PYMNTS Cryptocurrency Glossary: Decentralized Finance or DeFi

Cryptocurrency is a confusing business with a language all its own, in part because it is a genuinely new way of doing business and also because it was created in large part by programmers and cryptographers, who should never be allowed to name anything regular people will use.

See also: Dai or Die: ‘Payment Stablecoins’ and Why the Taxonomy of Crypto Matters

Cryptocurrencies have a lot of uses as an investment, as a currency for payments, as a store of value, as well as others. Like any investment, it’s vital to know what you’re talking about and more importantly, what the person trying to sell you something is really saying. And like any other field of finance, industry, art or basically every human endeavor, it has its own lingo, acronyms and definitions — and especially in matters of law and finance, definitions matter.

Read more: DeFi Series: DeFi’s Very Real Risks

In this series of articles, we’re going to create a number of glossaries for various parts of the crypto industry, which we’ll combine into a larger reference tool. Today, we’re talking about the hottest, riskiest, most lucrative, most scam-ridden part of crypto: decentralized finance.

Read more: PYMNTS Cryptocurrency Glossary: The Basics

PYMNTS Cryptocurrency Glossary: Regulations, Legal and Crime

Aggregator: A crypto investment program that searches for the best returns from liquidity pools and the best trade rates offered on various decentralized exchanges, making it easier for investors to find the best returns across many different platforms and protocols without having to bounce around from one to the other.

Algorithmic stablecoin: The DeFi version of a stablecoin maintains its dollar peg through a smart-contract-controlled arbitrage mechanism that incentivizes buying and selling a partner token with a free-floating price. When it fails, it fails big. Some also use overcollateralized crypto reserves (see forced liquidation below).

Read also: DeFi Series: What Is an Algorithmic Stablecoin? DAI and the Fiat-Free Dollar Peg

Annual percentage rate (APR): The interest generated over a year by an investment. In DeFi projects, returns are generally expressed in APR or APY (see below) but are paid frequently — daily and even hourly are not unusual.

Annual percentage yield (APY): The interest generated over a year by an investment, factoring in compounding interest. In DeFi projects, returns are generally expressed in APY or APR (see above) but are paid more frequently — daily and even hourly are not unusual.

Automated market maker (AMM): Decentralized exchanges’ answer to the traditional equities market maker, which is usually a large bank or financial institution that provides liquidity by guaranteeing to buy securities (bid) at a specified price and sell them (ask) at another price. This prevents a buyer from having to seek out a seller who wants a specific quantity of a specific equity at a specific price. Market makers profit from the bid-ask spread.

In a decentralized exchange, this function is carried out by a smart contract-controlled AMM which uses a Liquidity Pool (see below) of crypto funds pooled by investors in exchange for transaction fees and sometimes other cryptocurrency token rewards.

See more: DeFi Series: What Is an Automated Market Maker? The Beating Heart of DeFi

Borrowing/lending platform: One of the core DeFi project categories, these platforms allow lenders to lock in various cryptocurrencies — anything from ether to stablecoins to platforms’ own native tokens in exchange for “yield.” This can soar sky high, with 20% or more yields not uncommon. Like anything, the higher the return the riskier the investment.

Users can borrow stablecoins or other tokens by putting up crypto collateral — 125% to 150% of the amount borrowed is common to account for price volatility. If a token’s value drops close to the amount borrowed a margin call will be made, followed by a forced liquidation (see below).

The point is to get temporary liquidity out of crypto holdings without selling the bitcoin (or whatever) that you believe will continue to grow in value.

Read more: Crypto Basics Series: How Does Decentralized Crypto Lending Work?

Bridge: Bridge platforms are designed to facilitate cross-chain payments by forcing someone to sell one cryptocurrency and buy another, and then possibly reverse the transactions, racking up four transaction fees. Bridges are basically lending programs. You deposit one token (let’s say bitcoin) and receive a newly minted wrapped ether (wETH) token that is usable like ether on an Ethereum-based platform. Return the wETH and it is burned and your tokens returned (minus one fee). This is very straightforward and popular.

A big problem is security. These bridge programs take custody of your collateral and by necessity keep it in an online hot wallet, which makes it hackable. In the first six months of 2022, poorly developed bridges were hacked to the tune of well over $1 billion and closer to $1.5 billion.

Read also: The $100M Hack and Crypto’s Cross-Chain Payments Problem

CeFi: Centralized finance, meaning crypto projects with human management.

Decentralized autonomous organization (DAO): The smart-contract-controlled governance systems of all DeFi projects. DAOs have their own governance tokens that give a single vote on any change to the project, from code updates to a borrowing/lending program’s interest or fee rates.

Read more: DeFi Series: Unpacking DeFi and DAO

Decentralized Finance (DeFi): Any smart-contract-managed, DAO-governed (see above) crypto financial project.

See also: DeFi Series: What Is DeFi?

DApp: A decentralized application, meaning essentially any platform or software application built on a blockchain.

Decentralized exchange (DEX): A decentralized cryptocurrency exchange that is managed by a DAO and uses an AMM for liquidity.

Ethereum: The No. 2 blockchain by market capitalization, it is where smart contracts were created and first used. The vast majority of DeFi platforms (and many other crypto projects and DApps) are built on it. A years-long switch to an environmentally friendly and vastly more scalable proof-of-stake consensus mechanism is in the works as of August 2022.

See also: Blockchain Series: What Is Ethereum? The Blockchain That Moved Crypto Beyond Currency

Ethereum killer: A smart contract blockchain that seeks to lure projects and developers from Ethereum, generally by offering superior scalability, charging lower fees, offering faster finality among other things. They are largely environmentally friendly as well.

Ethereum virtual machine (EVM): Smart contracts on Ethereum run in a separate, protected environment rather than on the blockchain itself like more basic transactions. These environments are the EVM.

Fair launch: When a project’s developers do not keep a huge supply of tokens for themselves or for early seed and venture investors that can give them excess power over a DAO-controlled DeFi project.

Flash loan: One of the trickiest parts of DeFi lending/borrowing projects, flash loans are taken out and repaid in a single transaction, using them for some very quick purposes like certain DeFi investments or a governance vote.

Forced liquidation: When a borrower doesn’t meet a margin call, their collateral is automatically sold by a DeFi lending platform’s smart contract. Crypto volatility means this can happen very fast — as in overnight while you were asleep — and your crypto can be sold for a big loss in an industry in which even bitcoin can drop 10% in a day or even a few hours, often popping back fairly quickly.

Gas: The name for transaction fees on the Ethereum blockchain

Governance token: A native token issued by a DAO-controlled (see above) DeFi project that gives a vote on governance issues like code updates or setting fees.

Gwei: Each of Ethereum’s ether tokens is divided into one billion gwei, in the manner of dollars and cents. Ethereum gas (transaction) fees are denominated in gwei.

Impermanent loss: One of DeFi’s more frightening features, impermanent loss comes when the value of crypto an investor has locked into a liquidity pool drops, showing a “paper” loss (or gain if it rises). So with stablecoins, it would be virtually nothing, and with ether, it could be steep. The key is that these losses or gains don’t become permanent until funds are withdrawn from the pool.

Leverage: In DeFi, leverage is basically margin borrowing on exchanges for various purposes like derivative investments. These can be dangerously high, as in 10x, even 100x.

Liquidity: How quickly and easily an asset can be sold on a marketplace like a cryptocurrency or equities exchange without affecting its price. The higher the liquidity, the easier it is to sell an asset for its full value.

Read also: DeFi Series: What is Yield Farming and Liquidity Mining?

Liquidity pools: A pool of crypto funds deposited by multiple investors to provide liquidity to DEXs, lending protocols and other DeFi projects in exchange for yield (see APY above) and token rewards. There can be a waiting period before funds can be withdrawn.

Liquidity providers: Investors who supply liquidity pools with their assets in trading pairs. For example, USDC and ether, so buyers and sellers can go either way.

Liquidity provider token: Cryptocurrency tokens minted and given to liquidity providers, representing their share of a liquidity pool. They can be returned to withdraw the tokens invested in a pool. They can generally be sold, staked and used for loan collateral, creating the potential for complex yield farming (see below) investment strings.

Metamask: An popular Ethereum digital wallet required by many DeFi projects and platforms.

Multisig wallet: A type of digital wallet that requires multiple keys from multiple sources to open. They are frequently used in DAO governance

Native token: A native token is a cryptocurrency issued by a single blockchain, protocol or platform that can or must be used for internal transactions and other uses. Projects built on Ethereum can create native tokens built to standards that let them work on that blockchain — the most common being ERC-20, but non-fungible tokens (NFTs) are often built to a different standard, ERC-721.

Noncustodial: Platforms and projects that manage users’ cryptocurrency assets without taking actual possession and control of the private keys required to transfer tokens — essentially their ownership papers — are noncustodial. A common phrase in the crypto industry warning against custodial projects that take possession of those keys is “Not your keys, not your crypto.”

Oracle: A service that provides trusted sources of information to DeFi projects — for example, weather reports or sports scores — that can be parties to a self-executing smart contract agreement can be used to fulfill terms and pay out.

Read more: Smart Contracts Get Weather-Savvy With AccuWeather on the Blockchain

Over-collateralized: DeFi lending/borrowing programs require borrowers to put up more crypto than the value of the tokens or stablecoins they are borrowing to account for price volatility — generally 125% to 150%.

Prediction market: In a way this is gambling, but there’s more to it. Participants bet on the outcome of anything from an election to whether the Federal Reserve will raise interest rates, with the odds used to predict the outcome. Basically, people tell the truth and indicate the strength of their beliefs because they are putting their money where their mouth is. So the theory goes.

Slippage: In an exchange or marketplace, slippage is the difference between the expected price when an order is made and the actual price when it is executed. The high volatility of crypto means that slippage can be larger than in traditional markets. Poor liquidity is another reason for this.

Spread: The difference between the highest price a buyer is willing to pay (bid) and the lowest price a seller will accept (ask). A bid-ask spread is a good way to measure a market’s liquidity. Automated Market Makers (see above) that provide liquidity in DeFi markets make their profits from the spread.

Stake: A stake is basically a bond that a validator (see below) puts up in exchange for securing and adding new transactions to a proof-of-stake blockchain to guarantee good behavior. Anything from node downtime to approving an invalid transaction cause that stake to be automatically slashed — or seized.

See also: Crypto Basics Series: What’s a Consensus Mechanism and Why Is It Destroying the Planet?

Staking: In a proof-of-stake (PoS) blockchain, staking is the heart of the consensus mechanism replacing Bitcoin-style crypto mining. Instead of competing to solve a math puzzle first, PoS blockchains rely on validators who put up a stake in that blockchain’s native token. In PoS, randomly selected validators (see below) add new transactions to a blockchain. Instead of being totally random, they are selected in proportion to how much of the staking pool they possess, so if you put up 5% of the total you’ll get 5% of the rewards over time.

There’s an offshoot of this that is a major part of the DeFi ecosystem. Validators can increase the size of their stakes and their earnings by allowing other investors who don’t want to handle the work of running a full blockchain node and validating transactions — or can’t afford the minimum investment, to add their crypto to the validator’s stake in return for a cut of the profits.

Total value locked (TVL): The amount of tokens invested in a DeFi project like a lending pool. It can be expressed in either that token (often ether) or more often dollar value.

TradFi: Traditional finance. Meaning any non-crypto financial product or institution.

Validator: In a proof-of-stake blockchain, a validator replaces Bitcoin-style proof-of-work miners in providing security and ensuring that transactions are accurate and honest before they are added to a new block that is written onto the blockchain in exchange for rewards. They put up a stake (see above) that acts as a bond for good behavior and determines the size of their rewards.

Wrapped cryptocurrencies: By wrapping bitcoin, you lock it into a platform that gives a token usable on ethereum. You get the bitcoins back by returning them. There are many variations on the tokens that can be wrapped.

Yield farming:  Lending out cryptocurrency to a DeFi protocol that puts it in a lending pool in order to earn interest. These can get very complex.

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