DeFi protocols are pushing the boundaries of financial technology in a high-risk, high-reward game. Here are some of the basic terms, defined in plain English
Decentralized finance is the latest evolution of cryptocurrency trading and investing. Protocols that are not tied to a particular country or company and which allow anyone to interact with them have enabled many different kinds of people to make — or in some cases lose — large sums of money.
Allowing anyone in the world to permissionlessly access financial products and services that closely mirror those offered by TradFi companies is an exciting prospect. However, this is a world where responsibility for understanding exactly where your transactions are going sits firmly with the individual. In order to figure out what’s going on under the hood, the first thing to understand is what some of the obscure-sounding terms actually mean.
Here are some DeFi-nitions that I hope will demystify some of the jargon:
The acronym DEX stands for ‘decentralized exchange’. When the first exchanges for trading tokens were launched, you had to send your crypto to a wallet that someone else controlled and simply hope that the code was bug-free and the exchange admins were honest.
Over the years, hacks, thefts and even (alleged) deaths at the likes of MtGox, Cryptsy and Quadriga have proved over and over again the mantra of “Not your keys, not your crypto”.
While centralized exchanges are far more professional these days, it still means relying on someone else to take charge of your assets.
Decentralized exchanges are different. In order to swap tokens, you simply connect your wallet to an interface that allows you to interact with a smart contract. There is no need to set up an account or to log in. Of course, this means that if you lose your private key or seed phrase, there is no one to unlock your account or restore your login.
DEXs also allow traders to access more sophisticated financial products such as collateralized loans, options and derivatives.
Tax reporting is becoming easier, with the likes of tools such as Skytale, which includes QuickBooks integration with the many other features in its asset tracker. And, of course, residents in different countries are subject to the same money-laundering rules as users of the TradFi system.
However, because traders do not have to provide any personal information when they transact, regulators are in many cases figuring out how to apply more specific legislation without stifling the innovation brought by DeFi.
2. Automated market maker
Automated market makers are the protocols that allow DEXs to exist. Centralized exchanges use matching engines to match buy and sell orders and execute them at the best price, while market makers (either companies or individuals) add liquidity to the market by quoting both a buy and a sell price.
Within a DEX, such as UniSwap, all this is done by a smart contract called an AMM or automated market maker. Pairs of tokens are deposited in liquidity pools (below) by people who want to make money with their cryptocurrency instead of simply leaving it in a wallet and hoping its value increases. The code in the AMM calculates the price a token should be bought and sold at depending on how much demand there is to buy or sell the tokens in each pair.
What’s in it for the liquidity providers? They receive a fee every time a trade is executed and may also receive liquidity pool tokens as a reward. See the Liquidity mining definition for more detail.
3. Liquidity pools
A liquidity pool is a collection of assets locked in a smart contract. Pairs of assets are matched in a liquidity pool and the Automated Market Maker determines how they are priced against each other.
For example, if a liquidity pool contains Token A and Token B, and more of token B is being bought than sold, then the price of Token A in the pool will fall and the price of Token B will rise. There is no waiting around for an order in your order book to be matched and filled: instead, a buy or a sell happens instantaneously, once you have authorised by signing via your wallet.
4. Liquidity mining
Adding your tokens to a liquidity pool carries a certain amount of risk. Even though the risk of hacking or fraud is mitigated by the AMM code being open source, so anyone can scrutinise it, there have still been instances of DEXs being hacked. Additionally, while your tokens are in a liquidity pool, you are foregoing the chance of making money on them elsewhere — for example, by trading or using them as collateral. For this reason, liquidity providers are rewarded with a share of the fees generated by trading.
When you add liquidity to a pool, you receive a liquidity pool token in your wallet exchange, which is redeemed when you remove your liquidity. Because trading fees in liquidity pools might not be sufficient reward — and as an extra incentive to offset the possibility of impermanent loss, you can often use these liquidity pool tokens to earn even more yield.
5. Collateralized loan
The anonymous (or at least, pseudonymous) nature of DeFi means that no one will lend money to you… unless they can access some kind of collateral in case you default on the loan. The constantly shifting exchange rate between Ether, the US dollar and various other cryptocurrencies provides attractive opportunities to make money — and most loans within DeFi are used within the DeFi system to do exactly this.
Different cryptos can be used for collateral, but the most deposited collateral currency is Ether. MakerDAO was the first major decentralized lending platform, allowing borrowers to mint the DAI stablecoin in return for depositing Ether into a special smart contract. This is the equivalent of borrowing USD against Ether.
Borrowers have to deposit more collateral than they borrow to mitigate against the risk of exchange rate changes and default, and if the deposit-to-loan ratio falls below a certain level, they may be liquidated and the borrower has to pay a liquidation penalty.
While the rules vary from platform to platform, any third party can initiate a liquidation and claim the reward. Liquidation bots constantly trawl loan positions looking for profitable potential liquidations, and borrowers who do not top up their collateral or settle on time will lose some — or occasionally all — of their funds.
6. Synthetic assets
Synthetic tokens in crypto have the same function as derivatives in TradFi: they allow traders to benefit from price movements of a particular asset without actually having to own it.
Confused? The easiest way to understand this is to look at a protocol like Synthetix, which has around $0.5bn locked in synths.
Assets available to trade or stake on the platform include sUSD, sEUR, sBTC, sADA and sETH, as well as sDeFi, which tracks the price of the DeFi index as a whole. Asset prices are supplied by price oracles — and allows the easy trading of forex or cryptos without the trader having to hold the asset in question.
TVL stands for Total Value Locked. Most DeFi protocols involve asset owners committing their tokens to a smart contract, which is known as ‘locking’.
Sites such as DappRadar show both the TVL for the whole DeFi ecosystem and for individual protocols. As well as being useful for comparing the size of the market controlled by each protocol, it is instructive to see how the total TVL has soared: from $8bn in early 2019 to more than $80bn now.
8. Yield farming
As we have seen, there are different ways to make money from your crypt assets in DeFi — whether this is committing assets to be lent out to borrowers, staking, depositing in liquidity pools or even staking the liquidity pool tokens you have received.
Because rates change all the time, committed DeFi users will move their assets around to get the best yield. Some use automated programs to help do this, while others have their own strategies which they implement manually.
This process of actively seeking the highest yield is known as ‘yield farming’. In 2020, this resulted in memes that generated food-based tokens such as YAM, TENDIES and CAKE.
9. APY and APR
APY stands for Annual Percentage Rate and refers to the percentage reward you can make by locking up your tokens in different DeFi pools or protocols. In reality, this notion can be slightly misleading, as the highest APRs (often multiples of 100%) rarely last for very long, let alone a full year.
The APR in a liquidity pool is determined by the smart contract: when more funds are added to the pool, the APR will drop, for example. A high APR is a reward for risk and usually means an illiquid pool containing a lesser-known token.
APY is almost the same as APR except that it adds the compound interest, illustrating what you would receive if you allow your rewards to compound. At a high APR, compound interest will make a huge difference between APR and APY values.
Remember, these are a guide and not a guarantee!
10. Impermanent Loss
If you are depositing liquidity in a pool, it is also important to understand the concept of impermanent loss, which can entirely wipe out even a high APY and can mean you end up with less dollar value than you started with.
As the price ratio of two assets in a liquidity pool changes, so does the value you are entitled to when you remove liquidity. A liquidity pool token entitles you to a percentage of the assets in the pool, rather than a fixed sum. The word ‘impermanent’ is used because if the price returns to the ratio it was when you deposited liquidity, then the loss is wiped out — however, there is no guarantee that this will happen, and when you withdraw your funds, this will become an actual loss.
This is an excellent article which goes into more detail about the mechanics of impermanent loss.
Want to know more? I’ll follow up soon with some ‘how to’ guides.