7.4 ERC-20 Tokens and How They Work

ERC-20 is a technical standard for fungible tokens on Ethereum, defined in EIP-20, ensuring interoperability so tokens can seamlessly integrate with wallets, exchanges, and dApps. Fungible means each unit is identical and interchangeable, like dollars. This standard specifies a uniform API in smart contracts, allowing developers to build without reinventing interfaces.

Core Functions of ERC-20

The ERC-20 standard mandates six core functions to ensure compatibility, plus optional ones for user-friendly display:

• totalSupply(): Returns the total number of tokens in existence.
• balanceOf(address): Queries the token balance of a specified account.
• transfer(to, value): Sends tokens to an address, emitting a Transfer event.
• approve(spender, value): Authorizes a third party (e.g. an exchange) to spend a specified amount of tokens.
• transferFrom(from, to, value): Executes transfers on behalf of an approved account.
• allowance(owner, spender): Checks the remaining tokens a spender is authorized to use.
• Optional Functions: name(), symbol(), and decimals() (e.g. 18 decimals to mimic ETH’s subunits) enhance display in wallets and dApps.

Two events log actions for transparency:

• Transfer(from, to, value): Records token movements.
• Approval(owner, spender, value): Tracks spending authorizations.

How ERC-20 Tokens Operate

Once deployed, an ERC-20 contract creates a fixed or dynamic token supply. For example, approving an exchange to spend tokens via approve allows it to execute transferFrom for trades. Key operational notes:

• Zero-Value Transfers: Valid and must emit a Transfer event, useful for signaling or dApp triggers.
• Approval Safety: Approvals overwrite prior ones; to avoid race conditions (e.g. double-spending attacks), set allowances to zero before updating.
• Gas Efficiency: Implementations vary, with optimized contracts (e.g. OpenZeppelin’s) reducing gas costs, critical as gas fees on mainnet remain high during congestion.

All implementations must adhere to the EIP-20 spec for compatibility, ensuring tokens work across Ethereum’s ecosystem, including layer-2 (L2) networks like Arbitrum and Optimism.

Benefits and Applications of ERC-20 Tokens

The ERC-20 standard, formalized in Ethereum Improvement Proposal 20 (EIP-20), is a cornerstone of Ethereum’s ecosystem, enabling fungible tokens to power a wide range of decentralized applications with unparalleled efficiency and interoperability. As of September 2025, ERC-20 tokens facilitate over $2 trillion in annual transaction volume, with layer-2 (L2) networks like Arbitrum, Optimism, and ZKSync reducing costs by up to 90% compared to mainnet, enhancing scalability and accessibility. The following advantages and applications highlight why ERC-20 tokens remain integral to Ethereum’s dominance in decentralized finance (DeFi), governance, and beyond.

Key Advantages

The ERC-20 standard’s design delivers transformative benefits that drive its widespread adoption across the blockchain ecosystem:

• Standardization: The uniform API, including mandatory functions like totalSupply() and transfer(), ensures tokens integrate seamlessly with wallets (e.g. MetaMask), exchanges (e.g. Uniswap, Curve), and dApps. This eliminates the need for custom integrations, enabling rapid deployment and adoption. For instance, listing a new ERC-20 token on Uniswap’s automated market maker (AMM) requires minimal setup, as the protocol recognizes the standard’s interface.
• Liquidity in DeFi: ERC-20 tokens are the lifeblood of DeFi, powering liquidity pools, lending platforms, and yield farming. Protocols like Aave and Compound rely on tokens like USDC and DAI to facilitate billions in lending and borrowing, with over $150 billion in total value locked (TVL) across DeFi as of Q3 2025. The standard’s interoperability ensures tokens flow freely between protocols, enhancing market efficiency and user access.
• Programmability: ERC-20 tokens are highly flexible, enabling diverse functionalities beyond simple transfers. They support complex logic for governance (e.g. voting in DAOs), staking rewards, or stablecoin pegging mechanisms. Developers can embed custom rules in smart contracts, making ERC-20s adaptable to innovative use cases like tokenized real-world assets (RWAs) or in-game currencies.
• Scalability via Layer-2: Recent upgrades like Pectra (May 2025) and the upcoming Fusaka (December 2025) have bolstered L2 efficiency, with blob capacity increases (from 6/12 to potentially 48/72 blobs per block) slashing transaction costs. This makes ERC-20 tokens more viable for high-frequency, low-value transactions, such as micro-payments in dApps, without compromising Ethereum’s security.

(Note: See lesson 4.2 Token Standards: ERC-20, BEP-20, and Others)

Common Applications

ERC-20 tokens underpin a variety of real-world use cases, each leveraging their fungibility and programmability:

• Utility Tokens: These grant access to dApp services or ecosystems. For example, Chainlink’s LINK token is used to pay for decentralized oracle services, enabling smart contracts to fetch real-world data, with over $10 billion in value secured by LINK in 2025.
• Stablecoins: Pegged to assets like the US dollar, stablecoins like USDC and DAI maintain stable value, making them ideal for payments, remittances, and DeFi. USDC alone circulates over $50 billion in tokens, used in cross-border transfers and as collateral in lending protocols.
• Governance Tokens: Tokens like Uniswap’s UNI or Aave’s AAVE empower users to vote on protocol upgrades or fee structures in decentralized autonomous organizations (DAOs). UNI holders, for instance, govern Uniswap’s $1.5 billion liquidity pool, shaping its evolution.
• Tokenized Assets: Emerging use cases include tokenizing real-world assets, such as real estate or commodities, with ERC-20 tokens representing fractional ownership. Platforms like Centrifuge have tokenized over $500 million in RWAs by Q3 2025, enabling new investment opportunities.

Conclusion

ERC-20 tokens are a linchpin of Ethereum’s ecosystem, driving innovation through standardization, liquidity, and programmability. As of September 2025, they underpin over $2 trillion in transactions annually, from stablecoins like USDC to governance tokens like UNI, with L2 networks amplifying their scalability. For beginners, exploring ERC-20 tokens via testnets like Sepolia with tools like Remix IDE offers a risk-free way to grasp their mechanics, while their real-world impact—empowering DeFi, governance, and asset tokenization—continues to redefine decentralized systems.