The Most Popular Defi Terminologies Explained (Smart Contracts, Yield Farming, NFTs and more)
Smart Contract
A smart contract is a contract that is programmed to automatically execute when specific conditions are satisfied. DeFi applications make extensive use of smart contracts to automate financial transactions and eliminate the need for intermediaries.
Typically, smart contracts are created on blockchain platforms such as Ethereum, which permits developers to create and deploy smart contracts using programming languages like Solidity.
One key feature of smart contracts is their ability to execute automatically when certain pre-determined conditions are met. For example, a smart contract could be programmed to release funds from an escrow account to a seller once the buyer has confirmed receipt of the goods.
Yield Farming
Yield farming is a way to earn rewards or returns on cryptocurrency holdings by providing liquidity to decentralized finance (DeFi) protocols. It involves lending or staking cryptocurrencies to earn interest, which can be paid in the same or different currency.
To participate in yield farming, a user must deposit a pair of cryptocurrencies that are used for trading within the DeFi protocol and provide liquidity to a pool. A user may, for instance, deposit the same amount of Ether (ETH) and a stablecoin such as USDC into a liquidity pool that facilitates transactions between the two currencies. The user is then issued a liquidity provider (LP) token, which signifies which represents their share of the pool.
The LP tokens can be used to claim a portion of the trading fees generated by the protocol, which are distributed to the liquidity providers. Yield farming is a popular way of generating passive income in the DeFi space.
Non-Fungible Token (NFT)
A non-fungible token, or NFT, is a unique digital asset that is stored on a blockchain network. NFTs are used to represent ownership of digital assets such as art, music, and videos.
NFTs are distinguished by the use of smart contracts on a blockchain, typically the Ethereum blockchain. These smart contracts stipulate the conditions governing the ownership and transmission of non-fungible tokens. Each NFT is allocated a unique identifier, making duplication and counterfeiting impossible.
Decentralized Autonomous Organization (DAO)
DAO refers to an organization governed by smart contracts and operating on a decentralized blockchain network. DAOs are a type of blockchain-based organization governed by a group of individuals using a decentralized and democratic decision-making process.
DAOs are facilitated by smart contracts, which are blockchain-based, self-executing programs. These contracts are designed to implement certain actions automatically, such as the distribution of funds or the execution of a specific action based on a set of predefined rules.
However, DAOs are not devoid of hurdles. One of the greatest concerns is the possibility that malicious actors will exploit code vulnerabilities or manipulate the voting procedure. There have been several high-profile cases of DAOs being hacked or exploited, which has led to calls for greater security and oversight.
Stablecoin
Stablecoins are a form of cryptocurrency designed to maintain a stable value relative to a fiat currency like the US dollar. This stability is accomplished by backing the stablecoin with a reserve of assets that can be used to redeem the stablecoin at a fixed rate, such as cash, precious metals, or other cryptocurrencies.
Stablecoins are widely utilized in DeFi applications to facilitate stable payment solutions and reduce the volatility of other cryptocurrencies. Tether (USDT), USD Coin (USDC), and Dai (DAI) are examples of the most popular stablecoins.
Gas Fees
Gas fees are the transaction fees that users pay to miners in order for their blockchain transactions to be processed. It also refers to the quantity of cryptocurrency that the sender must pay in order for his/her transaction to be executed on the blockchain network.
Gas fees are determined by the quantity of computational resources required to execute a network transaction. The gas fee required to execute a transaction increases in proportion to its complexity. When deciding whether to transact on a blockchain network, gas fees are a key metric for consumers to consider.
Typically, gas fees are denominated in tiny fractions of the cryptocurrency used to execute the transaction, such as Ether (ETH) for the Ethereum network.
Depending on network congestion and other variables, gas prices can fluctuate significantly. During times of high network activity, gas fees may increase considerably, making transactions more costly. During periods of minimal network activity, gas fees may be lower, making transactions more affordable.
Governance Token
Governance tokens are a type of cryptocurrency that allow their holders to partake in the governance of a decentralized protocol or network. These tokens allow token holders to participate in decision-making processes related to the development and maintenance of the network, such as proposing and voting on protocol changes and electing representatives to the network’s governance board.
Governance tokens are frequently distributed to early investors or network users as an incentive for participation and as a reward for network contributions. As with other tokens, they can be purchased and sold on cryptocurrency exchanges.
See also: Understanding Cross Chain Bridges; The Key to Interoperability
Flash Loan
Flash loans are a form of decentralized finance (DeFi) transaction that permits users to borrow funds from a liquidity pool without providing collateral as long as the loan is repaid within the same transaction. They are called “flash” loans because they are executed very quickly, typically in a matter of seconds.
Flash loans have gained popularity in the DeFi industry because they enable users to access significant amounts of liquidity without providing collateral or undergoing a conventional lending process.
Wrapped Token
A wrapped token is a token that is backed by another asset, such as Bitcoin or Ethereum. Wrapped tokens are used to enable cross-chain interoperability and facilitate the integration of different blockchain networks.
The primary purpose of wrapped tokens is to enable the use of assets from one blockchain on another blockchain. This allows users to take advantage of the unique features and functionalities of different blockchains while still retaining ownership of their original assets.
Wrapped tokens can be used to provide liquidity to decentralized exchanges (DEXs) and other DeFi protocols because they can be traded and used as collateral in the same manner as other tokens on the blockchain. In addition, because wrapped tokens are issued on a blockchain with smart contract capabilities, they can be programmed to perform additional functions, including automated lending and staking.
Wrapped tokens are a valuable instrument for bridging the gap between various blockchains and enabling greater interoperability in the world of cryptocurrencies and decentralized finance.
Impermanent Loss
The concept of impermanent loss refers to the loss of asset value experienced by liquidity providers when providing liquidity to a decentralized exchange. It is the opportunity cost incurred when the price ratio of two assets in a pool deviates from its initial value.
When a user provides liquidity to an AMM (Automated Market Maker) pool, they deposit two cryptocurrencies of equal value. The user is then issued pool tokens representing their proportional share of the liquidity pool. These tokens are redeemable at any time for the underlying assets, but their value fluctuates depending on the price of the pool’s assets.
If the price of one asset rises relative to the other, traders will purchase or sell that asset, thereby altering the proportion of the two assets in the pool. As a consequence, the user’s share of the pool will shift towards the underperforming asset, resulting in a loss relative to holding the assets individually.
This loss is referred to as “impermanent” due to the fact that it only occurs when the prices of the two assets in the pool diverge from their initial ratio. If the values revert to their initial ratio, the loss is eliminated. If prices continue to diverge, however, the loss may become permanent.
By selecting low-volatility or highly correlated asset pairs and high-volume trading pools, it is possible to reduce the risk of impermanent loss.
Some AMMs also feature impermanent loss protection, which compensates liquidity providers for losses incurred as a result of price divergences. However, liquidity providers must carefully weigh the risks and rewards associated with providing liquidity to AMM pools.
Conclusion
DeFi is a revolutionary technology that is changing the way we think about finance. Understanding the key terminologies associated with DeFi is essential for anyone who wants to participate in this new paradigm of finance. Understanding these common DeFi terms can help you better navigate the DeFi market and profit from its many advantages.
