The DeFi Dictionary: Your Guide to Decentralized Finance
It’s no secret that the world of traditional finance is difficult to understand. Unfortunately, making sense of decentralized finance (DeFi) is even harder.
Decentralized finance is a growing collection of financial tools built on top of the blockchain – a digital ledger that lives on a collection of distributed servers. These platforms and protocols allow users to trade cryptocurrencies, borrow and lend money, and earn interest, all without a centralized bank or third-party intermediary.
A quick Google search will return searches for DeFi’s unprecedented financial rise and unthinkable annual return percentages. Likewise, you will find even more about hacks, scams and illegitimacy within its ecosystem. Still a largely unregulated gray area, decentralized finance is a mixed bag. That being said, when approached responsibly and prudently, DeFi can serve as a viable and legitimate financial investment option.
Whatever your feelings about cryptocurrency, one thing is certain: it is gaining momentum. As of May 2022, there were over $74 billion in crypto assets locked in DeFi. And as DeFi continues to grow in popularity, there’s a lot of training to be done around basic terminology, major protocols, and best practices.
That’s why we’ve created the DeFi Dictionary, a living resource you can refer to as you familiarize yourself with this new frontier of finance. After reading this document cover to cover, you will have a high-level overview of the main pillars of decentralized finance.
Ethereum is a decentralized blockchain network, widely used for its ability to execute smart contracts. Ethereum is the main blockchain in the DeFi ecosystem.
Decentralized application (dApp)
A decentralized application is a website or application that runs on top of the blockchain. dApps are powered entirely by smart contracts, eliminating the need for any centralized third party.
A smart contract is a native blockchain computer program that runs automatically once predetermined requirements are met. Smart contracts are the cornerstone of all DeFi applications and protocols.
Ether (ETH) is the native currency (or “token”) of Ethereum and is used to pay transaction fees on all Ethereum native decentralized applications. To participate in decentralized finance, you will need two things: ETH and an Ethereum wallet.
A wallet is a software application or physical device that allows users to interact with a blockchain. The wallets contain currency and user data and are interoperable with all decentralized applications. Each wallet comes with its own private and public keys. Although we are using Ethereum for this example, there are also wallets for other blockchains like Bitcoin and Solana.
Metamask is the most popular Ethereum wallet and is compatible with all major dApps.
A string of cryptographic numbers that allows users to access their funds and data. Private keys are used to sign and verify blockchain transactions.
Never give it to anyone, because it’s the fastest way to get your cryptocurrency stolen. You would never give out your bank account password, so don’t give out your private key.
A public key, or “wallet address”, is a string of letters and numbers that allows users to receive cryptocurrency or other tokens on their wallet. The same way someone sends an email to your email address, people send cryptocurrency to your wallet address.
Individuals must pay transaction fees (gas fees) for each function performed on a blockchain network. Gas fees (which are paid in a blockchain’s native currency) are used to compensate miners in exchange for the computing power they use to verify the transaction.
For example, all Ethereum gas fees are paid in ETH.
A centralized exchange is a regulated, for-profit entity that protects (and sometimes insures) users’ crypto funds. Centralized exchanges such as Coinbase (COIN) still facilitate the majority of total cryptocurrency volume, in part due to their smooth onboarding experiences and ease of use.
Centralized exchanges are custodians, meaning they hold users’ private keys. This allows users to log in with a basic password, instead of having to keep track of their private keys.
Decentralized exchange (DEX)
A decentralized exchange (DEX) is a peer-to-peer digital cryptocurrency exchange that operates without the approval of a third party or a centralized custodian. Instead, all exchanges and transactions are facilitated by self-executing smart contracts on the blockchain. All transactions are atomic, meaning coin A is sent at the same time coin B is received.
DEXs remove the traditional order book, and with automated market makers, you no longer need a buyer and a seller to trade.
Automated Market Maker (AMM)
Automated market makers are underlying protocols that set the price of assets on a decentralized exchange. The backbone of decentralized exchanges, AMMs allow users to trade against cash locked up in smart contracts called liquidity pools. They also allow anyone to act as a liquidity provider (LP) as long as they meet the pre-determined terms of the smart contract. All you need is sufficient liquidity in the liquidity pool and an AMM smart contract to create the market for you.
Uniswap is the most popular automated market maker, with over $42 billion in trading volume in April 2022 alone.
A liquidity pool is a two-asset market that is created when liquidity providers lock an equal amount of two tokens into a smart contract. From there, buyers and sellers can trade directly against that liquidity without waiting for an order to match.
Liquidity Providers (LP)
Liquidity providers provide essential funding to the liquidity pools that feed the DEX. To be an LP of a dual asset liquidity pool, you must provide equal value of both assets.
Let’s say you enter a Bitcoin/ETH trading pool and Bitcoin is at $20,000 and ETH is at $2,000. To be an LP in this pool, you need to lock 1 Bitcoin and 10 ETH.
In exchange for locking assets in a liquidity pool, LPs earn a small percentage of each trade. The total commission is proportional to a liquidity provider’s contribution to the entire liquidity pool. Additionally, liquidity providers also receive LP tokens – a separate token representing its stake against the entire pool. These tokens are tradable and transferable in their own right, and can be staked within the DeFi ecosystem to earn additional yield.
Providing liquidity (or liquidity mining) is a great way to earn passive income on your tokens, although LPs should always be aware of impermanent losses.
Impermanent loss occurs when the value of holding a cryptocurrency in your portfolio is greater than that of being a dual-asset liquidity provider. Depending on how an asset’s price changes over time, it may be better to hold the asset instead of using it to provide liquidity to a liquidity pool. While an impermanent loss is possible with any two-asset liquidity pool, it is more likely when dealing with highly volatile assets.
Slippage is the difference between the executed price and the initial trade price. This is particularly relevant in DeFi, where asset price volatility and trading pool liquidity are quite common. When trading on decentralized exchanges, always watch out for slippages and try to avoid market orders whenever possible.
Decentralized lending is an alternative to traditional lending that uses smart contracts and blockchain technology to automate the credit granting process. On platforms such as Compound and Aave, users can borrow and lend cryptocurrency anonymously without the need for third-party credit approval.
Smart contracts record all loan transactions and automate the collection of interest on all loans. Decentralized lending is another great way to earn passive income on your crypto.
Staking is the process of locking cryptocurrency to help secure and maintain the integrity of the blockchain through proof-of-stake consensus. In return, bettors are rewarded with a portion of the block reward generated by the network. “Yield farmers” can earn passive income by staking their coins or LP tokens in liquidity protocols such as Aave and Curve. NFTs can also be staked to earn DeFi yield.
Yield farming is the process of using various DeFi platforms and protocols to seek the best yields. It involves lending, borrowing, continuously staking cryptocurrency to earn interest, and then reinvesting that interest into new pools to earn even more interest. Yield farming is a very high risk, very high reward Game.
Stablecoins are cryptocurrencies pegged to the value of government-backed currencies, such as the US dollar. While most crypto assets are highly volatile, stablecoins are used to hedge against these fluctuations. While the most popular stablecoins, such as USDC, are backed by US dollar liquidity reserves, other stablecoins are backed by algorithms or other cryptocurrencies.
Compared to Bitcoin and Ethereum, fiat-backed stablecoins like USDC and Tether are a lower-risk way to explore the benefits of DeFi. To date, stablecoins have most strong hold. But with Terra’s recent crash, many are wondering if they’ll be able to hold their own over time.
By now you should have a good understanding of DeFi basics. But I want to take a moment to reiterate an important point: these topics are very complex, many of which offer high levels of risk. Always do your own research before approaching any investment and don’t get caught up in FOMO.
We plan to update this dictionary regularly as the world of DeFi rapidly evolves.