To understand DeFi, it is significant to know DeFi terms.
Decentralized Finance or DeFi. Though the term was coined in 2018, Bitcoin and Ethereum blockchain paved the way for DeFi much earlier and made DeFi possible.
Some of you may not be a firm believer in crypto. However, it is significant to know about DeFi as this could be the future of finance.
Before going into the DeFi world, it is indispensable to understand DeFi jargon.
If you are new to DeFi, you would definitely be scratching your head over the DeFi terms. Worry not. Here we have decoded DeFi components and/ or DeFi terms.
Decentralized finance (DeFi) is a revolutionary financial technology that allows its users to access financial instruments directly on the blockchain and eliminates the need for any centralized middle man such as banks and institutions.
As DeFi is operated by open-source code, users can access its services 24/7. In DeFi, users can lend, borrow, earn interest, buy insurance, and more.
You don’t need any KYC process or set of procedures to access DeFi services. You only need an Internet connection and some digital assets to lend or borrow.
In the DeFi ecosystem, users have full control over their money and transparency.
DeFi terms one should know
- Governance Token
- Liquidity Pool
- Pump and dump
- Smart contract
- TVL/ TLV
- Yield farming (aka liquidity mining)
Automated market makers (AMMs) are smart contracts or sets of protocols that power all decentralized exchanges (DEXs). AMM makes trades automatic 24/7—by using a liquidity pool rather than the traditional buyer and seller concept.
AMM is a part of the DeFi ecosystem that enables permissionless and automatic trading of digital assets.
Annual percentage rate (APR) is a traditional financial term that refers to the yearly rate of interest that a borrower has to pay—for his loan/ credit card.
If an individual borrows a cryptocurrency or tokens in any DeFi platform, he has to pay APR to the asset lender.
Annual percentage yield (APY) is also a traditional financial term that refers to the yearly rate of interest that a lender will get—such as interests from a savings account/ money market account.
If an individual lends her/ his cryptocurrency or tokens in any DeFi platform, he will earn APY.
A blockchain is a kind of database that stores information in a chain of blocks. The basic mechanism of blockchains is decentralization and cryptographic hashing.
- Decentralization is achieved through the distribution of blocks across multiple connected systems known as nodes. That’s why blockchains are sometimes known as distributed ledger technology (DLT).
- Blockchain stores all information in the form of encryptions with cryptographic hashing.
Since blockchains are distributed, it is impossible to make changes. Hence, it is highly secure and transparent.
Without blockchain, there would be no decentralization and cryptocurrency. Without cryptocurrency and tokens, there would be no DeFi.
Examples of blockchains include Ethereum, Solana, and Cardano.
Collateral is another traditional financial term that refers to pledging. Like, putting your land up as collateral for a loan, you need to put any cryptocurrency or tokens as collateral to borrow a different cryptocurrency or tokens.
DeFi loans typically require a higher percentage of cryptocurrency or tokens as collateral.
For example, 100 USDC as collateral for 70 DAI.
A decentralized autonomous organization (DAO) is a fully autonomous entity that has no central leadership. It purely operates using smart contracts. The smart contracts set the rules for the DAO.
Changes in this organization’s operations are made by the voting of a group of people who own certain governance tokens.
As it runs on the blockchain, just like DeFi, it is immutable and transparent.
Decentralized applications (dApps) are like normal computer applications but run on the blockchain. Just like DAO, dApps run by themselves with no intermediaries/ centralized control.
Users of dApps are directly engaging with another user instead of relying on a central authority.
Ethereum blockchain is the home for most of the dApps. However, other blockchains such as Tron and EOS also support dApps.
A few examples of dApps include CryptoKitties, Uniswap, and SushiSwap.
DEX stands for decentralized exchanges. DEXs are autonomous exchanges that are totally run by algorithms and smart contracts. Like, centralized exchanges (CEXs) anyone can buy and sell cryptocurrencies and tokens in DEX.
The price of assets in DEXs totally depends on pricing algorithms rather than the traditional order book.
A few examples of DEX include Uniswap, SushiSwap, PancakeSwap, and 1inch.exchange.
DEX vs CEX
Unlike centralized exchanges (CEXs), DEXs are not owned and operated by a centralized authority. DEXs are non-custodial, meaning, all your private keys are stored in your wallet; hence more secure than CEX.
A few examples of CEX include Coinbase and Binance.
Ethereum is an open-source blockchain with smart contract functionality. It has its own cryptocurrency Ether (ETH). It is home to digital money, global payments, NFTs, and dApps.
10. Governance Token
In a particular project, a person with a governance token can shape the future of that project by participating in the voting.
A few examples of governance tokens include Maker (MKR), AAVE, and UNI.
11. Liquidity Pool
Liquidity pool is one of the core technology in the De-Fi ecosystem. It is a collection of funds deposited by liquidity providers into a smart contract to create a market. In exchange for depositing their assets, liquidity providers earn trading fees when transactions happen in their liquidity pool.
Anyone can be a liquidity provider by adding a pair of equivalent tokens in a specific pool.
Non-fungible tokens (NFTs) are non-interchangeable tokens that are used to represent the owner of unique items.
NFTs are digital files minted on the blockchain. NFTs can be an audio file, video file, domain name, or virtual land. In DeFi, you can use NFTs as collateral to borrow other tokens.
Most NFTs are part of the Ethereum blockchain, followed by Solana.
As the name suggests, it allows users to retain full custody of their assets including private keys.
Examples include Metamask, Phantom wallet, and Solflare wallet.
14. Pump and dump
Pump and dump is an illegal act of inflating the price of any cryptocurrency or token through false or misleading information and selling it immediately after reaching a higher price. This happens during the new token listings.
15. Smart contract
Smart contracts are pieces of code that automate certain tasks if certain conditions arise. The smart contract is the basic foundation of decentralization, without them, DeFi couldn’t exist.
In contrast to traditional contracts, a smart contract cannot be altered once it is written and launched.
16. Stable coins
Stable coins are cryptocurrencies that are pegged to a reserve asset like the U.S. dollar or gold to tackle the volatility. Since it inherits the stability of fiat currency and the decentralization of digital currency, the demand for stable coins is high.
Hence, you can lend stable coins and earn interest.
DAI, USD coin (USDC), Tether (USDT) are some popular stable coins.
Staking is a process of depositing cryptocurrency to receive rewards. An individual with cryptocurrency needs to be there in the DEX to support the network and verify transactions. The individual will be rewarded for this service.
Tokenomics is the study of crypto tokens—from token creation, management, and sometimes removal from a network. This is an essential thing one should do before buying a token.
Cryptocurrencies or crypto-assets such as NFT are also known as tokens. Tokens can be traded like stocks of the companies.
ERC-20, ERC-721, and ERC-1155 are some popular tokens in the crypto world.
20. TVL/ TLV
As of January 8, 2022, the Total value locked (TVL) in DeFi is $93.25 billion. The previous all-time high (ATH) was $111.758 billion.
21. Yield farming (aka liquidity mining)
Yield farming, also known as liquidity mining, is a process of staking or locking cryptocurrency for a reward. A person who stakes in a DeFi application project receives the project’s native token as a reward.
This method is used to provide liquidity to a particular DeFi project.