Key Terms
To understand decentralized finance, we must first understand some key terms in finance. Then we can look into the essential key terms that are unique to DeFi. As mentioned, finance can be defined as the “study of systems of money, investments, and other financial instruments”. It can be seen as a societal tool to manage resources nominated in money, risk, and rewards across space and time between entities. DeFi upgrades this to occur on the “internet of value” via programmable blockchains like Ethereum with protocols written in smart contracts.
Economics in 30 seconds
A key foundation of finance is economics which deals with how people interact with value, specifically the production, distribution, and consumption of goods and services. Core to this idea is the concept of scarcity, or simply the gap between limited resources and unlimited wants. To solve this problem, we look towards allocating resources to the most productive uses.
We use market-based systems based on property rights to allow individual entities to own and allocate resources to where they best see fit. From this arises supply and demand, another central idea in economics. In finance, scarcity, allocation and supply and demand translate into deploying limited amounts of capital across a range of possible investments. As we will see later, smart contract based systems make it easy to enforce and audit ownership, and what owners can do with their digital assets.
Key Financial Terms That Appear in DeFi
Finance extends economics to the management of money and investments. Money has certain properties, some of which is the ability to quantify and transfer value. The most common example of money is fiat currency, a type of money a government has declared legal tender that allows for the settlement of private or public debts within a political jurisdiction. Examples of fiat currencies are the United States Dollar $, European Union’s Euro €, The People’s Republic of China’s Renminbi RMB, Japanese Yen ¥, South African Rand R.
Once we have money, we want to grow it. This is because inflation slowly eats away at the value of money. A dollar today is worth less than a dollar 20 years ago. So we must invest our money to keep up. In finance, that means investing in financial instruments defined as assets or bundles of capital represented by real or virtual documents. Not all opportunities or financial assets are equal. Out of this emerges a central idea in finance: risk, which is the probability of losing money. Risk for a financial product can be affected by the type of asset, time an asset is held, liquidity for the asset, depreciation, volatility and more.
From risk emerges the risk-return trade off that states the potential return rises with an increase in risk. Individuals use this to assess an investment and consider many factors, like their overall risk tolerance, the potential to replace lost funds, the investment’s return in relation to other assets and more. In simple terms, the riskier the project, the greater the expected. A little more context can be found here.
In the crypto industry and DeFi, one of the main sources of risk is due to volatility. Volatility is the unsteady spread of an asset’s price movements around its average price. The greater the swings, the more volatile, the riskier the asset is perceived. Volatility can be measured in different ways. You can see volatility in action here.
This volatility contributes to exchange rate risk, or the risk of devaluation of one currency compared to another. An example can be holding ETH compared to the US dollar, then ETH’s price drops 15% in relation to the dollar. This problem is further compounded by holding two volatile currencies in relation to each other.
Volatility emerges from various sources including market liquidity risk, or the lack of buyers and sellers. Liquidity is the ease in which you can buy or sell an asset. The less liquidity an asset has, the greater the volatility of an asset’s price when buying or selling. Liquidity is the lifeblood of DeFi, since large amounts of liquidity also helps to create price stability. Illiquid assets have wilder price swings, making them less predictable, risker for network participants, and contributes to higher slippage. Slippage occurs when a trade settles for an average price that is different from what was requested.
Think about a market of lots of buyers and sellers for an asset. A deep pool of buyers and sellers results in a narrow bid-ask spread, since you can find alternative takers if someone quotes a price that deviates from the crowd. In DeFi, slippage is most often seen when trading niche tokens with small networks or limited liquidity on decentralized exchanges, covered in a later section.
To help reduce volatility and risk in DeFi, stablecoins were created. Stablecoins are fungible tokens that mimic a fiat currency’s performance through a peg. Fungibility is the ability of a good or asset to be exchanged for another of the same kind, like exchanging two different dollars. A peg is a system by which one currency latches on to another to form a tight correlation. Stablecoins can maintain this peg in a variety of ways discussed in a later section. One method is through the use of collateralization and liquidation.
DeFi protocols rely on collateral to allow for permissionless participation. Collateral is an asset a borrower pledges to a lender in case they cannot pay back a loan. In DeFi, collateral is in the form of crypto assets like ETH, other tokens with deep levels of liquidity. Even NFTs, which are non-fungible tokens issued to prove ownership of a unique digital asset, can be staked as collateral. Staking refers to depositing assets into an escrow contract thereby passing custody of the collateral to the protocol.
Due to the volatility of crypto assets and the lack of decentralized credit systems, most DeFi protocols rely on the overcollateralization pattern to issue assets. This means requiring to cover over 100% of the loan. For example, say you wish to get $100 in one crypto asset. You will need $100 of collateral value in another asset.
These assets are in sense collateralized loans and are the backbone of DeFi because they allow open, pseudo-anonymous finance, without credit scores or any sort of formal identity tied to a loan. Through overcollateralization, protocols can mitigate their risk, while providing access and possibilities for returns. This functioning is common in DeFi protocols and is explained here. The loan to collateral ratio expresses the degree to which a protocol is overcollateralized. The total value locked represents the amount of funds in a contract and is a proxy for contract’s popularity.
Due to volatility, the value of the collateral can drop below the value of the borrowed asset. When this occurs DeFi protocols typically begin to liquidate the users assets to maintain stability. Liquidation is the process of selling/distributing assets to settle debts.
This is one of the ways a user can get rekt. Another is via rug pulls, where protocol developers run off with the assets, or DeFi hacks, where malicious actors exploit a bug in the contract code.
Many protocol developers aim to achieve deep liquidity, broad usage and network effects. The ideal point culminates in a Schelling Point or a natural place of collaboration, brand awareness, and user evangelism. To achieve this, protocol developers rely on incentives to encourage and discourage certain types of behavior.
One method to bootstrap the network is via liquidity mining programs. These programs can be seen as part of a marketing program to onboard users to engage with protocol. Users engage in yield farming to find the best APY by shifting capital across various places.
There are various protocols like Yearn.Finance which help users automate strategies to maximize APY and the lowest cost through the use of vaults. There are some indicators that DeFi protocol Devs should know.
Additional Resources
DeFi Primitives Via Campbell Harvey - Duke University