Educational Byte: Understanding the Basic Concepts of DeFi and Liquidity Mining

Decentralized Finance, or DeFi, refers to the use of distributed ledger technology to recreate and enhance traditional financial systems in a decentralized manner. It eliminates intermediaries and enables individuals to engage in various financial activities, such as lending, borrowing, trading, and much more. They do this directly with each other by using smart contracts, or with automated agents that operate independently from humans.

DeFi offers numerous advantages over traditional finance. It provides financial services to the unbanked and underbanked, enabling greater financial inclusion. Additionally, DeFi eliminates the need for intermediaries, reducing costs and enabling faster transactions. It also promotes transparency by allowing users to verify transactions on public ledgers.

Liquidity Mining is, maybe, the most popular activity in the DeFi industry. Also known as Yield Farming, is a practice that involves providing liquidity (funds) to decentralized platforms in exchange for monetary rewards. It operates on the principle of incentivizing users to contribute their digital assets, such as cryptocurrencies, to liquidity pools without intermediaries.

These pools are automated agents (they come by different names on different platforms, e.g. smart contracts on Ethereum, autonomous agents on Obyte, Chaincode in Hyperledger Fabric) usually holding a pair of tokens for others to exchange. For example, GBYTE-WBTC: to provide liquidity, you need to buy and deposit any amount of the pair in the pool. The funds will be used by others to “swap” or exchange between different coins without intermediaries, while you’ll get a share of the involved fees and additional rewards. This facilitates efficient trading and enables various DeFi protocols to function seamlessly.

Must-know concepts of DeFi and Liquidity Mining

Going a bit more “inside” the bowels of these activities, there are some basic concepts that you need to know before starting. Terms like AMM, APY, CEX, DEX, LP, TVL, governance, impermanent loss, and leverage will repeat in all your journey and different platforms.

• Automated Market Maker (AMM)

  It’s a decentralized exchange mechanism that uses algorithms to set prices based on the available liquidity in a liquidity pool, facilitating automated trading without relying on traditional order books —like those from centralized exchanges.

• Annual Percentage Yield (APY)

  It’s a metric used to measure the total amount of interest or returns earned on an investment or deposit over a one-year period, taking into account compounding effects, fees, and other factors. This percentage is mostly available to check at first sight in any DeFi platform.

  
  

• Centralized Exchange (CEX)

It refers to a digital asset trading platform that operates under the control and authority of a central entity (like a company). It typically requires users to deposit funds into their accounts, and trading occurs through an order book managed by the exchange. Binance and Kraken are CEXs.

• Decentralized Exchange (DEX)

It’s a digital asset trading platform that operates on a decentralized network, typically utilizing autonomous automated agents. It allows users to trade directly with each other without the need for intermediaries or central authorities. Oswap.io and ODEX on Obyte are DEXs.

• Liquidity Provider (LP)

It’s an individual or entity that contributes their coins to a liquidity pool on a decentralized exchange or lending platform, facilitating smooth transactions and earning rewards in return. Anyone can be an LP.

• Total Value Locked (TVL)

It’s a metric used to measure the total amount of funds locked or held within a decentralized finance (DeFi) protocol or platform at a specific time, indicating the level of participation and value within the ecosystem. Statistics sites like DeFi Llama and DeFi Pulse use this measure (in USD).

• Governance and Voting

  It’s not an exclusive concept of DeFi, but it’s quite important here. It's the process by which participants collectively make decisions and influence the direction of the protocol. It involves token holders voting on proposals, such as protocol upgrades, parameter changes, and allocation of funds, to achieve consensus and shape the platform's development. Usually, each DeFi platform has its own governance token to allow voting.

  
  

• Impermanent Loss

When providing liquidity to a pool, it refers to the temporary reduction in the value of your assets compared to their value if you had simply held them outside the pool, due to price fluctuations. It could be "permanent" if you exchange the tokens at a negative fluctuation point.

• Leverage and Margin

Leverage in DeFi platforms allows users to amplify their exposure to assets by borrowing funds to increase their trading position. Margin refers to the collateral or funds users need to provide as a percentage of their borrowed amount to enter leveraged trades. Classic leverage comes with a risk of liquidation if the market moves against you, however, Oswap.io since version 2 (the current version) provides leverage without liquidations.

Now, if you’re ready, you can also check our guide about how to profit from the different types of liquidity mining available in the Obyte ecosystem. It’s easy, it’s decentralized, and it’s quite rewarding too!