Top DeFi Terms Explained
DeFi is short for “Decentralised Finance”: an alternative financial system made possible by Blockchain technology that doesn’t rely on the traditional banking ecosystem driven by debt-powered “Fiat currency”.
The idea is that a financial ecosystem can function reliably without needing concepts such as “trust” and “permissions”. By using theoretically incorruptible technology to store data worldwide, and by giving payments to people for doing processing, systems such as Bitcoin and Ethereum prosper.
Activities that can take place in this new world are traditional activities such as lending, depositing and borrowing, as well as new activities such as “staking”.
Of course, being a new technology, it brings new concepts and terms with it, so here’s a guide to some of the most common terms. We’ve tried to introduce them in a sensible order!
A Blockchain is a shared database that holds details of transactions. It also contains an almost infinite number of “addresses” (like mini-wallets) that can hold a digital record of whatever asset is being used. First introduced in Bitcoin, this concept underlies all Cryptocurrency – its genius is that it allows a financial system to be run by a crowd of normal computers and people without being controlled by any of them. All Blockchains have an associated native Cryptocurrency: BTC for Bitcoin, ETH for Ethereum, XRP for Ripple, etc.
A token is a digital entity that exists on a host Blockchain, which can be transferred between addresses as required. Unlike real-world currency, it can also contain data. Governments regard tokens and Cryptocurrency as “property”, and therefore trading them for other tokens can be a taxable activity. It’s complicated!
Some tokens are used to represent shares in something in the real world, or simply promise buyers that the price will increase. This may make them “securities”, and securities that are unregistered with the relevant financial agencies such as the SEC are unlawful. This is a giant problem in the current token ecosystem.
Each token might behave in a slightly different way, and it can be important to know how it’s designed: how tokens are created, how are they destroyed, how people are rewarded for transaction processing, and whether there are any benefits to HODLing or staking tokens, etc.
There’s a debate over whether this originated as a typo or as an acronym: “Hold on for Dear Life”. As you might gather, HODL means to hold onto coins long-term whatever life may throw at you (or them).
Stablecoins are tokens that are designed to mirror and track the value of an underlying asset, usually a real-world one. For instance, there are tokens such as USDC that mirror the US Dollar. These tokens use code to stabilise their own price and require the coin to be backed by some underlying asset to justify its price – for instance, you might expect an organisation that had issued billions of US Dollar Stablecoins to own the equivalent amount of US Dollars or other assets.
Both of these terms refer to exchanges: organisations where tokens can be swapped for other tokens. DEX is a Decentralised Exchange where buyers and sellers attach their wallets and the DEX facilitates trades between anonymous buyers.
A Centralised Exchange (CEX) is a company that runs their own trading platform and gets to dictate what tokens they support (which will be spread over many Blockchains). Recent regulation means that anonymous exchange accounts are now effectively illegal, with exchanges running “KYC” and “AML” – “Know Your Customer” and “Anti-Money Laundering”, which effectively means “proof of identity” such as photo ID and proof of address.
7. Pump and Dump
This is when a group of investors collude to defraud investors. They drive the price of a token up by buying enough tokens to make it appear as if genuine positive price action is happening: once enough other investors have jumped on the bandwagon and driven the token price up, the schemers jump ship and the token plummets again. Quite often the pump and dump action is amplified by hype: on social media “Pump and Dump” groups exist.
The bigger the coin, the more difficult it is to manipulate this way, but smaller coins on bigger exchanges suffer from it all the time.
9. Gas Fees
This refers to the need on any Blockchain for payment to be made to make a transaction happen. On the Ethereum Blockchain, Gas itself is a separate token (convertible to and from ETH). While the ideal for Cryptocurrency is for negligible Gas Fees, on Ethereum that’s very far from true: a situation that the new version of Ethereum (ETH 2.0) aims to correct.
Transmission fees are the biggest obstacle to “Yield Farming”.
A dApp is a smart contract with a user interface.
“Total Value Locked” is the total amount of tokens stored in a given ecosystem (such as a DEX or dAPP).
12. Smart Contract
A Smart Contract is a piece of code on a Blockchain that contains a set of rules about transactions. For instance, you could have a piece of code that, when it received money, would automatically distribute the money that it received to multiple addresses. A series of interacting Smart Contracts would form a financial ecosystem. Improperly written Smart Contracts can be an existential danger to a Blockchain if they allow it to be hacked.
“Decentralised Autonomous Organisation”. An organisation whose functions consist entirely of Smart Contracts. In the interests of transparency, the Smart Contracts running the Blockchain would always be visible.
As in the real financial world, most loans of any risk involve putting up collateral: something you own that can be taken away if you fail to repay the loan.
15. Liquidity Mining/Yield Farming
This is the strategy where the yield from one investment is invested into another opportunity elsewhere to optimise returns. Note that re-
investment of yields in interest-bearing accounts is the easiest form of Yield Farming.
16. Liquidity Pools
Decentralised exchanges only work because they have a pool of tokens to help in the trading process. Those pools are called “Liquidity Pools”, and anyone can insert their coins to put them at the service of the DEX. In return, they receive rewards of varying kinds, including shares of fees and DEX tokens. The rewards, like everything else, are different from DEX to DEX and governed by Smart Contracts.
Providing funds to Liquidity Pools is an important part of the DeFi process that allows interest-bearing Crypto accounts such as AQRU.io to exist and to offer returns of up to 7% on Stablecoins and 0% on Crypto.
The whole point of a currency is that each token is more or less identical to the other ones. The term for this is “fungible”. But what if you create one token that represents one real-world thing? Well, then you have a “Non-Fungible Token”, or NFT. Like other tokens, these can be sold or traded, but each NFT has different characteristics from all the others.
At the time of writing the most visible use of NFTs is representing digital media, but their most sustainable and sensible use would be for digitally storing data such as ID.
Many regard the current NFT marketplace as an unregulated marketplace selling dubiously sourced items of unreliable valuation for inflated prices.