If you are one of the many wondering how #DeFi experienced explosive growth in the past few years, you are not alone. Until now, intermediation was a necessary feature of finance, you might think. However, innovations such as #flashloans opened a new way for gaining #liquidity, and we think now is the time to explain the basics.
Our contemporary financial system has been highly centralized. Particularly, the financial crisis of 2008 made it very evident that certain decision-makers were responsible for the safety of entire currencies. When #bitcoin was introduced in 2009, it represented a first countermovement against the centralized nature of financial power. With the most well-known #cryptocurrency, Satoshi Nakamoto intended to challenge the current financial order, resulting in decentralization. However, decentralized finance (DeFi) gained relevance with the introduction of #ethereum, as its #smartcontracts make it easy to program and design digital money. The combination of decentralization and programmability is now a megatrend in decentralized finance.
DeFi stands for Decentralized Finance and describes a special ecosystem in the blockchain space. As a rule, DeFi is based on #blockchain technology that supports smart contracts. Currently, the most important blockchain solution for DeFi applications is Ethereum. Interested parties can already find numerous decentralized applications (#dapps) that focus on the financial sector. Such a DApp is comparably easy to create and can be programmed at will. The developers can fall back on different functions and thus publish an individual result. Once implemented on the blockchain, a DApp is independent and decentralized. If you take a closer look at the source code of a DeFi app, it consists of numerous "if-then" instructions. The programmed instructions are stored decentralized after implementation; adaptation is no longer possible. Another advantage of a DeFi application is its efficiency. By combining smart contracts and cryptocurrencies, these applications are particularly efficient. Normally, the costs amount to a few cents, even with higher investment amounts.
DeFi is for everyone as its applications are based on public blockchain. Nevertheless, interested parties must make a request - a wallet and an Internet-capable gadget are prerequisites.
There are already numerous fields of application that make it clear that DeFi is a fast-growing sector in the blockchain sector. Its areas of application range from payments, cryptocurrency lending, stablecoins, stock exchanges, and trading venues to gaming and gambling.
DeFi terms explained
To assist you in understanding the market and beginning to explore the new opportunities it presents, we have summarized the most common DeFi terms below.
01 - Decentralized Exchange (DEX)
To begin using DeFi, you need a decentralized exchange. It is a decentralized trading platform where users can buy and sell coins. A well-known DEX that uses an algorithm for trading is UniSwap, for instance. So who controls the cryptocurrency's operation and decides how much it will cost, you might ask? This is accomplished by using an AMM system.
02 - Automated Market Maker (AMM)
An AMM, also known as a protocol DAO, is a type of decentralized exchange that relies on liquidity controlled by an algorithm, instead of using an order matching system. In order to facilitate trades, AMMs utilize smart contracts to build their own liquidity pools. The goal is to guarantee that there is always accessible liquidity.
03 - Liquidity Pools
Anybody may supply liquidity to AMMs using liquidity pools as long as they can provide the token pairs specified by smart contracts called Liquidity Providers (LPs). By introducing two tokens with equal value to a pool, these LPs create markets and liquidity pools. LP tokens serve as incentives for each LP.
04 - Liquidity Mining
Liquidity mining is an investment strategy where Liquidity Providers switch their LP tokens between different liquidity pools to earn the highest interest rate possible. This is done by leveraging a position by taking a loan on lending platforms like Compound. This system enables you to invest your LP tokens in several liquidity pools to receive additional rewards. DeFi is a composable solution because of its ability to connect various decentralized finance components.
05 - Composability
Composability points to how DeFi enables users to "own" their interactions and expand upon them through future interactions. Example: If you are a liquidity provider, you will get LP tokens, which you can use to earn extra incentives, such as extra rewards on your investment.
Note: The traditional world has several different types of composability as well. You take advantage of each application's composability, whether you pay for a service with PayPal or sign into an app with your Facebook login. These integrations depend on the confidence of a third party, even if they can be helpful. Every time you use PayPal to make a payment, it functions as an intermediary, and Facebook may have data from times you signed into an app using the social network. (Source: medium.com)
06 - Slippage
In finance, slippage means the price difference between when you submit a transaction and when that particular transaction is confirmed. Because each transaction on a blockchain network does not occur quickly, it is fairly common in the cryptocurrency market, particularly in the DeFi space. Between the time you submit the transaction and the time the blockchain network confirms it, there is a delay. The price of an asset may rise or fall between the time you place an order and the time it is actually executed, depending on whether it is positive or negative.
07 - Total Value Locked (TVL)
The amount of all digital assets locked in various decentralized finance protocols is known as Total Value Locked, or TVL.
08 - Collateral
Prior to receiving a loan, borrowers must deposit collateral as per lending regulations. Essentially, it consists of digital assets that are further locked until the entire borrowed sum is repaid.
09 - Flash Loans
In the DeFi sector, not all loans demand collateral. Flash loans can be obtained without the need to deposit digital assets or conduct special checks. Flash loans, do, however, demand that you pay back the loan quickly, or the transaction would end abruptly. These loans are frequently employed in arbitrage trading.
10 - Arbitrage Trading
The value of cryptocurrencies varies across different decentralized exchanges, and since Automatic Market Makers operate their own internal market with distinct values, these two prices frequently diverge from those of the external market. Arbitrage trading is the practice of taking advantage of price differences to quickly profit from trades.
Decentralized finance has opened up a whole new financial universe of chances that allow more individuals than ever to engage in the financial system fairly when old finance was exclusive, ruled by a small central group, and delivered inadequate returns for its users. We believe that having a basic understanding of DeFi will be beneficial for your future financial endeavors.
Note: Our vocabulary selection has been based on DeFi and The Future of Finance, Harvard Law School on Corporate Governance. (Available here). Last entry: 5.3.2023.
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