Ultimate DeFi Glossary
|— DeFi has ushered in a new set of terms which may sound similar to the traditional financial world, but, in DeFi, they are different. |
— For beginners, understanding the whole lexicon of unfamiliar words can be quite challenging – so, we have broken them into easy-to-understand language
— If slippage, DEX, dApps and collateral sound confusing, read on. This DeFi glossary will help you understand them, and get involved.
DeFi is changing hte norms of what we expect from finacnce, and it’s worth knowing. Here, we give you a DeFi glossary, to help you get started.
Decentralized Finance (DeFi) has erupted into a hundred billion dollar industry, sparking a wave of global disruption. Part of the reason for its enormous growth is the idea of decentralizing the financial world, which, as of now, is largely controlled by intermediaries. DeFi intends to change this through community participation that will eventually leave users in control of their finances instead of relying on an intermediary.
DeFi offers a world of new opportunities for users, yet it is filled with new terms and jargon that may sound confusing, as well as prohibitive for anyone stepping into it. So, we have prepared this DeFi glossary to help you grasp the industry, and take your first steps into the new possibilities it offers.
Here we go….
DEX (Decentralized Exchange)
In order to start with DeFi, you require a decentralized exchange (DEX). It is a trading platform for buying or selling cryptocurrencies that run independently of any central authority. For example, UniSwap is a popular DEX that performs trading using an algorithm. But, if no one operates it, who is responsible for setting the price of a cryptocurrency? UniSwap does that by utilizing an AMM system. You can learn more about DEX in our academy article.
AMM (Automated Market Maker)
An AMM – also known as a protocol DAO – is a type of decentralized exchange that relies on liquidity controlled by an algorithm, instead of using an order matching system. What exactly does that mean?
A centralized exchange (CEX) oversees the operations of traders centrally and matches the buying/selling orders using a central order book. For example, when you decide to buy 1 BTC at $60,000, the CEX ensures that it finds a trader willing to sell 1 BTC at your preferred exchange rate.
By contrast, AMMs use smart contracts to create their own liquidity pools in order to facilitate trades – the idea behind this is to ensure there is always readily available liquidity, and minimise “slippage”, something we discuss below.
OK, so AMM’s use liquidity pools – but where does the liquidity actually come from? Anyone can provide liquidity to an AMM protocol, as long as they can provide the token pairs set by the smart contract; they are called Liquidity Providers (LPs). These LPs create a market by adding an equal value of two tokens in a pool, and thus, liquidity pools. But, what do LPs get in return?
Each LP is incentivized through LP tokens. For example, when LPs deposit funds to a pool on UniSwap, they get UniSwap’s LP tokens for that particular pool. The rewards vary from protocol to protocol. They can either be native tokens or governance tokens. Later on, you need these tokens to redeem your assets. But, until that time, you can use LP tokens to yield farm or mine liquidity. Learn more about Liquidity Pools.
Liquidity mining is an investment strategy where LPs switch their LP tokens between different liquidity pools to earn the highest interest rate possible. It is done by leveraging a position by taking a loan on lending platforms like Compound. The platform allows you to stake your LP tokens to earn extra incentives in different liquidity pools. This ability to interconnect separate decentralized finance components is the reason DeFi is a composable system.
Composability in DeFi is sometimes expressed as “DeFi money legos”; it refers to the fact that DeFi allows users to “own” their interactions and build on them with further interactions. Let’s understand that in the context of Liquidity mining. If you are a liquidity provider, you’ll get LP tokens, which you can use for earning extra incentives. For example, Compound provides cTokens for providing liquidity to its pools. You can then use your cTokens (LP tokens) on other liquidity pools on Compound to get extra rewards on the same investment.
Let’s refresh on AMMs to understand “impermanent loss”.
In an automated market maker, the value of your tokens is constantly adjusting in order to keep the value of token pairs in synch and to keep an equilibrium between the two tokens in the pair. What does this mean for the liquidity provider (you)?
If you remove your liquidity at a time when the pool is adjusting to a significant price change in the market, you might find that – in that particular moment – your withdrawn tokens are worth less than if you had just HODLed. This is known as “impermanent loss”. It’s known as impermanent because the loss is only realised by the LP if they choose to withdraw their funds at that point, and normally corrects over time.
In the financial world, the term “slippage” means the price difference between when you submit a transaction and when that particular transaction is confirmed. It is quite common in the crypto market, especially in the DeFi space because each transaction on a blockchain network doesn’t happen instantly. There is a lag when you submit the transaction and when the blockchain network confirms the transaction. It can either be positive or negative, which means the price of an asset can increase or decrease from the moment you made an order to the moment the order is actually executed. This is one area where new developments that enable more efficient swapping – such as liquidity pools and aggregators – can significantly improve the user experience.
TVL (total value locked)
Total Value Locked, or TVL, in the DeFi context, is the sum of all digital assets locked in different decentralized finance protocols. For example, if you deposit $5000 in ETH on Yearn Finance, the sum you deposited will be a part of the DeFi TVL. The metric is important to gauge the value of the whole DeFi ecosystem, as well as the stability of a given project. Currently, the TVL of the DeFi market is equivalent to ~ $111.2 billion.
DAO (decentralized, autonomous organization)
Short for Decentralized Autonomous Organizations, DAOs are organizations that are operated via rules encoded as a transparent computer program on a blockchain network. UniSwap is an ideal example of a DAO that is operated by its community members.
But, not everyone wants to create an organization. Some just want to create a decentralized app (dApp).
dApp (decentralized application)
Similar to DAO, decentralized applications (dApps) are software programs that perform specific tasks and aren’t in control of a particular individual. But, what kind of task does it do? Can it give us high APY?
A lending protocol requires the borrowers to deposit collateral before taking out a loan. It is essentially digital assets that are further locked until the borrowed amount is paid in full. For example, you want to borrow Ethereum from the Compound protocol. In order to take a loan, you need to supply another type of crypto (say USDT) as collateral, which will stay locked on Compound until you have repaid the amount.
But, with the emergence of different lending protocols, how do you ensure you get the best deals in terms of APY? This is where Aggregators come in!
Not all loans in the DeFi industry require collateral. You can take out flash loans without depositing digital assets or going through KYC checks. However, they require you to repay the loan within a very short time period or the transaction expires like a flashlight. These kinds of loans are widely used in arbitrage trading.
Aggregators are DeFi protocols that look for the best APY through multiple platforms and automatically invest your cryptocurrencies on the highest-yielding protocol. The 1inch platform is a great example you can check out.
Much like Trivago that scans different websites to get you the best hotel deals, Aggregators are DeFi protocols that scan different platforms to give you the best APY on your investments. For example, Yearn Finance. It is an aggregator that looks through multiple DeFi lending platforms and even switches your funds automatically to get you the best rates possible.
In the DeFi space, cryptocurrencies have different prices on different DEXs – and with AMMs operating their own internal market with its own values, these two frequently differ from external market pricing. This price discrepancy opens up a small window of opportunity for traders to make a quick profit – it is called arbitrage trading.
Ready, set, DeFi!
Now you have your trustty DeFi glossary, you’re all set to start benefiting from this incredible industry. Did we miss anything?
Where traditional finance was exclusionary, dominated by a central few, and offered poor rewards for its users, decentralized finance has opened up a whole new financial world of opportunities that allow more people than ever to participate, and to do so fairly.
Yes, DeFi looks confusing if you are not familiar with the space. However, if you take the time to learn a few key terms, you’ll be able to navigate the ecosystem with confidence and access the benefits of the new services it offers. Here, we’ve given you what you need to start your DeFi journey – go forth and enjoy the ride!
Knowledge is power.
Trust yourseld and keep on learning. If you’re getting to grips with the unbelievable world of DeFi – trust us, we have you covered. Check out our School of Block episode for a deeper introduction to the financial revolution.