DeFi Foundations Understanding ERC-20 Tokens and Contract Basics

When I was twenty‑six I bought my first outright‑ownership asset—a vintage DSLR camera. I held it in my hands, felt the weight of it, and then I remembered the amount I spent. My excitement faded a moment later with a quick glance at the wallet app that said my purchase was a small fraction of what I’d planned for my emergency fund. That moment of “I spent too much” was the same feeling that surfaces when people look at a new blockchain initiative and decide, “Do I even need to understand this?”

We’ll spend the next few pages unraveling that “something” in the crypto world that makes most tokens comparable to the kind of assets you can touch and hold: ERC‑20 tokens. The goal isn’t to promise that you’ll turn a hobby into a fortune, but to equip you with the kind of clarity that lets you evaluate a token’s worth with the same eyes you use to look at a physical bottle of wine.

The basics of a fungible token

“Fungible” translates from Latin to “interchangeable.” A one‑EU euro bill can be swapped for another in the exact same way as a one‑US‑dollar bill. ERC‑20 tokens share that quality. Every unit is the same as every other, whether you’re holding 10 or 10 000 of them.

In practice that means you can do this:

• Transfer 10 ERC‑20 tokens from your wallet to someone else, or
• Burn (destroy) them to reduce supply, or
• Mint (create) new ones to increase supply.

These actions are enabled by a set of interface rules that smart contracts have to follow. That’s the heart of the ERC‑20 standard. The standard is a specification that says:

• totalSupply() tells how many tokens exist.
• balanceOf(address) tells how many tokens a particular address possesses.
• transfer(address, uint256) moves tokens from the caller to another address.
• approve(address, uint256) allows a third party to spend a certain amount on your behalf.
• transferFrom(address, address, uint256) is the third‑party transfer that works only after approve.
• Events Transfer and Approval fire whenever moves happen so outside observers can see the history.

Think of the ERC‑20 token as a small, self‑contained ledger that lives inside a block‑chain. Every time you want to send or spend, you ask the ledger to update, and the ledger writes the new state in a new block. Everyone can verify that the math checks out because all the code that does the math is open‑source and immutable.

What’s a smart contract?

Let’s break that down. A smart contract is a bit of code that lives on the chain and runs whenever its rules are triggered. Imagine a vending machine. You put a coin in (the trigger) and the machine hands you a snack (the result). In the same way, you send a transaction to the node that points to the contract address. The code takes the data you put in, follows its rules, and writes the new state.

When you create an ERC‑20 token, you write a smart contract that implements the interface above. Once it’s deployed, you have a new token that anyone can now see on the network.

Below is a stripped‑down example written in Solidity (the programming language used for Ethereum). Notice how the tokens are just numbers that get stored behind the scenes.

pragma solidity ^0.8.0;

import "@openzeppelin/contracts/token/ERC20/ERC20.sol";

contract MyToken is ERC20 {
    constructor(uint256 initialSupply) ERC20("MyToken", "MYT") {
        _mint(msg.sender, initialSupply);
    }
}

You might wonder why the contract inherits from OpenZeppelin instead of writing all the logic yourself. Think of OpenZeppelin as a well‑tested library of plumbing. It saves you from rewiring the whole thing and reduces the chance of a subtle bug that could cost millions.

Why does the standard matter to you?

A standard is a safety net. If you want to buy something with a token or provide liquidity to a pool, the platform you’re using must know the rules. The ERC‑20 standard becomes the common language that exchanges, wallets, and other contracts read. If you had a token that didn’t conform, it would sit in limbo—a “token” that nobody could trade because they didn’t know how to interact with it.

By following the standard, your token gains automatic trust: any wallet that can read ERC‑20 balances can interact with it. It also opens the door for integration with the entire DeFi ecosystem—yield farms, staking platforms, lending pools.

How to get your hands on an ERC‑20 token

If you have a wallet (MetaMask, Trust Wallet, Ledger, etc.), the first thing you do is look a token address up. On Etherscan, paste the address and you’ll see three critical numbers that sum up your token’s identity:

1. Name – “MyToken”
2. Symbol – “MYT”
3. Decimals – Usually 18, which tells the chain how many fractional units there are

Why “decimals”? Remember the bank notes analogy? 18 decimals mean that one token is equivalent to 1 × 10¹⁸ tiny units. That’s a lot of them—perfect for scaling. If you see 18 decimals when you look up your token, the contract’s balanceOf() will return a big number. To convert to a readable figure, you’d shift the decimal point 18 places to the left.

A quick way to see your real balance is by using a token‑tracking site like Etherscan or a wallet like MetaMask which automatically does that conversion for you.

Sending and receiving

Once you’ve confirmed the token exists, you can send it. The process is almost identical to sending any ERC‑20 token:

1. Open your wallet, choose “Send”.
2. Enter the token address. The wallet will load the metadata (name, symbol, decimals).
3. Provide the counterparty’s address.
4. Specify the amount (input will automatically shift decimals).
5. Confirm the transaction.

On the network side, the wallet constructs a transfer() call to that contract, signs it with your private key, and broadcasts it. When it lands in the chain, blocks will show the Transfer event and the balance will update instantly.

Building a token: a “quick start” approach

If the thought of writing a token makes you nervous, you’re not alone. What is necessary is a clear outline of the steps.

1 – Choose your supply model

You can:

• Fixed supply – A hard cap no contract can exceed.
• Mintable – An authorized account can create new supply.
• Burnable – Tokens can be destroyed, reducing supply.

Pick the model that matches your intention. If you’re thinking about issuing a governance token you might want mintable or burnable features.

2 – Pick a development environment

There are two common ones:

• Hardhat – JavaScript‑centric, great for debugging.
• Remix – Browser‑based, no setup needed for a quick test.

3 – Write minimal contract

You can start with the example I shared and modify only the name, symbol, and initial supply. Keep the code short; the longer a contract is, the more room for mistakes.

4 – Compile and test

Before hitting the mainnet, send a testnet transaction on Rinkeby or Goerli. Look at the testnet explorer and ensure the token’s fields match. You can also use unit tests with Chai or Hardhat’s built‑in testing framework to verify transfer logic.

5 – Deploy to mainnet

Once the tests pass and you’re comfortable, the last step is a small deployment fee—just a few bucks in ETH. After the transaction is confirmed, the contract address is yours.

At that point, you’ll have a token that anyone can see on the blockchain. Your token will show up on Etherscan’s “Token Tracker” page along with analytics on holder distribution and transaction volume.

The ecosystem around ERC‑20 tokens

Tokens are not isolated. That’s the compelling part of DeFi. A token that follows ERC‑20 can become a liquidity pair on Uniswap, a collateral asset on Aave, a yield‑bearing token on Compound, and so forth. All of this is made easier by the standard.

Let’s zoom out and look at a typical DeFi recipe:

1. Token – An ERC‑20 token living on Ethereum.
2. Pair – Combined with another token or ETH in a liquidity pool, so trades can occur.
3. Uniswap pool – Automated market maker swaps tokens in and out, making liquidity a trade‑off.
4. Yield farm – Users deposit liquidity provision (LP) tokens into a smart contract that rewards them with additional tokens for staking.

Picture it like a garden. Your token is a seed. If you plant it in a shared pot (a liquidity pool) and water it (provide liquidity), the pot nurtures it and it produces more seeds (farming rewards). If the pot is abandoned (no liquidity), the seeds won’t sprout.

And because every participant’s actions are recorded on the blockchain, the entire garden can be monitored for fairness and health, which is why many projects publish on‑chain analytics dashboards.

Potential pitfalls and how to guard against them

No system is immune to risk. A few recurring problems with ERC‑20 tokens are worth mentioning:

• Smart‑contract bugs
  A typo or mis‑coded logic can allow anyone to steal tokens or create them out of thin air. The best defense is a thorough audit from an independent security firm, and preferably several iterations of open‑source review.

• Rug pulls and honeypots
  A project can promise high rewards, but once users add liquidity, the creators dump the tokens. Vigilance involves checking the code for any selfdestruct calls, whether the contract holds an external owner, and the history of the token’s transfers.

• Centralization of control
  Even if the token is fungible, the person or contract that can mint new tokens can effectively control the economy. Make that function limited or use governance to restrict actions.

• Inflationary pressure
  An unchecked mint function can lead to a rapid rise in supply, diluting each holder’s claim. An answer is an on‑chain governance where token holders decide to add or remove minting capabilities.

Always treat a token like any other investment with a due‑diligence checklist: read the code, look for audits, inspect the team’s background, review the tokenomics, and ask yourself whether the promises align with the mechanics.

Let’s look at a real token for reference

Take the example of USDC. It’s an ERC‑20 token backed by fiat reserves. The contract code is published, audited, and immutable. The token’s totalSupply() is updated by a trusted operator each time a bank issues or redeems dollars. This kind of transparency gives users confidence.

That image above shows a split of the reserve backing, which is a nice illustration of how tokens can be tied to real assets. The same principle underlies many stablecoins, bridging the gap between fiat certainty and crypto fluidity.

How to stay informed

The simplest way to keep track of an ERC‑20 token’s health is the analytics data behind the scenes:

• Holder concentration – If 90% of tokens are held by one wallet, you have a risky centralization.
• Transaction count – Low activity might signal a stagnant project.
• Total value locked (TVL) – For DeFi protocols, TVL is a clear gauge of user engagement.

Multiple platforms aggregate this data: Etherscan, DefiLlama, CoinGecko, and Nansen. A quick glance at those dashboards can tell you whether a token is just a one‑week buzz or a lasting fixture.

The big takeaway: treat ERC‑20 tokens with the same disciplined lens you use for any investment

Remember our starting point: the DSLR purchase that made me question financial priorities. If you were considering buying a token, pause and ask the same questions:

1. What is the token’s role?
   Is it governance, utility, or a speculative asset?

2. How is it distributed?
   Does the supply model make sense for a long‑term ecosystem?

3. Who controls it?
   Is there an auditable process for minting or burning that prevents abuse?

4. What is the liquidity?
   Is it easy to trade without large slippage, and are there active exchanges?

5. How does the token compare to existing assets?
   Does it solve a problem you know exists, or is it just another copy?

Spend a few minutes scanning these answers with a skeptical but open mind, and you’ll reduce the risk of falling into hype. If you’re still unsure, dig deeper into the token’s economics and code.

“Take one token, read the code, understand its economics, and decide if it aligns with your risk tolerance.”