DeFi Made Simple: Your Go-To Glossary for Understanding Decentralized Finance Terms

DeFi has gained a lot of attention in recent years. And why not? It is one of the most revolutionary things that happened to finance in centuries.

A report by Statista states that the revenue in the DeFi market is expected to hit a staggering US$26.17 billion in 2024. This growth is fueled by increasing user adoption, with the average user generating a substantial US$1,378 in revenue.

DeFi has a lot of untapped potential. While it's gaining popularity, many are still intimidated by its complex jargons. This article aims to simplify DeFi terminology, making it easier for beginners and experts alike to understand and dive into the world of decentralized finance.

1. DAO

A DAO, or Decentralized Autonomous Organization, is a community-run entity governed by rules encoded on a blockchain without central leadership. Members make decisions collectively through voting, and smart contracts automatically enforce these decisions. DAOs enable transparent, democratic control of financial services, where participants have a direct say in the organization’s roadmap, replacing the need for traditional intermediaries like banks or financial intermediaries.

2. Dapp

A DApp (Decentralized Application) is an application that runs on a blockchain or peer-to-peer network rather than relying on a centralized server. Unlike traditional apps, which are controlled by a single company or entity, DApps operate in a decentralized manner, with their data and backend code distributed across a blockchain. The Ethereum blockchain is the most widely used platform for dApps, serving as a vast library where most DeFi dApps are built and hosted.

3. Immutable

Immutable refers to the characteristic of a blockchain that ensures data cannot be altered or modified once recorded. This property guarantees the integrity and permanence of transactions, making it impossible to change historical records, which enhances trust and security within the blockchain ecosystem.

4. Flash Loan

Flash loan is a unique, uncollateralized loan in DeFi that allows users to borrow and repay funds within the same blockchain transaction, usually within seconds. Unlike traditional loans, no collateral is needed because the loan must be repaid immediately.

If the borrowed amount isn’t repaid during the transaction, the loan is canceled, and the funds are returned to the lender automatically. Flash loans are often used for arbitrage, debt refinancing, or executing complex financial strategies, taking advantage of the speed and flexibility of smart contracts. However, they also come with risks, as they can be exploited in certain attacks if not appropriately managed.

5. Gas Fees

Gas fees are the transaction fees paid to compensate for the computational power required to process and validate transactions on a blockchain, particularly on networks like Ethereum. These fees are measured in a unit called gwei, a small fraction of the cryptocurrency Ether (ETH).

Gas fees prevent spam by attaching a cost to each transaction. The amount paid can fluctuate based on network demand—when activity is high, users may have to pay higher fees to prioritize their transactions. This makes gas fees essential to maintaining decentralized networks' functionality and security.

6. Governance and Governance Tokens

Governance refers to the system by which decisions are made regarding the development, management, and future direction of a DeFi protocol by the community of users through a transparent and democratic process.

Governance Tokens are digital assets that give holders the right to participate in governance decisions, such as voting on protocol upgrades, changes in fee structures, or new feature implementations. The more governance tokens a user holds, the greater their influence in decision-making. Token holders can propose new ideas, vote on important issues, or delegate their voting power to others.

7. Governance Protocol

Governance protocols are mechanisms that allow communities to make decisions about a blockchain network. Token holders can propose and vote on changes, ensuring the network remains decentralized and adaptable. While governance protocols offer benefits like transparency and community involvement, they also face challenges such as complexity and potential manipulation.

8. Yield farming

Yield Farming is a way to earn rewards by depositing cryptocurrency on a decentralized exchange (DEX) or app (dApp).

For example, you can deposit your cryptocurrency (like Ethereum or a token) on a platform/protocol. In return, you earn rewards (often in the form of more cryptocurrency). You can then use these rewards to deposit on other platforms for even higher returns.

9. Liquidity

Liquidity refers to the availability of assets that can be easily bought or sold in a market without causing significant price changes. It represents how easily users can convert cryptocurrencies into cash or other tokens.

High liquidity in a market means that there are enough buyers and sellers, allowing transactions to occur quickly and at stable prices. Conversely, low liquidity can lead to slippage, where the price of an asset changes unfavorably between the time a trade is initiated and when it is completed.

In DeFi, liquidity is crucial for functioning various protocols, including decentralized exchanges (DEXs) and lending platforms. Users provide liquidity by depositing their assets into liquidity pools, which are used to facilitate trading or lending. In return, they earn rewards, often in the form of transaction fees or governance tokens.

10. Liquidity Pools

Liquidity pools are like a marketplace for cryptocurrency trading. They're on decentralized exchanges (DEXs) and allow people to trade directly with each other. Smart contracts keep things fair and balanced.

How it works: People deposit their cryptocurrency into these pools. In return, they get tokens from the DEX. These tokens earn fees every time someone trades on the platform. It's like earning rent from a property.

11. NFTs

NFTs, or Non-Fungible Tokens, are one-of-a-kind digital assets representing verifiable ownership of something, such as a piece of art, a collectible, or even a virtual item. Each NFT is distinct and cannot be replicated. They are stored on blockchain networks, ensuring their authenticity and security.

There are two main types of NFTs: ERC-721 and ERC-1155. ERC-721 is for individual, unique items, while ERC-1155 is a mix that is often used in gaming.

12. Pump and Dump

Pump and Dump involve artificially inflating the price of a cryptocurrency only to sell off their holdings all at once, leading to a sharp price crash. This practice is widespread with new token listings, where hype and private pre-sales can trigger an initial price spike before it falls.

It's essential to be aware of pump-and-dump schemes and exercise caution when investing in cryptocurrencies. Research thoroughly, be skeptical of sudden price spikes or exaggerated claims, and diversify your investments.

13. Smart Contracts

Smart contracts are self-executing contracts with terms directly written into lines of code. They are deployed on a blockchain network, ensuring transparency, security, and immutability.

These contracts automatically execute when predetermined conditions are met, eliminating the need for intermediaries. They are used in various DeFi applications, such as decentralized exchanges, lending platforms, derivatives, and gaming, to automate processes, enforce agreements, and reduce the need for trust.

14. Stablecoins

Stablecoins are cryptocurrencies designed to maintain a stable value relative to a fiat currency, such as the US dollar or the Euro. Unlike traditional cryptocurrencies, which can experience significant price fluctuations, stablecoins aim to minimize volatility.

Stablecoins play a crucial role in the DeFi ecosystem by providing liquidity, enabling users to conduct transactions without the risk of price fluctuations, and serving as a bridge between the traditional financial system and the world of cryptocurrencies.

15. Staking

Staking is a process in the cryptocurrency world where you deposit your tokens to earn rewards. It contributes to network security and can be a way to earn additional tokens. There are different types of staking, such as Proof of Stake and yield farming. However, it's essential to understand the risks involved before staking your cryptocurrency.

16. Proof of Stake

Proof of Stake (PoS) is a consensus mechanism blockchain networks use to verify transactions and maintain the network's integrity.

PoS rewards network participants based on their stake in the network. In PoS, participants stake their cryptocurrency holdings to become validators, who are selected to create new blocks in the blockchain. Validators receive rewards for their contribution, making PoS a more energy-efficient and democratic alternative to PoW.

17. Proof of Work

Proof of Work (PoW) is a consensus mechanism used by blockchain networks to verify transactions and maintain network security. It involves solving complex mathematical puzzles to create new blocks of transactions.

18. APY

Annual Percentage Yield (APY) is the effective interest rate that takes into account compounding over a year. It's used to compare investments and understand their growth potential.

For example, if you invest $100 at a 5% annual interest rate compounded monthly, your APY will be slightly higher than 5% because of compounding.

19. Deposit APY

Deposit APY (Annual Percentage Yield) is the annual interest rate you earn on your cryptocurrency when you deposit it on a lending and borrowing platform. It's influenced by market conditions, platform popularity, and risk. Higher APYs often come with higher risks, so it's essential to research and understand the risks before depositing your cryptocurrency.

20. Borrow APR

Borrow APR is the annual interest rate you'll pay on a cryptocurrency or stablecoin loan. It's influenced by market conditions, collateral value, and platform policies. Higher APRs mean higher loan costs, so comparing rates and understanding the risks is important before borrowing cryptocurrency.

21. Stable APR

Stable APR is a fixed interest rate that remains unchanged throughout the loan term. It offers predictability and stability but may have higher initial rates and limit the opportunity to refinance if interest rates fall. It's suitable for those who prefer certainty and long-term planning. ‍

22. Variable APR

Variable APR is an interest rate that can change over time. It offers lower initial rates and the potential for savings if interest rates fall but also introduces uncertainty and the risk of rising rates. It's suitable for those comfortable with risk and believing interest rates will decline.

23. Tokenomics

Like an investor prospectus for a company’s shares listed on a stock market, tokenomics outlines a newly issued token's essential functions and projected performance. It typically includes details such as the total number of tokens to be issued, their distribution methods, and the rights and functionalities associated with them.

24. Token

Tokens are similar to company shares. They represent ownership in a specific project, like a DAO, DEX, or dApp. The most common token type is ERC-20, which runs on the Ethereum blockchain. Some tokens give holders the right to vote on how the project is managed. These are called governance tokens.

25. DEX/CEX

DEX (Decentralized Exchanges) and CEXs (Centralized Exchanges) are two different types of cryptocurrency trading platforms. DEXs operate without a central authority, allowing users to trade directly with one another through smart contracts on a blockchain, which means users retain complete control of their funds and private keys, enhancing security and reducing the risk of hacks.

They typically use automated market makers (AMMs) or order book models to facilitate trades, often requiring little to no personal information, thus offering greater privacy.

CEXs are managed by a centralized entity that acts as an intermediary, handling transactions and maintaining order books. Users deposit their funds into the exchange's wallets, which means they do not have direct control over their assets during trading.

26. Automated Market Maker (AMM)

Automated Market Makers (AMMs) are decentralized exchanges (DEXs) that use a mathematical formula to set asset prices. Unlike traditional exchanges that match buyers and sellers using an order book, AMMs automatically calculate prices based on the supply and demand of assets in a liquidity pool. Popular AMMs include Uniswap, Curve Finance, and Balancer.

27. TVL/TLV

TVL (Total Value Locked) is a crucial metric in DeFi that measures the total amount of money invested in a platform, whether it's a decentralized exchange (DEX), a decentralized application (dApp), or the entire ecosystem. It's like the total amount of money a bank holds in deposits.

While TVL is often used to gauge the success of DeFi projects, it's important to remember that it doesn't always tell the whole story.

28. Peer to Peer (P2P)

Peer-to-peer (P2P) networks are decentralized systems where participants (peers) contribute to the network's operation and share resources directly with each other. Unlike traditional client-server models, no central authority or server is controlling the network. Instead, each peer acts as a client and a server, connecting directly to other peers on the network.

29. Non-Custodial

Non-custodial refers to a type of cryptocurrency wallet where users have direct control over their private keys, meaning they are solely responsible for the security and management of their funds. Non-custodial wallets empower individuals to maintain full ownership of their cryptocurrencies. This provides a higher level of security, as users are not reliant on an external entity to safeguard their assets, thereby reducing the risk of hacks, theft, or mismanagement associated with custodial solutions.

Wrapping Up

As DeFi continues to gain momentum, its potential for revolutionizing finance is undeniable. With revenue projections soaring and increasing user adoption, it's an exciting time to explore this innovative space. By demystifying DeFi terminology, we hope to empower more people to embrace this transformative technology and unlock its vast potential.

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