dollar is interchangeable with its equal worth. Similarly, in the crypto space, you can exchange USDT for UNI tokens as they are fungible tokens on the Ethereum network.

ERC-20 grew popular during the ICO craze in 2017, with the launch of several tokens. It has been critical in Play-to-Earn games and also enables the creation of stablecoins like USDC, USDT, TUSD, etc.

ERC-20 defines the rules that Ethereum-based tokens must follow to ensure compatibility with various platforms, such as exchanges and wallets (notably Metamask and My Ether Wallet), and to facilitate interaction between tokens. The six primary functions of the ERC-20 token standard must be implemented for a token to be considered compliant. These functions are:

1. Total Supply: This is used to determine an ERC-20 token’s supply. It specifies the limit on the number of tokens the smart contract allows.
2. Balance: This keeps track of the token balance in each Ethereum wallet. It indicates the number of tokens an address holds.
3. Transfer: This refers to the capacity to send all of the tokens to one wallet or distribute them to ICO investors. It requires that the sender have a sufficient balance to send.
4. Transfer From: This allows token holders to trade tokens with one another after the initial distribution.
5. Approve: This function is applied to approve the withdrawal of tokens from the account invoking the function of other accounts before allowance.
6. Allowance: Allowance is used after approval to determine how many tokens the approved account may withdraw from the starting account.

The three basic optional functions for the ERC-20 are token name, ticker symbol e.g., Ether, and decimal places; that is, how many decimal places your token will support (Source: Bitpanda Academy)

ERC-777

Just like ERC-20, ERC-777 is a standard used for fungible tokens. The only difference is that ERC-777 is an improved version of ERC-20, and it focuses on allowing more complex interaction when trading tokens. It efficiently brings tokens and Ether together by providing the equivalent of a msg.value field, but for tokens.

The ERC-777 standard includes various features that bring multiple quality-of-life improvements. It gets rid of the confusion around decimals, enables minting and burning with proper events, and much more. It also includes a special feature that distinguishes it from other token standards in the cryptocurrency space. This unique feature is called “receive hooks.” A hook can be defined as a function in a contract that is called when tokens are sent to it. In other words, accounts and contracts can react when they receive tokens.

The “receive hooks” feature has enabled many interesting use cases, such as atomic purchases using tokens, which ensures that there is no need to approve and transfer in two separate transactions. It also allows rejecting the reception of tokens by reverting on the hook call and redirecting the received tokens to other addresses, among many others.

Moreover, since contracts are an integral factor needed to implement these hooks to receive tokens, no tokens can get stuck in a contract that is unaware of the ERC-777 protocol, which has happened innumerable times when using ERC-20.

ERC-223

The ERC-223 token standard is an improvement on the ERC-20 protocol, which is a widely used standard for creating tokens on the Ethereum blockchain. The ERC-20 protocol is known to have a significant issue where tokens can be lost if mistakenly sent to a smart contract. Due to this flaw, over $3 million worth of ERC-20 tokens have been lost. However, the ERC-223 standard has been designed to address this issue by enabling users to transfer tokens to smart contracts without the risk of losing them.

Moreover, ERC-223 is more efficient than ERC-20 tokens as it requires only one step instead of two for transactions. This standard has been developed to improve the interactions between smart contracts and ERC-20 systems.

Source: SlideServe

ERC-721

Source: Kaleido

The Ethereum blockchain has a non-fungible token standard, known as ERC-721, which provides a set of guidelines for creating unique tokens that represent digital assets. These tokens are non-fungible, meaning they cannot be exchanged on a one-to-one basis due to their uniqueness. ERC-721 sets itself apart by facilitating the creation of NFTs, which have a wide range of applications in gaming, art, collectibles, and more. The standard ensures a secure transfer and ownership of these unique assets.

Furthermore, ERC-721 offers a framework for creating dApps that use NFTs for various purposes, such as virtual worlds and DeFi platforms. The ERC-721 standard is made up of a set of functions that developers can implement in their smart contracts to create, transfer, and manage NFTs. These functions allow for the creation of unique tokens with their own metadata, making them distinguishable from one another.

ERC-1155

Source: Kaleido

ERC-1155 is a token standard that draws its inspiration from ERC-20, ERC-721, and ERC-777. It uses a single smart contract to represent multiple tokens at once, making it different from ERC-20 and ERC-777 in terms of its balance of function. This standard has a unique feature of an additional ID argument for the identifier of the token that you want to query the balance of.

In ERC-1155, each token ID has a distinct balance, and non-fungible tokens are implemented by simply minting a single one of them. This approach has resulted in significant gas savings for projects that require multiple tokens. Instead of deploying a new contract for each token type, the ERC-1155 token contract can hold the entire system state, significantly reducing deployment costs and complexity.

The gaming industry, as well as sectors such as fashion, music, collectibles, art, and IoT, widely use the ERC-1155 standard. The standard provides flexibility for developers and enables batch processing while preventing accidental token burns. It can be used to create tokens for the purchase of in-game items and other limited-edition collectibles with unique properties and functionalities.

Artists can accrue royalties in the smart contract and receive a certain percentage when their art/collections are sold.

A summary of the basic Ethereum token standard (Source: ResearchGate)

ERC-1400 and ERC-1404

These are two popular token standards used to create security tokens that represent real-world assets (RWAs). The first, ERC-1400, is a comprehensive but complex standard that manages transfers, documents, and compliance for security tokens on the blockchain. The second, ERC-1404, is a simpler standard that focuses on transfer restrictions for security tokens, enabling issuers to control ownership and comply with regulations. Both standards are designed to ensure that security token issuance is compliant.

Additionally, these token standards require issuance companies to govern ownership by making it mandatory for the token recipients to undergo know-your-customer (KYC) and anti-money laundering (AML) checks during the onboarding process.

Apart from the Ethereum token standards mentioned above, there are several other standards available on the Ethereum network, including ERC-165, 621, 827, and 865, as shown in the image below:

ERC token standards and their uses (Source: Blockchain Council)

These token standards have specific use cases and play a pivotal role in developing decentralized finance.

Common Token Standards on the BNB Ecosystem

The Binance Smart Chain (BSC), also known as the BNB Chain, is a popular platform for decentralized applications (dApps) and cryptocurrency projects. To simplify token development and promote interoperability within this ecosystem, several important token standards have been established.

BEP-20

Source: Techopedia

BEP-20 is a token standard that was created to expand beyond the ERC-20 standard. It acts as a blueprint for token usage and dictates rules about its overall usage. BEP-20 is compatible with ERC-20 but with modifications to improve its protocol, speed, and transaction costs. It aims to offer a versatile framework for developers to deploy diverse tokens that could represent anything, from company shares to stablecoins.

BEP-2

BEP-2, or Binance Chain Evolution Proposal 2, is a standard for tokens that enables the creation and use of new tokens on Binance Chain. Unlike BEP-20, which is used for smart contract transactions on the chain, BEP-2 is a protocol used for native transactions on the Binance Chain. This protocol allows for easy trading between different cryptocurrencies in a decentralized exchange format.

BEP-2 token standard prioritizes efficiency and security, making it easier to create and transfer fungible tokens within the Binance Chain.

Key difference between the BEP-20 and BEP-2 token standard

(Source: 101 Blockchains)

Solana Blockchain Token Standard

Solana Primary Library (SPL)

Source: Coingecko

In the Solana blockchain ecosystem, the manual that directs how tokens function is called the Solana Primary Library (SPL). This standard outlines the operation of both fungible and non-fungible tokens on the Solana chain. It also ensures that all SPL tokens can work together with Solana wallets and smart contracts. The key difference between this token standard and Ethereum’s ERC is that, while ERC has different token standards for different types of tokens (e.g., ERC-20 for fungible tokens and ERC-721 for non-fungible tokens), the SPL token standard applies to all token types on the Solana chain.

Common Token Standards on Tron Network

The Tron network is a decentralized platform used for building blockchain-based applications and creating tokens. The platform employs several token standards to allow for diverse functionalities within its ecosystem.

TRC-10

TRC-10 is the first token standard on Tron, introduced in 2017, and is primarily designed for smaller-scale use cases. Unlike other Tron token standards, TRC-10 does not require the use of smart contracts. It was initially used for issuing tokens during Initial Coin Offerings (ICOs) and for utility purposes within Tron-based applications.

TRC-20

TRC-20, on the other hand, is a more advanced token standard that makes use of smart contracts in creating and managing tokens. It was designed to execute smart-contract-based applications and offer more functionality than the TRC-10 standard. It is a dominant standard in the TRON network as it can create decentralized applications and automated token-based transactions. TRC-20 offers a broader set of functionalities compared to TRC-10, including transfers, approvals, burning, and querying token information. This flexibility makes it suitable for various use cases, from utility tokens to security tokens.

TRC-721

TRC-721 is a token standard that caters to the creation and management of non-fungible tokens (NFTs) on the Tron network. It enables developers to represent unique digital assets like collectibles, artwork, or in-game items.

Common Token Standards on Bitcoin Blockchain

BRC-20

Source: Sonic Wallet

BRC-20 is an experimental token standard that stands for “Bitcoin Request for Comment 20”. It is designed to allow the creation and transfer of fungible tokens on the Bitcoin blockchain. Unlike Ethereum’s ERC-20, which depends on smart contracts, BRC-20 makes use of the Bitcoin Ordinals protocol to inscribe data, including token information, directly onto individual Satoshis. All BRC-20 tokens of the same type are interchangeable and have the same value, making them fungible. The standard focuses on basic functionalities such as token creation, transfer, and balance inquiries. It aims for simplicity and compatibility with existing Bitcoin infrastructure.

Refer to the link to learn more about Bitcoin Ordinals Protocol.

Dogecoin Blockchain Token Standard

DRC-20

DRC-20 is a token standard that was introduced on May 9, 2023. Its primary objective is to enable the creation and management of fungible tokens on the Dogecoin blockchain. It addresses the limitations of its predecessor, the BRC-20 standard, and empowers the Dogecoin ecosystem with greater functionalities.

To achieve this objective, DRC-20 utilizes smart contracts on the Dogecoin blockchain, which offers more flexibility and security compared to Ordinals used by BRC-20. The token standard also ensures that all DRC-20 tokens of the same type are interchangeable and have the same value, promoting fungibility.

Neo Blockchain Token Standard

NEP-5

The Neo blockchain has two primary token standards, NEP-5 and NEP-17. NEP-5 is the initial token standard introduced by the Neo blockchain in 2017. It is aimed at simplifying how tokens are created and managed within the ecosystem. NEP-5 provides basic functionalities such as token creation and issuance, token transfers between user accounts, and querying token balances. However, it has some limitations such as the lack of advanced functionalities like approvals or burning mechanisms, which are essential for building more complex applications. There were also certain vulnerabilities in NEP-5 contracts that raised security concerns.

NEP-17

To address these limitations, NEP-17 was launched in 2020 as a replacement for the original NEP-5 proposal. It currently serves as the recommended token standard on the Neo blockchain. NEP-17 builds upon NEP-5 and offers a wider range of functionalities, including improved security, advanced features like approvals, burning mechanisms, and even the creation of non-fungible tokens (NFTs) through extensions. Moreover, NEP-17 exhibits greater compatibility with other blockchain protocols and standards, allowing for smoother interaction between Neo tokens and other digital assets.

Advantages, Disadvantages and Drawbacks

Advantages of Token Standards

Token standards are essential in the cryptocurrency ecosystem, offering several benefits to the whole community. Some of these advantages are outlined below:

• Simplified Development: Standards provide a clear framework and structure for creating tokens. This saves developers the effort of creating everything from scratch and offers pre-defined functions and functionalities for basic tasks like transfers, approvals, and balance queries.
• Reduced Complexity: Token standards reduce the complexities of managing different token implementations across various blockchains. By adhering to established standards, developers can focus their energy on innovation and creating unique applications rather than reinventing the wheel.
• Enhanced Interoperability: Token standards enhance interoperability by allowing standardized tokens to interact seamlessly with each other, wallets, and decentralized applications (dApps) that support the same standard. This fosters a more interconnected ecosystem and facilitates the creation of applications that can utilize diverse tokens without compatibility issues.
• Increased Security: Many standards, like ERC-20, incorporate security best practices and undergo rigorous reviews to minimize potential vulnerabilities. This provides developers with a more secure foundation to build upon, reducing the risk of security exploits and protecting users’ assets.
• Improved User Experience: Standards ensure a consistent and familiar experience when interacting with different tokens. Users can expect similar functionalities like transfers and balance queries regardless of the specific token they are using. This simplifies the process of managing and using various digital assets within the cryptocurrency space.
• Wider Choice and Accessibility: Token standards foster a more diverse and interconnected ecosystem, offering a wider range of available tokens and applications for users to explore and utilize. This empowers users with greater choice and flexibility in their endeavors.
• Reduced Transaction Fees: Some standards, like those on high-throughput blockchains such as Solana, contribute to lower transaction fees. Lower transaction fees benefit users who frequently engage in token transfers and interactions within the ecosystem.

Disadvantages of Token Standards

Token standards have several advantages, but they also have limitations and potential drawbacks that cannot be ignored. Below are some of the limitations of token standards:

• Reduced Flexibility: Standards can limit developers who want to try out new and innovative functionalities for their tokens. The standard may not cater to every specific use case, which can limit creativity and innovation in niche areas.
• Dependence on the Underlying Protocol: The security and functionality of a token standard are tied to the underlying blockchain protocol it operates on. If the protocol itself has security vulnerabilities or limitations, the token standard and its respective tokens will also be affected.
• Limited Interoperability Across Different Standards: Although token standards promote interoperability within a specific blockchain ecosystem, tokens built on different standards across various blockchains may face compatibility issues and limitations when interacting with each other.

Potential Drawbacks

The process of introducing and gaining widespread adoption for new standards in the crypto space can be slow and challenging, which may force developers to choose between using established but potentially limited standards or taking a risk with newer and more flexible, but less widely adopted ones.

Over-reliance on existing standards could hinder the development of entirely new and innovative functionalities that may not fit within the framework of existing standards, which may potentially stifle long-term innovation in the crypto space.

Although token standards are not centralized, the process of establishing and modifying them can involve centralized entities like core development teams or governance bodies. This raises concerns about potential centralization in decision-making processes within the ecosystem.

Blockchain Bridge

Source: Blockchain Council

Blockchain bridges are protocols that enable the transfer of digital assets and data between different blockchains that would not naturally interact with each other. These protocols address the challenge of different networks operating in isolation by acting as intermediaries that allow networks to communicate and exchange information and assets.

Why are They Needed?

Blockchain bridges are needed for the following reasons:

1. Different blockchain networks operate on independent protocols and have their own unique functionalities. This leads to a lack of inherent interoperability, hence creating isolated ecosystems.
2. When there is an isolated ecosystem, it poses a challenge and hinders the free flow of digital assets and data.
3. Blockchain bridges solve this problem by providing a communication channel between these otherwise isolated environments.

Source: Blockchain Simplified

How Do They work?

There are two main approaches to how a blockchain bridge functions:

• Locked Assets and Minted Representatives: In this approach, users deposit their original assets on the source blockchain into a smart contract controlled by the bridge. The bridge locks these assets on the source chain and mints representative tokens on the destination blockchain. These tokens represent the locked assets that exist within the new ecosystem.

When a user wants to move their assets back, they send the representative tokens back to the bridge. The bridge then permanently removes (burns) these tokens and unlocks the original assets on the source chain.

• Relay Networks: In this approach, a network of validator nodes secures the bridge and monitors transactions. Users send their assets to a custodian contract on the source chain. Once these assets are sent, validator nodes verify the transaction and relay the information to the destination chain. Once verified, the destination chain mints new tokens representing the transferred assets.

Wrapped Tokens

Wrapped tokens can be defined as assets that allow for the transfer of the value of a native asset from one blockchain to another blockchain. It plays a vital role in the cryptocurrency space by facilitating interoperability and unlocking new functionalities across different blockchains.

Source: Cointelegraph

The following are the importance and potential drawbacks of wrapped tokens:

Importance of Wrapped Tokens

Wrapped tokens play a crucial role in facilitating the seamless transfer of assets from one blockchain to another. They allow users to utilize their holdings from one blockchain within applications built on another, thus expanding the reach and utility of their assets.

Moreover, wrapped tokens enable users to participate in Decentralized Finance (DeFi) activities on different blockchains, providing them with new opportunities for earning interest, lending, and borrowing.

Wrapped tokens also contribute to increasing liquidity by allowing for the free movement of assets across blockchains. They offer the ability to bring the functionality of one blockchain to another, which enables developers to leverage the unique strengths of different blockchains. They can combine the security of one blockchain with the scalability or smart contract features of another.

Lastly, wrapped tokens allow developers to extend the reach of their applications by making them accessible to a broader audience across different blockchain ecosystems.

Drawbacks and Considerations of Wrapped Tokens

• Potential Security Risks: When wrapping assets, the original asset is locked in a smart contract on the source chain, creating a centralized point of failure if the custodian or bridge managing the locked assets is compromised.
• Vulnerability to Bridge Attacks: Bridges connecting different blockchains can be complex and become targets for hackers, making them vulnerable to attacks.
• Additional Fees: Wrapping and unwrapping tokens involve transaction fees on both the source and destination blockchains, which can increase the overall cost for users.
• Limited Interoperability: Wrapped tokens enhance interoperability but do not solve the underlying issue of complete blockchain interoperability. Different blockchains may still have limitations in how they interact with each other.

Conclusion

The use of various token standards has greatly improved interoperability within the blockchain ecosystem. These standards serve as guidelines that specify how tokens operate, making it easier for developers to create new tokens and reducing complexity in the overall system. By implementing token standards, security has been bolstered and the user experience has been enhanced, providing users with a wider range of choices and greater accessibility.

As the crypto space continues to evolve, it is expected that new token standards will be introduced. This expansion will further improve interoperability within the ecosystem and reduce existing complexities.