Whereas cryptocurrencies seek to decentralize money, DeFi seeks to decentralize the entire financial system. Decentralized Finance is providing the capabilities for crypto holders to do so much more with their crypto, to earn interest on it, to loan it, and to borrow it without any middleman. Essentially, DeFi is the framework that allows crypto to be put to work the same way FIAT is put to work in traditional finance and it promises to change the global economy forever.
However, for all the excitement surrounding DeFi, it can seem very intimidating for newcomers. There are a lot of terms that simply do not exist in traditional finance. This article is going to serve as a guide for some of the most general terms so that you can start to understand and engage in DeFi.
You may know Ethereum simply as a cryptocurrency but it is, in fact, so much more than that. Ethereum is a decentralized network of computers that utilizes a blockchain to create an entire decentralized ecosystem. In effect, Ethereum is a programmable blockchain. Developers can create decentralized financial services, games, and applications that are free from centralized control.
Ethereum is the second biggest cryptocurrency but, because of its programmable nature, it is the main platform for DeFi. Many other cryptocurrencies that support DeFi protocols are modeled off Ethereum in some way.
Smart contracts are programs that run on a blockchain. Developers can create these smart contracts and program them in ways that facilitate lending, borrowing, trading, and so much more. They are what allows transactions to occur trustlessly and what makes DeFi possible.
Whenever a transaction occurs on a blockchain, a fee representing the computational effort required to process a transaction, known as a gas fee, must be paid to validators. Validators are users who are responsible for processing transactions and adding new blocks to a blockchain, ensuring its security.
A dApp, or a decentralized application, is an application that runs on a blockchain as opposed to a centralized server. They store data on the blockchain and utilize smart contracts for their logic. Because they are controlled by the smart contract’s logic, they are free from centralized control.
Tokens are a type of digital asset that is stored on blockchains like Ethereum. They can be used to represent almost anything. Tokens differ from coins like Ethereum or Bitcoin in that they are not the native currency for that blockchain. Anyone can create their own token as they are smart contracts. However, tokens also have development standards to ensure composability with other contracts. Two of the most popular token standards include:
- ERC-20: The token standard for fungible tokens such as $UNI or $MLN. ERC-20 tokens are exactly the same in type and value, allowing for the most common use cases you see in DeFi such as trading, lending, borrowing, staking, and voting.
- ERC-721: The token standard for non-fungible tokens (NFTs). NFTs can be used to identify something that is unique, due to its non-fungible nature.
Tokenomics, derived from “token” and “economics”, refers to the economic characteristics of a cryptocurrency. Whenever a project launches a token, it will release a plan for how the token will be used and how it will be distributed. This will include who gets tokens from the initial launch, how the tokens are allocated, how many go on general sale, how long these tokens are locked for before they can be sold, how many are released over a specific period of time, and the total (if any) that can ever be created. All of these factors, and much more, are included under the umbrella of tokenomics and help a buyer determine if the token is a good investment.
A DEX, or decentralized exchange, is an exchange where users trade with one another without the need for a centralized body. Unlike centralized exchanges, that utilize an order book model, DEXs tend to use a mechanism called Automated Market Makers (AMMs) to facilitate peer-to-peer trading. AMMs utilize what is called a liquidity pool i.e. a smart contract containing a pool of assets to enable trades to occur through an algorithm (more details below).
Liquidity pools are an essential part of a DEX. A liquidity pool is a smart contract that locks in a pool of tokens. Traders can use this pool to trade. They will input one token and receive the other. The pool will then automatically reprice the assets, ensuring that an equal valuation of each remains. This mechanism is what allows DEXes to eliminate a centralized body or market makers. Anyone can also add tokens to a pool, becoming a liquidity provider (LP), and receive a portion of the trading fees for that pool.
Proof of Stake (PoS) has become the most popular form of the validation process in crypto. Every time a transaction is made, its validation is voted on by all members of the network. A node’s (or computer’s) vote is weighted based on how much crypto they have staked. The node will then be rewarded with part of the transaction fee.
Staking is one of the simplest ways to earn rewards on your crypto.
Yield Farming, also known as liquidity mining, is the process of adding tokens to liquidity pools. By adding tokens into liquidity pools, you are essentially providing more liquidity to that pool. In exchange, you receive a portion of the trading fees for that pool and any extra incentive set by the protocol.
Annual percentage return and annual percentage yield are two ways to measure the return on your staked crypto. The difference between the two is that APY takes into account compounding, allowing the total return to grow substantially bigger.
As we’ve mentioned, a liquidity pool reprices the assets it stores every time a trade is made. When the time comes to withdraw your funds, you’ll always receive an equal valuation of each token. This means that if the price of one increases, you’ll receive less of that token. This leaves you exposed to something called impermanent loss.
Impermanent loss is the difference between how much you have when you withdraw your funds and how much you would have had had you not contributed to the pool. It’s important that the return you make yield farming is greater than the impermanent loss in order for you to turn a profit.
A Decentralized Autonomous Organization is an entity without a centralized governing body where ownership and management fall to its community. Generally, a token will give holders access to voting rights to decide the direction of the DAO. Users can propose plans and everyone else can vote on them. DAOs will usually govern on-chain projects which means that plans can be implemented automatically. In other words, the system is trustless, the code will automatically implement the winning proposal. Think of it like an internet-native, community-owned corporation.
As you can probably tell, a lot goes into choosing a Web3 investment. That’s why Capital-as-a-Service (or CaaS) is such a significant tool. Exponent is the decentralized Capital-as-a-Service (CaaS) protocol that enables Web3 organizations to grow, monitor, and manage the risks of their idle crypto capital. Three core components of CaaS include:
- A bespoke non-custodial vault built on Gnosis Safe and Enzyme Finance,
- Automated capital allocation and yield optimization strategies
- A Suite of risk monitoring and alerting tools
The protocol is operated by the core Exponent team with the vision to launch a community-driven decentralized governance mechanism using XPN as the native ERC-20 token. The Exponent CaaS will first be available on Ethereum and Polygon. Cross-chain services are expected to launch in the second half of 2022.