Decentralized finance can be a world of jargon — from liquidity pools to yield farming, here are the basic terms you need to get started
Decentralized finance, or DeFi for short, is an umbrella term for financial products built on top of decentralized, open-source blockchains. A true DeFi instrument should be programmable, permissionless, and composable — which means there isn’t always an analogous example in the banking system.
Right now, the pace of innovation in DeFi can be hard to keep up with, leaving newcomers swimming in a sea of jargon. We hope these ten core concepts will help.
📝 Smart contract
A smart contract is a computer program on the blockchain that can self-execute when certain conditions are met. In this way, agreements between a buyer and seller (or tokenholder and protocol) are written directly into lines of code. Smart contracts are the building blocks of DeFi “money lego” because they enable sophisticated interoperability between many different financial instruments without the need for third parties. In theory, once a smart contract is deployed to the blockchain, dapps (decentralized apps) can run themselves with little to no human intervention. For example, yearn.finance is a DeFi protocol that leverages smart contracts to maximize yield for liquidity providers and yield farmers.
On the Ethereum blockchain, gas is a unit that measures the computational effort required to perform a transaction on the network. Gas prices are denoted in gwei, which are worth 0.000000001 ether. Note that gas prices can differ across dapps and protocols depending on the complexity of the transaction involved. A simple ETH transfer could cost you 21,000 gas, while more complex transactions could consume a few hundred thousand and up to several million gas.
2020 has seen gas fees skyrocket, although many hope that Ethereum 2.0 will solve these congestion problems through sharding — essentially splitting the entire Ethereum network into multiple sections or ‘shards’. This Bankless article is a great intro to understand how sharding will increase the composability and scalability of the Ethereum economy.
In the meantime, try not to scream when you find out how much you’ve spent on gas fees using the fees.wtf calculator.
This one seems obvious, but people still have a hard time wrapping their heads around different kinds of wallets and how they can be used. The main distinction is between non-custodial wallets — where you have full ownership, possession and responsibility over your assets — and custodial wallets, where a third party stores your private keys for you. Different kinds of wallets include:
- Hardware wallets: A physical device stores your private keys e.g. Ledger, Trezor, etc.
- Web3 wallets: A self-custody wallet enables access to the next generation of internet applications. For example, MetaMask is a browser plugin that serves as an Ethereum wallet, allowing users to store Ether and other ERC-20 tokens.
- Smart-contract wallets: These are wallets that live as a program on the blockchain instead of providing the user with a public and private key pair. Examples include InstaDapp’s DeFi Smart Accounts, Argent, Gnosis Safe, etc.
Stablecoins are designed to minimize price volatility by holding on to a specific value. There are generally three types:
- Fiat-collateralized stablecoins e.g. Tether (USDT) and TrueUSD are pegged 1:1 to the US dollar and are backed by dollar deposits.
- Crypto-collateralized stablecoins e.g DAI — although this stablecoin is also pegged to the US dollar, its reserves are held in ETH
- Commodity-collateralized stablecoins e.g. Digix is a stablecoin backed by gold.
- Non-collateralized (algorithmic) stablecoins
🏊♂️ Liquidity pool
Liquidity pools are an automated market making strategy used in decentralized exchanges like Uniswap, Curve, Kyber and Bancor. Although these exchanges use different approaches, at their core they consist of transactions traded against a smart contract, and not other traders as in the traditional order book model. Anyone can become a liquidity provider by depositing crypto into a liquidity pool to earn trading fees in proportion to their share in the pool. Learn more with our deepdive into liquidity pools.
⛏ Liquidity mining
Liquidity mining is a community-based approach to market-making and protocol governance. A token issuer or exchange can reward a pool of miners to provide liquidity for a specified token. For example, on the Compound protocol, users who deposit tokens will earn both interest and a share of the Compound governance token, COMP.
👨🌾 Yield farming
By leveraging the incentives of liquidity mining, your crypto can be put to work across a number of DeFi instruments. Yield farming attempts to maximize returns by earning native governance tokens on protocols, and typically applies recursive investing to achieve this. For example, adding 100 USD as collateral on Compound will earn you both interest and $COMP governance tokens. You could then borrow 70 DAI against your 100 USDC collateral, where you will pay a small interest fee but still earn more $COMP. Finally, you could swap the 70 DAI for 70 USDC and repeat the whole process. With large amounts of capital, an investment can thus be folded many times over in order to maximize the amount of governance tokens earned. To learn more, check out our article on yield farming with Synthetix, Balancer and Curve.
⚡️ Flash loan
Flash loans allow you to borrow instantly from a publicly funded smart contract pool without providing any collateral. These loans are only valid within one block transaction and must be repaid before the end of the transaction used to borrow the loan. If the borrower does not repay their debt by this time, the transaction is reverted. This process ensures that liquidity is always returned to the pool. Flash loans are commonly used for arbitrage, collateral swapping, self-liquidation, and more.
In DeFi, staking usually involves depositing liquidity pool tokens into a smart contract in order to earn rewards. Staking is similar to earning interest from a bank account — the longer you hold, the more you earn.
The easiest place to build and manage your entire DeFi portfolio 😉