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Lesson No. 9: DeFi Terms
Exploring DeFi terms and concepts.
Welcome back, readers! In our last lesson, we covered alternative Layer-1 blockchain networks. Today, we’re diving deeper into DeFi by providing simple explanations of the following terms and concepts:
Liquidity Providers (LPs)
Automated Market Makers (AMMs)
Vladimir Kazakov | Getty Images
Introduction to DeFi
DeFi (decentralized finance) solves issues that exist in the traditional financial market by replacing centralized institutions with blockchain technology. Comprehension of these terms is essential to fully understand the DeFi model.
To buy an NFT or purchase crypto, you'll first need a crypto wallet. To make transactions, you'll need your public key or wallet address (like your bank account number), and your private key (like your bank account PIN). There are different types of wallets and they all provide distinct benefits. Custodial wallets are centralized crypto exchanges (like Coinbase) that hold your private keys for you. Noncustodial wallets allow users full control of their private keys. Hot wallets are connected to the internet, while cold wallets are hardware devices that keep your data offline (like a USB drive). There are also software, hardware, and paper wallets. One can have a noncustodial software hot wallet, a custodial hardware cold wallet, or other types depending on your personal need.
Crypto whales are individuals or organizations that hold large amounts (about 10%) of a specific coin or token. Whales often can influence market prices because of their large holdings. They also impact Proof of Stake (PoS) protocols because they have more voting power. This raises concerns over voting allocation and centralization of power. Notable crypto whales include Brian Armstrong (CEO of Coinbase), Changpen Zhao (CEO of Binance), and Falcon Global Capital (British investing firm).
The best way to understand the role played by Oracles is to think of them as middlemen between the blockchain network (on-chain) and the outside world (off-chain). Essentially, oracles provide blockchain networks and smart contracts the ability to interact with real-world data. Consider this example: John makes a $5 bet with Casey that the New England Patriots will defeat the Atlanta Falcons in the Super Bowl. They create a smart contract reflecting this wager. An oracle will feed the result of the Super Bowl to the smart contract, initiating an automatic transfer of the funds depending on the result.
This example is helpful because of its simplicity. In reality, oracles are much more complicated because of their ability to authenticate, verify and provide data in real time. This is important in the context of DeFi because market prices fluctuate every second, and participants in a network need to be certain that the data provided is accurate. Check out this Forbes article for a deeper understanding.
4. Liquidity Providers (LPs)
You may have heard the word “liquidity” being thrown around a lot, not just in the context of DeFi but in any conversation regarding money or assets. Liquidity simply refers to the availability of a particular asset (usually cash). For example, when a business is said to be liquid, it means it has easy access to cash to meet whatever obligations or debts it may have.
A liquidity provider refers to someone who deposits cryptocurrency tokens into a DeFi platform, typically in a liquidity pool (explained below). In return for depositing their cryptocurrency, a liquidity provider earns fees as a reward.
5. Liquidity Pools
In the traditional financial market, a liquid asset refers to one that can be sold at a price close to the market price. Stocks and bonds are highly liquid, meaning they can be easily and immediately converted into cash for the expected value. Regular exchange markets can meet immediate demands from large orders because of market makers. These companies (large banks or financial institutions) provide liquidity and volume to the market and facilitate market efficiency.
This model can't be applied in the decentralized ecosystem. To achieve economic decentralization, market makers are replaced by liquidity pools that store cryptocurrencies by locking them in a smart contract. Liquidity pools are funded by liquidity providers (LPs) who lend their crypto assets and are rewarded by liquidity pool tokens (LPTs). Liquidity pools are essential to DeFi because they provide a steady supply of buyers and sellers which facilitates efficient trading.
6. Yield Farming
Liquidity pool investors are liquidity providers (LPs), and the returns they receive are through yield farming. Yield farming (aka liquidity farming) is the process of earning rewards by lending crypto assets to DeFi protocols or platforms. DeFi platforms provide different yield rates, rules, and risks causing yield farmers to move their funds around. The search for high yields has resulted in yield farming strategies, such as: staking, lending, and NFT-Fi.
7. Automated Market Makers (AMMs)
To understand AMMs, it is important to understand what a market maker does. Say you had $200 and wanted to exchange them for Euros. You would need to find an individual who not only has Euros they are willing to exchange for Dollars but are willing to do it at an exchange rate acceptable to you. A market maker is an individual or an institution that is always willing to buy and sell assets. They play a key role in markets by providing liquidity, ensuring that you always have the opportunity to make a trade.
AMMs play a key role in the DeFi ecosystem by replacing institutional market makers with liquidity pools that are based on smart contracts and mathematical equations. AMMs ensure DeFi protocols like Uniswap are decentralized, allowing users to trade at any given time without interacting with other traders.
8. Impermanent Loss
Understanding impermanent loss is essential for any DeFi participant. Impermanent loss occurs when the price of the token you have deposited in a liquidity pool is lower than what it was when you first deposited it. So, if you decide to withdraw your tokens, you get back less than what you had put in. The reason why it's called “impermanent” loss is because if you choose not to withdraw your tokens from the pool you haven’t actually lost anything. This is a very simple explanation. In reality, an impermanent loss is a bit more complicated because it is based on how liquidity pools are designed to work on mathematical ratios, and arbitrage traders play a role in the entire process. Check out this article by Binance Academy for a deeper understanding.
Tokenomics is a combination of the words “token” and “economics.” Essentially, tokenomics refers to all the factors that make a particular cryptocurrency worth investing in. These factors are wide-ranging, spanning from a token’s total supply to the utility it provides.
It is helpful to consider each cryptocurrency token as an economy in itself. Like every economy, factors like demand, supply, rewards, and utility play key roles in how valuable a token is to investors. Therefore, whether a particular token has a limited or unlimited supply, the fees earned by depositing it on platforms, and whether it gives you access to services all influence how attractive an investment it is.