11 Defi Terms to Know Before You Buy Your First Crypto

Decentralized Finance: To the moon?

What is common between the first man on the moon, the walkman, and the debut Mac computer? Each of them was a disruption that revolutionised the functioning of a global society. The next such watershed moment for our civilization is the rise of Decentralized Finance (Defi).

Think of an online banking ecosystem that eliminates intermediaries such as banks, investment managers and organizations, built on a secure cryptographic network using fully automated contracts. 

Too good to be true? Using blockchain technology, Automated Market Makers (AMMs) and smart contracts, Defi has proved to be the cornerstone of 21st-century technology. Users from around the world can save, invest, borrow, lend- all while bypassing the friction caused by financial institutions and regulation. 

According to DefiPulse, the total value locked in (TVL) of Defi is $113 billion (15th November 2021). Businesses, startups, and even central banks are now looking to Defi as an alternative to an insulated, exclusive, and frankly inefficient centralized banking system.

But, before diving into this newfound universe and hopping on the ‘BitCoin’, one must equip themselves with the vocabulary to be able to make confident decisions on its platforms. Here are a few to start with.

1. Smart contracts

Smart contracts refer to programs on a blockchain that are self-executing. This means that when a predetermined set of conditions are met (which have been coded into the smart contract) an automated set of actions are put in motion.

The funds or liquidity in a smart contract only change when a coded set of inputs are received. This eliminates transaction time in traditional financial systems and is a large part of what makes Defi decentralized. 

2. Automated Market Maker (AMM)

Think of AMMs as mathematical formulas that eliminate traditional pricing systems. They refer to an algorithm-based protocol that automatically determines the price of an asset and then executes a smart contract. This enables instant trading using liquidity pools, locked in smart contracts. This makes crypto trading truly permissionless. 

For example, UniSwap is an AMM protocol that uses a series of smart contracts to conduct price matching/discovery to ease the process of swapping/trading on its platform.

3. Decentralized Autonomous Organization (DAO)

A DAO is like a fully functional ship run by ghosts (not literally) - it refers to an entire organization that functions through a set of smart contracts. It does not have any central leadership and is governed by a community of stakeholders.

DAOs are fully transparent and their code is open-sourced. Its regulations and functions are recorded on a blockchain. Tokens that are native to a DAO act as an incentive for the entire community to vote and support a DAO’s growth.

DAOs enable consensus-based decision-making and instant movement of assets, thanks to smart contracts. Human error is minimised at a smaller and cheaper scale. Some of the most popular DAOs are Compound, AaveDAO and MakerDAO. 

4. Decentralised Applications or dApps

dApps mean decentralized apps, they can function automatically with the help of smart contracts. The key difference between a dApp and a centralized app is that a dApp’s code runs on a decentralized network as opposed to running on a centralized server.

Some examples of dApps include decentralized exchanges (DEXs), wallets, games, social network platforms, betting platforms and other applications. 

Ethereum is currently host to the largest network of dApps, but network congestion and high gas fees have led to the creation and subsequent rise of platforms like Solana, Polygon and Binance Smart Chain.

5. Decentralized Exchange (DEX)

Decentralized Exchanges refer to platforms that enable peer-to-peer (P2P) transactions of digital currencies. They are decentralized i.e. they do not rely on any third-party organizations to complete transfers between two parties, making the transactions non-custodial.

DEXs make use of smart contracts to power trades and swaps through liquidity pools, making them automatic. Some of the popular DEXes include UniSwap, Pancake, and Sushiswap. 

6. Liquidity Pool (LPs)

The foundational prerequisite to any self-executing contract on a DAO or DEX is liquidity. Liquidity pools facilitate the instantaneous trade of digital assets in a permissionless manner.

It eliminates the traditional need of a buyer and a seller, by giving a user an automatic transaction from crowdsourced tokens on a platform. Assets in a pool, liquidity, and ease of trade with the pool are directly related.

7. Liquidity Providers

A liquidity provider refers to an individual who supplies liquidity to a liquidity pool. They receive incentives in the form of returns and yields through fees generated by trading, farming or lending. The net returns are proportional to the amount locked into a pool.

Liquidity providers facilitate decentralized trading on a platform in exchange for passive income. Some popular LPs include SushiSwap and UniSwap’s platforms.

8. Yield Farming

Yield Farming refers to the staking of tokens with the aim of generating high returns. Users lock a certain amount of assets into liquidity pools and earn through a predetermined percentage of the transaction fees, interest via lending or through the platform native token reward.

Yield Farming has attracted many early-stage investors into crypto, who stake and lend using popular yield farms like Aave, Compound and UniSwap, and look to earn passive income. 

9. Gas Fees

Gas Fees refers to the charges levied from users for the completion of a transaction over the blockchain network. They are denoted in the platform’s denomination (gwei in ETH) and are essentially the fees paid to miners for validating transactions on a blockchain.

10. Pumping/Dumping

It is important to be wary of ‘pump and dump’ schemes on DEXes - wherein a group of users, usually in synchronization, pump assets into a token to raise its value.

This is sometimes complemented by social media efforts to create hype around a specific token and attract investments. Once the value of a token reaches a zenith, the collaborators then sell their assets, making a profit and the token value falls as a result of this coordinated dumping.

11. Non-fungible Tokens (NFTs)

NFTs are digital assets on a blockchain that are not interchangeable, like other tokens. They are unique and come with metadata that prevents the replication of data without the permission of its owner.

This has proven to be a great method for artists and creators to claim ownership of their products without any financial intermediaries. NFTs act as proof of ownership that also provides a history of previous owners. 

Is this all of it?

The dictionary for Defi is still expanding, with newer and diversified use-cases creating new avenues. But for the meanwhile, these keywords are enough to enable you to log onto a DEX and understand what’s going on, without feeling FOMO. dApps have paved the way for exciting products that have been gamified for maximum user engagement. 

As a new investor, it is critical to understand that at the end of the day Defi and all its applications and services require prudent human decision-making. These aren’t slots at a casino and come with financial responsibility. So give it a shot, open a DEX and try your hand. With Defi on the wheel, the world has boundless opportunities.