6 Cryptocurrency Buzzwords You Should Know Before Investing
Common misconceptions debunked
Cryptocurrency is blowing up once again with Defi ( Decentralised Finance) taking the center stage in the current bull market cycle of 2021.
Naturally, there are so many terminologies that make it confusing to wrap our heads around — especially for beginners. In the following sections, I’ll discuss a few crucial terms that are good to know before you think of investing. While some of them might be obvious, you could be in for a surprise with others.
#1 — Coin vs. token
To kick things off, let’s shine a light on the trivial concepts that most people refer to interchangeably. Yes, coins and tokens aren’t the same things as you might have supposed them to be.
Coins are a native asset of the blockchain network whereas tokens are built on top of another blockchain platform.
So, Bitcoin and Litecoin are coins, our meme currency Dogecoin is also a coin whereas ChainLink and Uniswap are tokens. To our amazement, USDT (Tether) which is popularly termed as a stable coin is actually a token.
Most tokens that you’d notice today are built on top of the Ethereum network. It’s also worth knowing that Ethereum is not a coin. Instead, it’s a blockchain network with Ether ( ETH) being the actual name of the coin that’s native to it.
Besides conforming to the blockchain network’s protocols, the owner of the token needs to create a smart contract that defines certain rules such as maximum circulation supply, burn rate, and more. Most tokens created on the Ethereum network use the standard ERC-20 protocol whereas the Non-fungible (NFT) ones adhere to ERC-721.
So how are coins and tokens related?
Simply put, transferring tokens on the blockchain or interacting with its smart contract requires a fee. This transaction fee is known as gas. For the Ethereum network, you need to pay for that gas in ETH which eventually gets rewarded to the miners who verify that transaction (more on this later).
Given the number of tokens on the Ethereum, the network is highly congested right now which should explain why the ETH gas price has been skyrocketing lately.
Okay, explain the difference to me in simple words
Think of coin like a programming language. Let’s say Java. The token is a framework that’s built upon it. In other words, a coin is to a token as Java is to Android.
Most coins are deemed as currencies whereas tokens are perceived as a utility value. Bitcoin on its own was largely seen as the future currency initially. However, given its volatility, it is now perceived as a store of value. Ethereum on the other hand is a giant ecosystem on which you can build apps.
#2— Proof of Work vs. Proof of Stake
We know that banks continuously monitor payments in a way that no avoid erroneous transfers occur.
But, blockchain is a decentralized system. So how do we validate digital currency transfers?
Two popular mechanisms are implemented in most cryptocurrencies to ensure there’s no room for fraudalent activities.
What is Proof of Work?
Proof of work (PoW) is a solution that’s seen in Bitcoin and Ethereum networks since the beginning. Basically, it’s a technique that requires mining — a process where every miner bundles the recent transactions and then competes in solving a complex hashing math puzzle.
The miner(it’s a computer, basically) who solves the problem first gets to add the block(a collection of transactions) and is rewarded in the cryptocurrency once the transaction is verified by a majority of other nodes.
With more miners joining the workforce, the difficulty level of the math puzzle increases in order to keep the block time intact. While this does a great job in preventing hacks such as the 51% attack — a scenario where a majority of miners join hands to compromise the network.
PoW has a downside, however. Mining consumes a lot of processing power and electricity which is neither scalable nor energy efficient.
What is Proof of Stake?
Unless you’re living under a rock, you’d probably have heard of ETH 2.0. It’s Ethereum’s transition towards PoS, the other popular mechanism.
Unlike PoW, PoS doesn’t require the miner to solve complex cryptography problems. Instead, mining power is represented by the number of coins you hold. This concept is known as staking, wherein every participant locks their coins for a certain period of time. From ETH staking, a minimum of 32 ETH needs to be locked.
The algorithm then determines who validates the transaction based on the coins staked (though there is a probabilistic distribution to ensure the same participant or the one with the most number of coins isn’t made the validator every time).
Unlike PoW miners, the validators of PoS don’t get any coin rewards. However, they do receive transaction fees.
So PoS ensures you don’t need to purchase a supercomputer to become a validator. And though it takes a few extra steps to stake individually, you can always join a staking pool through digital wallet apps. In staking pools the participant is rewarded coins as a percentage of their stake.
Okay, explain PoW vs PoS in simple words?
PoW is like an employee working hard every day with the hope they will get rewarded at the end of the day. PoS is like being an investor and earning more coins based on the amount you’re already invested in.
#3 — Liquidity pools and Yield Farming
We’ve seen how PoS and PoW help remove the middleman from payment transactions. But Decentralised Finance (Defi) also gives rise to Liquidity Pools and Yield Farming. These powerful projects have given rise to peer-to-peer lending, borrowing and made decentralized exchanges a reality.
Let’s see what these terms are.
Liquidity Pools
Think of stock market brokers like Robinhood. They are centralized and have a clearing house responsible for settling trading accounts between the buyer and seller.
A liquidity pool is like a decentralized exchange that consists of pairs of tokens locked in a smart contract.
To put it simply, you need to lend two assets to the pool and in return, you’d get a Liquidity Provider token and trading fees for any lending, borrowing, or trading that occurs on your pair of tokens.
The whole goal of liquidity pools is to facilitate trading.
Yield Farming
The LP token that you receive from pools acts as governance tokens. This means you hold voting rights on changes happening in that pool.
But more importantly, you can further leverage those liquidity provider tokens by staking them in other pools to earn even bigger rewards.
While yield farming and liquid pools do involve staking, both of these actually don’t force you to lock your funds. Unlike staking which is done to validate a network, yield farming is like swing trading with the sole goal to chase maximum returns on LP tokens.
But wait… doesn’t liquidity pools and yield farming seem too good to be true?
Yes, despite the high returns you could reap from these DeFi projects, liquidity pools are the riskiest form of investment in cryptocurrency today.
It’s worth knowing that liquidity pools require maintaining a strict ratio of both the coins/tokens.
Consider an example, of a liquidity pool that accepts a 50: 50 ratio. Now, one of the token’s prices could swing up or down a lot more than the other. Or some trader could swap them using a DEX in a way that skews their ratio.
In such cases, the pool will need to rebalance the number of coins so that the initial ratio is maintained. This could put you at a loss when you eventually withdraw your coins.
Essentially, DeFi gives us the ability to be our own banks such that you can lend and borrow cryptocurrencies and also provide liquidity to exchanges. However, there’s always a chance of an impermanent loss — a term that indicates a loss of the initial investment due to volatility.
Conclusion
I hope you found the above buzzwords useful. It’s important to get an idea of the key terminology before you begin investing.
Thanks for reading.
