Decentralized Finance, or commonly known as DeFi, is one of the fastest growing sectors in blockchain. According to DeFi Pulse, as of March 3rd, 2021, DeFi has more than 40 billion USD locked in the system, and this number has tripled since December 2020.
During the DeFi craze, many investors have put their capitals in DeFi projects even though they are not really knowledgeable about them. Warren Buffett once said that he only invests in companies he understands well. If you are not knowledgeable about the DeFi projects you fund, you will not be able to assess their future potentials and the risks you may face.
Therefore, to make it easier for you to learn about this field, we will provide you with basic DeFi terms in this article. First, shall we find out what DeFi is?
DeFi stands for Decentralized Finance. To put it simply, the decentralized financial system will not be managed by any individual or organization. This is in contrast to the centralized financial system with banks and other financial institutions, which is subject to the control of one party.
DeFi includes financial applications built on blockchains like Ethereum, EOS, Tron, or Binance Smart Chain, etc. These apps allow you to save, borrow, or invest without a high minimum investment and cumbersome approval process. Thus, people with different levels of incomes can access a variety of financial services more easily.
To get a better grasp of DeFi as well as the benefits and risks that come with it, you need to take a deep dive into the jargon. Below are some basic concepts in DeFi listed in alphabetical order.
AMM or Automated Market Making model is a protocol in the DeFi ecosystem that automatically calculates asset value based on algorithms instead of a conventional order book. AMM allows tokens to be traded automatically using a liquidity pool via smart contracts. For example, if you want to buy 1 ETH with USDT, the smart contract will send your request to the liquidity pool and calculate the amount of USDT required for this transaction.
APR is the annual interest rate on a loan or savings account, excluding compounding.
Example: If a savings account has a quarter interest rate of 5%, then the 12-month interest rate of that savings is: 5% x 4 = 20%
APY is the actual annual rate of return, including compounding.
Example: If the quarter interest rate of a savings account is 5% and the interest rate is compounded, then the APY that savings is: (1 + 0.05) ^ 4 – 1 = 0.2155 = 21.55%
Collateral is pledged assets when you want to take out a loan. In DeFi, the collateral must be different from the assets you borrow. For example, you mortgage ETH to borrow DAI. This mechanism is similar to pledging real estate to borrow money. To avoid a liquidity shortfall, you must mortgage assets that are worth more than the loan with the ratio ranging from 125% – 150%. For example, you need to mortgage $100 ETH to borrow $70 DAI (~143%).
DAO is a decentralized autonomous organization, which means that it does not need human management in its operation. All operational processes are encrypted in the form of smart contracts. DAO is essentially an open computer program that anyone can view and use. All decisions on the development of the DAO must be voted on to reach consensus, so even if there is a coding error, it must wait for the majority opinion to fix.
Dapps are decentralized applications. Quite similar to DAO, dapps do not need human intervention and can run smoothly on their own. Currently, Ethereum is the blockchain platform with the highest number of dapps. Nevertheless, due to network congestion and other problems arising therefrom, many development teams have chosen other platforms such as EOS, Tron, or Binance Smart Chain, etc. Dapps are usually divided into 7 main groups including: exchanges, wallets, games, finance, betting applications, social networks, and others.
DEX is a decentralized exchange, and CEX is a centralized exchange. DEX is operated by algorithms and smart contracts, while CEX requires human management. As a trader, you can buy digital assets on both exchanges, but the liquidity on DEX is much lower than on CEX. Therefore, you should pay attention to this issue when deciding to invest a significant amount of capital in a DEX like Uniswap or Kyber. Coinbase and Binance are the two most popular CEX’s today.
ERC-20 is the technological foundation that tokens in the Ethereum ecosystem must meet. Wallet addresses of ERC-20 tokens always start with “0x”. This will help you somewhat reduce the risk of copying the wrong wallet address when circulating tokens in the Ethereum system.
Flash loans are unsecured and instant loans commonly used in the Ethereum ecosystem that allow users to borrow money without collateral. However, the loans need to be repaid before that block completes the transaction; otherwise, interest fees will be incurred. Users often use flash loans to take advantage of the exchange rate difference when converting the borrowed token to another token in the same ecosystem.
Similar to flash loans, flash swaps allow users to withdraw some or all of the tokens in their wallet to perform a swap between tokens to achieve the exchange rate difference without any fees before the transaction is completed. When the transaction ends, you must pay the withdrawal fee or refund the tokens you have advanced.
Gas fees are fees that miners on the Ethereum platform receive for executing a transaction. Gas fees are calculated in proportion to the resources and energy required for a successful transaction. The more transactions, the higher the gas fees. If your transaction value is too small, high gas fee will be a significant barrier for you.
Hodl is a slang commonly used by crypto enthusiasts and an intentional misspelling for “Hold”. Hodl means holding assets for a long time, or “Hold On for Dear Life”. Hodler is a term used to refer to investors who buy cryptocurrencies for long-term storage.
Liquidity Pools are smart contracts with tokens available for lending or trading. A liquidity pool is seen as a small exchange for two tokens in which there is no need for both sellers and buyers for a transaction to proceed. For example, if you want to buy ETH in the ETH/USDT pool, the system will automatically calculate the corresponding amount of USDT. When the transaction is complete, you will receive ETH in your wallet, and USDT will be transferred to the pool.
Liquidity Provider is the person who provides liquidity to a liquidity pool. For financial transactions to be carried out, the system needs to have a certain amount of money available in the liquidity pool. The liquidity provider receives interests (coming from the borrowers) or user transaction fees when users exchange between tokens.
An impermanent loss occurs when the price of your current asset in the liquidity pool changes compared to the price when you provided liquidity to the system. The bigger the change in price, the more severe the impermanent loss. This is called “impermanent” because the loss only becomes real and “permanent” when you withdraw your tokens from the liquidity pools. However, you can partly compensate for such losses by receiving transaction fees (as a percentage of your asset value to the total value of the pool) when providing liquidity.
Liquidity Mining is a form of Yield Farming, which involves putting your assets into a pool to lend or provide liquidity. This way, you can receive money in the form of tokens that you own or another type of tokens. This service allows users to earn passive income and hold assets while waiting for an increase in price. Also, there is no time limit on leaving money in the pool, which means you can withdraw your money any time you want.
Non-fungible tokens (NFTs) are digital assets that have the unique characteristics of a thing or event. Because of this, no two NFTs can ever be exactly the same. NFTs are non-fungible and not exchangeable like Bitcoin or other standard tokens. They are often used in games to represent a character or an object with specific properties and uses.
The term “pump and dump” describes a rapid rise in the price of an asset, but then massive selling pressure occurs, causing the price to drop suddenly. This phenomenon usually happens for new tokens that are listed on exchanges. If you buy these assets when the price is too high and you have not taken profits yet, you will have to accept a loss when the price drops.
Slippage means the difference in the expected price and the actual price when you swap tokens. Slippage occurs when the price movement is too fast, so the system automatically matches lower or higher values to complete your trade.
Smart contracts are computer programs designed to operate on their own without any human intervention. In the cryptocurrency market, smart contracts first appeared on the Ethereum platform. Because it is programmed to run automatically, the transactions executed by the smart contract are transparent and cost-effective by eliminating the middlemen. In addition, the transactions on smart contracts are trackable and irreversible so users’ transactions are secure.
Stablecoins are cryptocurrencies whose value is pegged to a particular currency or underlying asset. They facilitate users to convert value between different assets with minimal price fluctuations. There are 3 main types of stablecoins as follows:
- Stablecoins that are backed by a currency in a 1:1 ratio. For example, 1 USDT is worth 1 USD. The amount of USDT issued will depend on the total USD value held by the issuer.
- Stablecoins that are backed by cryptocurrencies. Here, cryptocurrencies will be used as collateral to generate stablecoins automatically through smart contracts. The collateral rate will always be greater than 100% to ensure liquidity for that stablecoin. For example, users will lock their ETH on the system to generate DAI. If the collateral is 150%, then with 1 ETH locked, the system can generate 66 DAI.
- Algorithmic Stablecoin uses algorithms to balance the supply in the market. For example, ESD is generated at the value of 1 USD. When the price of ESD is less than 1 USD, the system will automatically buy back a certain amount of tokens to push the price to 1 USD. Conversely, when the ESD price is greater than 1 USD, the system will issue more ESD. This algorithm will ensure that the value of ESD is always around 1 USD.
Token is an asset on the Blockchain system. Each token will usually have its own application and is often built on top of another coin’s blockchain like Ethereum, EOS, NEO, etc. For example, BNB was created to reduce transaction fees for users when buying and selling on the Binance exchange, and it was originally built on the Ethereum platform. The development team will have to pay fees in platform coins (e.g., ETH) to generate their tokens as well as convert tokens back and forth on that blockchain.
Token Burn is the process of permanently reducing the total supply of a token. If the supply decreases while the demand stays the same or increases, the token price will increase.
Tokenomics is a term used to describe the principal functions and uses of a new token. It is like a stock prospectus that outlines a company’s business, financial condition, and future growth plans. Tokenomics will typically include the total supply number, distribution, specific applications, and growth potential of a token. Therefore, you should take the time to read tokenomics before making an investment decision.
TVL stands for Total Value Locked, which means the total value of assets locked in a decentralized exchange, decentralized application, or the entire DeFi system. It is also known as TLV (Total Locked Value). As aforementioned, currently, the TVL of the DeFi market is about 40 billion dollars according to DeFi Pulse.
As DeFi grows, the terms used in this field will definitely develop as well. For now, these terms are the very basic information that you must know if you want to invest in any DeFi project.