It’s no secret that understanding the traditional world of finance is challenging. Unfortunately, understanding decentralized finance (DeFi) is even more difficult.
Decentralized finance is a growing collection of financial tools built on top of blockchain – a digital ledger that lives across 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 research on DeFi’s unprecedented financial growth and unimaginable annual percentage returns. Similarly, 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 cautiously, DeFi can serve as a viable and legitimate financial investment option.
Regardless of your feelings about cryptocurrency, one thing is certain: it’s gaining quite a foothold. As of May 2022, there were more than $74 billion in crypto assets locked up in DeFi. And as DeFi continues to gain wider adoption, there is a lot of education needed on basic terminology, leading 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 run smart contracts. Ethereum is the primary blockchain of 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, removing the need for any centralized third party.
A smart contract is a blockchain-native computer program that automatically executes when predetermined requirements are met. Smart contracts are the lifeblood of all DeFi applications and protocols.
Ether (ETH) is the parent currency (or “token”) of Ethereum and is used to pay transaction fees in 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 the blockchain. Wallets hold currency and user data and are interoperable across 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 such as Bitcoin and Solana.
Metamask is the most popular Ethereum wallet and is compatible with all major dApps.
A cryptographic string of numbers that gives users access to their funds and data. Private keys are used to sign and verify blockchain transactions.
Never, ever give this 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 cryptocurrencies or other tokens into their wallets. In the same way that someone sends an email to your email address, people send cryptocurrency to your wallet address.
Individuals must pay a transaction fee (gas fee) for each function performed on the blockchain network. Gas fees (paid in the blockchain’s native currency) are used to compensate miners in exchange for the computing power they use to verify a 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 assets. Centralized exchanges like Coinbase (COIN) continue to facilitate the majority of overall cryptocurrency volume, in part due to their seamless experience and ease of use.
Centralized exchanges are custodial, meaning they hold the users’ private keys. This allows users to log in with a master password, rather than 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 centralized third party or custodian. Instead, all trades 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 do away with the traditional order book, and thanks to automated market makers, you no longer need a buyer and seller to trade.
Automated Market Maker (AMM)
Automated market makers are the underlying protocols that define the price of assets on a decentralized exchange. The backbone of decentralized exchanges, AMMs allow users to trade against liquidity locked in smart contracts called liquidity pools. They also allow anyone to act as a Liquidity Provider (LP) as long as they meet pre-determined smart contract conditions. All you need is enough liquidity in the liquidity pool and the AMM smart contract to create the market for you.
Uniswap is the most popular automated market maker, with more than $42 billion in trading volume in April 2022 alone.
A liquidity pool is a dual-asset market created when liquidity providers lock an equal amount of two tokens into a smart contract. From there, buyers and sellers can directly trade against this liquidity without waiting for the order to match.
Liquidity Providers (LP)
Liquidity providers provide critical funds for the liquid pools that power the DEX. To be an LP in a dual asset liquidity pool, you must submit an 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 up 1 Bitcoin and 10 ETH.
In exchange for locking up assets in a liquidity pool, LPs earn a small percentage of each transaction. The total commission is proportional to the contribution of the liquidity provider in relation to the entire liquidity fund. In addition, liquidity providers also receive LP tokens – a special token that represents one’s ownership stake relative to the entire pool. These tokens are fungible and transferable in themselves, and can be invested within the DeFi ecosystem to earn additional returns.
Providing liquidity (or liquidity mining) is a great way to earn passive income from your tokens, although LPs must always be aware of the volatile loss.
A volatile loss is when the value of holding a cryptocurrency in your wallet is greater than the value of a dual-asset liquidity provider. Depending on how the price of an asset develops over time, you may be better off holding that asset outright rather than using it to provide liquidity to a liquidity pool. While a volatile loss is possible with any dual-asset liquidity pool, it is most likely when it is a highly volatile asset.
Slippage is the difference between the strike price and the initial trade price. This is particularly relevant for DeFi, where asset price volatility and trading fund liquidity are quite common. When trading on decentralized exchanges, always be aware of slippage and try to avoid market orders wherever possible.
Decentralized lending is an alternative to traditional lending that uses smart contracts and blockchain technology to automate the lending process. On platforms like Compound and Aave, users can borrow and lend cryptocurrencies 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 from your cryptocurrency.
Staking is the process of locking a cryptocurrency to ensure and maintain the integrity of the blockchain through proof-of-stake consensus. In return, actors are rewarded with a portion of the block reward generated by the network. “Yield farmers” are able to earn passive income by investing their coins or LP tokens in liquidity protocols such as Aave and Curve. NFTs can also be invested to earn DeFi returns.
Yield farming is the process of using different DeFi platforms and protocols to achieve the best yields. This involves continuously borrowing, borrowing, investing cryptocurrency to earn interest, and then reinvesting that interest into new funds to earn even more interest. Yield farming is a very risky, a very high reward the game.
Stablecoins are cryptocurrencies that are pegged to the value of government-backed currencies, such as the US dollar. Although 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 cash reserves in US dollars, other stablecoins are backed by algorithms or other cryptocurrencies.
Compared to Bitcoin and Ethereum, fiat-backed stablecoins like USDC and Tether are a less risky way to explore the benefits of DeFi. To date, stablecoins have mainly held strong. But with the recent collapse of Terra, many wonder if they will be able to sustain themselves over time.
By now you should have a good understanding of the basics of DeFi. But I want to take a moment to reiterate an important note: these topics are very complex, with many suggesting high levels of risk. Always do your own research before making any investment and don’t get caught up in FOMO.
We plan to update this dictionary regularly as the world of DeFi evolves rapidly.