Your shortest DeFi dictionary

Photo by Markus Winkler on Unsplash

DeFi is the hottest trend right now, but only a few people really understand what it’s all about. This article aims to showcase the basics of how a DeFi app looks and feels, and works.

First things first: What is DeFi?

Decentralized Finance (DeFi) refers to blockchain applications aimed at disrupting the financial industry by removing intermediaries. This class of products includes digital assets, smart contracts, and dApps, to provide decentralization and a trustless financial system. Protocols are almost exclusively being developed and used on Ethereum, but they can work on other platforms with smart contract features too (such as DAI).

DeFi aims to automate everyday actions performed in the market through a non-custodial open-source network (E.g., borrowing, lending, buying, selling, investing, trading, etc.). Unlike centralized systems, limiting the speed and other transactions’ capabilities, DeFi allows users to directly control their funds by eliminating the intermediaries like banks, clearinghouses, and other financial institutions.

Essential characteristics of a DeFi dApp

Credits: 101blockchains

The term DeFi is used for various financial applications, each having its particularities and contributing to disrupting financial intermediaries. Next, I am going to explain how a DeFi dApp works and what its properties are.

They are built on a decentralized P2P channel

A dApp is a service built on a decentralized P2P channel. The user must connect their crypto wallet to the network (for instance, if the dApp uses Ethereum, one must connect their wallet to the blockchain through Metamask or other similar services).

No third party

DeFi products aim to promote autonomy. There is no third party (such as a bank) that handles the financial processes. All the workflows are managed by the code written in the smart contracts. Once a smart contract is deployed in the blockchain, the dApp runs itself, creating a trustless system. Therefore, the assets are entirely under the user’s self custody.

Transparent code

Everyone can view the code, understand the contract’s functionality, and debug without any limitation in a jurisdiction or geographical location. DeFi applications are completely permissionless, meaning that everybody can use them and create their new ones. Moreover, new dApps can be developed using other DeFi products, such as stablecoins, prediction markets, and decentralized exchanges.

Composability

Composability is the ability to combine various software components in different ways to build applications from parts. A system is highly composable when it provides components that can be assembled in certain combinations that satisfy specific user requirements. In crypto, the primary factors driving the proprietary software stacks are the closed data structures and the monopolistic business models.

An application that gathers more user data increases its developer company monetization potential. Because many DeFi projects are composable, relying on the blockchain’s base layer, users can perform multiple actions that can be done in one single, smart contract.

For example, they can take out a loan of DAI on Compound and put one half of it into a DeFi app and the other into a leveraged position for ETH on a different DeFi platform. They can then pull out the funds from both at a given price level of ETH, repay the loan and interest to Compound, and finally keep the remaining balance earned from the leveraged position.

Most common DeFi products

Photo by Austin Distel on Unsplash

Decentralized Exchanges (or DEXs)

They aim to connect users directly and allow them to trade cryptocurrencies with one another without relying on a mediator. DEXs are automatic lending and trading platforms constructed from open-source software and programmable cryptocurrencies and developed on distributed computing networks, like Ethereum. The purpose of DEXs is to provide banks and traditional exchanges a more-efficient and less-costly way of conducting transactions. For example, IDEX (built on Ethereum), Binance DEX, EtherDelta, and Radar Relay are among the most popular DEXs. Rarebits and OpenSea are open marketplaces focusing on non-fungible tokens (NFTs) exchange, helping the buying, selling, discovering, and exploring of such crypto-assets referred to as crypto-collectibles. There are other types of marketplaces, like DistrictoX, which allows for the creation of marketplaces to vote on governance procedures.

The difference between DEXs and other centralized exchanges (like Coinbase) involves P2P transactions, no sign-up protocols, no identity verification, and no withdrawal fees involved.

Stablecoins

These are cryptocurrencies designed to offer price stability. Stablecoins represent financial assets denominated in foreign currencies and held by central banks. Reserve assets are used to balance payments and have four primary characteristics: they must be physical assets, readily available to monetary authorities, easily transferable, and controlled by policymakers. The most predominant reserve asset considered is the US dollar. Stablecoins have gained traction for having the advantages of both payments of cryptocurrencies and fiat currencies. The transaction is processed instantly and benefits from cryptocurrencies’ security and privacy, also being volatility-free stable valuations of fiat currencies.

Lending Platforms

They allow users to deposit and lock their funds into smart contracts, from where other users can borrow and pay interest on them. Each loan is collateralized by crypto. The most popular DeFi platforms currently in use are:

  • Compound. It is an open-source algorithmic autonomous and decentralized protocol built for developers. It allows them to access multiple financial applications and earn interest in Ethereum digital assets by lending them real-world assets like real estate, commodities, and vehicles.
  • Aave, also an open-source protocol, focusing on creating a transparent infrastructure for decentralized finance. Aave’s algorithm uses a pooling strategy to adjust interest rates. They also have their aTokens for paying interest and LEND tokens, granting voting rights for decisions related to the contract upgrades and protocol parameters.
  • Nuo Network, a decentralized debt marketplace that allows users to instantly borrow ETH and ERC20 tokens from debt reserved by staking collateral in their smart contract and earning interest in their crypto assets, creates a debt reserve without charging any platform fees.
  • MakerDAO, a decentralized protocol, comprises a smart contract service that manages borrowing and lending, using MKR and DAI to regulate loans’ value. There are no lenders on MakerDAO, and the only asset available to borrow is DAI. The protocol is built on the Ethereum blockchain, enabling users to create currency. The project is managed by any person around the world that holds its governance token. MKR tokens holders make decisions on the protocol and DAI’s financial risks to ensure transparency, stability, and efficiency.

Wrapped Tokens

Wrapped Tokens are ERC-20 tokens with a value identical to the assets they represent, either through smart contracts or by being backed one-to-one with the underlying assets, in the same way, US dollars back stablecoins like USDT and USDC. A wrapped token is hosted on the Ethereum blockchain with a price that is the same as another underlying asset, even if it’s not on the same blockchain or a blockchain at all.

The development of the wrapped crypto tokens enabled Ethereum-based BTC trading on DEXs, facilitating speed. Wrapped tokens helped the Ethereum ecosystem grow and opened the possibilities of DeFi to more investors.

Prediction Markets

They represent exchange-traded markets having the purpose of trading the outcome of events (like presidential election results, exchange averages, quarterly sales results, commodity prices, or even such things as gross movie receipts). Prediction markets bet on the occurrence of events in the future and depend on the scale; the more people participate in the market, the more data occurs, and the more effective the market prediction algorithm becomes. Also known as betting markets or information markets, they have been utilized in various fields of study, such as data analytics and artificial intelligence. Their principal scope is eliciting aggregating beliefs over an unknown and uncertain future outcome.

Yield Farming & Liquidity Mining

Yield Farming is a recently emerged concept of getting rewards with cryptocurrency holdings using permissionless liquidity protocols. In simpler terms, yield farming means locking up cryptocurrencies and getting a reward. With the decentralized ecosystem of “money legos” built on Ethereum (typically using ERC-20 tokens), yield farming allows anyone to earn passive income. This is an innovative perspective that is believed to change the way investors manage their cryptocurrency (refusing to sell, regardless of the price increasing or decreasing). The concept is also known as liquidity mining because, in many cases, it works with users called liquidity providers. These users add funds to liquidity pools, which are smart contracts that contain funds.

Liquidity Mining is when a yield farmer receives a new token and the expected return in exchange for the farmer’s liquidity. It represents a network participation strategy in which a user provides capital to a protocol in return for that protocol’s native token. What is particular to liquidity mining is that the network has a specific need, which is liquidity provisioning, so the users do not need to purchase tokens. Instead, they are rewarded with tokens that allow their holders to vote on protocol parameters, including value capture mechanisms. Liquidity mining supercharges yield farming. The tokens’ value is stimulated by the network’s usage, creating a positive usage loop that attracts users. Apart from being a lending platform, Compound is also the most popular liquidity mining platform. Its purpose is similar to the previous products described: decentralizing the product and giving a fair amount of ownership to those who make the platform popular. The ownership would take the form of the COMP token.

The difference between yield farming and liquidity mining is that yield farming is a process through which people maximize yield by automatically moving funds. Through liquidity mining, people earn tokens by giving liquidity.

Money Legos

Money Legos is a Node Package Manager package (online repository for publishing open-source Node .js projects) that provides users the mainnet addresses, ABIs, and Solidity interfaces for popular DeFi protocols. Money Legos allow the DeFi ecosystem to benefit from individual progress. The concept is associated with everybody’s childhood toy, Lego. As people visit a large bin of random legos, pieces get combined in new and creative ways. Then, when people dive into the Lego bin, they find preassembled combinations of Legos, which can be used to build bigger and better things, creating a whole new Lego universe. Similar to this, DeFi projects are designed not only as stand-alone products but also as easily integrable parts of innovative projects.

This snowball way of developing the ecosystem leads to a whole new world of decentralized financial products.

MakerDAO is a money legos tool, in which DAI and the custom smart contract are considered the lego pieces. MakerDAO accepts ETH as collateral for a loan in DAI. This way, users are allowed to take out funds in DAI without selling off Ether. Thus, they maintain exposure to the price of ETH while using Dai.

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Your shortest DeFi dictionary was originally published in Data Driven Investor on Medium, where people are continuing the conversation by highlighting and responding to this story.