Crypto 101: Understanding DeFi and Its Terminology
Decentralized Finance or DeFi has played a crucial role in the rise of crypto over the past few years.
Starting off with the DeFi Summer of 2020, the space is blooming with innovation and keeping up with the pace of it all is surely the most arduous of tasks. DeFi makes financial products (e.g. loans) available on a blockchain without the need for a central authority to oversee them. Instead, DeFi is controlled via a series of smart contracts written to ensure that all participants in the financial ecosystem have their best interests represented. This whole concept is a huge paradigm shift in and of itself.
All of this simply says that you've got a decentralized network (the blockchain) responsible for ensuring that all financial participants are happy. If you've ever heard people discussing DeFi, you might be wondering what half of the things they mention mean. And naturally so!
Understanding the space can be overwhelming if you don't know what's going on. One of the most daunting aspects of De-Fi is the terminology. Sometimes, it's like De-Fiers are speaking a whole different language. However, with the right direction, you can figure out what all these De-Fi terms are about and how to use them in your day-to-day.
We've been around the crypto space for a while, and we know how complicated the terms can be. It's hard to prevent information overload. There are simply so many places where you can get resources that could help you decipher the code that is the language around decentralized finance. We've distilled this information into a few critical terms that will give you a handle on what's going on in the De-Fi space. Are you ready to jump in feet-first into the heady world of De-Fi terminology?
Ethereum: Ethereum (ETH) is both a blockchain and a cryptocurrency. Most of the projects that one encounters in the De-Fi space are built on top of the ETH blockchain. The chain is undergoing some changes and evolution, making it better suited to handle the innovative projects that teams have put forward. Ethereum remains one of the best-suited blockchains for developing De-Fi projects.
L2: Blockchains can be either Layer 1 (L1) or Layer 2 (L2). Scalability issues often plague L1 blockchains. For example, transactions can be slow and expensive, which diminishes a given blockchain's utility and general usability. Layer 2 solutions are there to speed things up and provide a fix. They are an additional protocol layer on top of L1s, making the L1 more scalable by increasing throughput and transaction speed.
Some examples are The Lightning Network, an L2 scaling solution for the Bitcoin network that makes transactions faster and cheaper. For Ethereum, a well-known L2 helping drive adoption is Polygon.
Smart Contracts: Smart contracts are self-executing contracts where code strictly defines the terms within the contract. These smart contracts are typically found on decentralized networks (such as Ethereum), written to ensure that both parties get what is agreed to once certain conditions are met. The code within the smart contracts controls the execution and the criteria for success or failure. Smart contracts are both traceable and irreversible - once executed, the contract details become a permanent element on the blockchain.
Decentralized Exchange (DEX): Decentralized exchanges or DEXes are a revolutionary way of trading cryptocurrencies. Currently, the market is dominated by Centralized Exchanges (CEXes) that require users to go through verification as a regular brokerage would. They also require users to put faith in an intermediary organization (the exchange itself). DEXes are more in line with the decentralized vision of cryptocurrency. DEXes don't use a central organization to make exchanges but instead rely on smart contracts to automatically execute currency exchanges based on user needs. Because there is no formal, central organization, there's no organization to submit verification to, making a DEX more private and anonymous than a CEX.
Stablecoins: Stablecoins are cryptocurrencies whose value is directly pegged to the value of another asset class. A stablecoin such as USDC, for example, is pegged to the value of the U.S. Dollar and follows any USD-related price action. They are helpful to measure how a particular cryptocurrency squares up against the fiat currency many regular investors are used to.
Tokenomics: In a nutshell, Tokenomics is the cryptocurrency version of economics - it gives you a glimpse into the economic reality of a given cryptocurrency. It helps you better understand the supply and demand characteristics of a token. As tokens are pre-programmed with a distinct set of algorithmically created features, tokenomics models accurately layout the number of tokens that will be issued on X date and how that will, in turn, affect the supply.
Liquidity: In traditional economics, liquidity refers to how easily an asset can be converted into cash (liquid assets). The term is slightly different in the cryptocurrency community. While liquidity refers to the ability of a given token to be exchanged and converted into cash, it also refers to how easy it is to transform into other coins or tokens. In the context of DEXes, users must provide liquidity (in other words, 'lend' their tokens) in order for other users to be able to transact freely and enjoy the availability of trading pairs. Providing liquidity is a means of earning money from a DEX as exchanges provide very healthy interest rates for lenders.
Liquidity Mining: Also known as Yield Farming, liquidity mining is a term that refers to locating the optional yield from investments on an exchange. The yield of a token or currency is represented as a percentage. It is based on how many people invest their tokens into the liquidity pool. The more demand for the token, the higher the interest rate, raising the incentive for users to invest their tokens. Users, therefore, can "shop around" to find out where the best yields are for their token investments.
Collateral: In traditional economics, collateral can be an asset that you give to a financial institution as a guarantee that you will repay a loan. The premise is similar in a cryptocurrency exchange. When you borrow a particular token from an exchange, you give up a portion of your assets on that exchange to guarantee repayment of the loan. The amount that you guarantee is known as your collateral.
Staking: Staking enables you to participate in the validation of transactions on the blockchain directly. We previously explained the Proof-of-Stake (see here) consensus mechanism, and this is where staking comes into play - by staking your tokens, you are essentially helping the network develop and validate more transactions. You could consider it your personal contribution to the health and well-being of the network. Additionally, you could generate a healthy profit if you stake your tokens for long enough.
APY: APY stands for Annual Percentage Yield and refers to the annual rate charged for earning or borrowing cryptocurrency. APY is a compound interest calculation, something most of us should remember from our early days in school. Usually, cryptocurrency exchanges represent the potential earnings for a particular coin or token as its APY value. The exchange may also use APR, but the difference is that APY takes compounding into account, while APR does not.
Gas: When you use the Ethereum network for a transaction, you need to pay the network fees for that transaction. These fees go towards compensating the network processing providers whose power is required to complete the transactions. Gas fees vary, depending on supply and demand.
Rugpulls/Pump-and-Dump Schemes: One of the most insidious abuses of trust on the decentralized web are companies involved in these kinds of practices. Cryptocurrencies tend to be elements of much speculation. When an entity creates a particular token, they can use social media influencers and other individuals to market their token for them, driving up adoption (the pump). As more people buy into the token, the price of the token skyrockets. Once it gets to an acceptable level, the initial investors divest themselves of the token and crash the market (the dump), leaving people who are not in the know holding tokens worth nothing. Rugpulls are easy to spot if someone understands that the value of a token comes from the benefit it provides. If a project doesn't seem like it makes much sense, and no one can give a concrete answer to the question, "What does it do?" then chances are good that it's a rug pull waiting to happen.
Hopefully, this handy glossary will get you started on your journey to understanding the ins and outs of decentralized finance.
Keep an eye on this blog for more information about cryptocurrency and De-Fi terms you might want to learn about.