DeFi 101

This is an introductory guide to understand DeFi, most commonly used terminology and underlying protocols & services used to create FIREDAO.

What is DeFi?

According to ConsenSys, DeFi (Decentralized Finance or sometimes also called Open finance) is a paradigm shift from today’s closed financial system towards an open financial economy based on open protocols that are interoperable, programmable, and composable:

  1. Interoperability means openness of the DeFi system. The protocols are open-source and can interact with each other without any restrictions.

  2. Programmability allows automated execution according to the rules encoded in the smart contract.

  3. Composability is the key feature of DeFi enabling to connect separate DeFi protocols to provide different services, that could not be done as a standalone protocol. It is Lego of the decentralized finance.

What is a smart contract?

DeFi is enabled by smart contracts that automatically execute, control, or document events and actions on the blockchain according to the terms of a contract. The benefits of having a smart contract running the protocol include eliminating dependence on a centralized institution, and increased democratization of finance, because smart contracts are inherently transparent and globally accessible.

Even though smart contracts are also available in Ethereum, Solana, Tron and other blockchains, Binance Smartchain has currently earned traction in the DeFi space due to its cheap gas fee and fast transaction speed.

What are DeFi use cases?

DeFi applications are broadly divided into two categories: finance and exchange Dapps, however their use cases include:

1. Borrowing & lending (Venus.io)

2. Exchange and trading (PancakeSwap)

3. Investing and allocation of capital (UMA, Synthetix, DyDx)

4. Stablecoins (BUSD, USDT)

5. Aggregators (DEX aggregator 1inch, yield aggregator FIREDAO)

What is Venus.io?

Aave is a decentralized non-custodial money market protocol (smart contract) where users can participate as depositors or borrowers. Depositors provide liquidity to the market to earn a passive income, while borrowers are able to borrow in an overcollateralized (perpetually) or undercollateralized (one-block liquidity) fashion.

For example, by depositing 1 USDT you will receive 1 aUSDT – an interest bearing Aave token. The interest is based on the market borrowing demand. The higher the demand for the deposited assets, the higher return you will earn.

What is Uniswap?

Uniswap is an automated liquidity protocol powered by a constant product formula and implemented in a system of non-upgradeable smart contracts on the Ethereum blockchain. It obviates the need for trusted intermediaries, prioritizing decentralization, censorship resistance, and security.

Each Uniswap smart contract, or pair, manages a liquidity pool made up of reserves of two ERC-20 tokens.

Anyone can become a liquidity provider for a pool by depositing an equivalent value of each underlying token in return for pool tokens. These tokens track pro-rata liquidity pool’s (LP) shares of the total reserves, and can be redeemed for the underlying assets at any time.

Uniswap applies a 0.30% fee to trades, which is added to the LP’s share, generating revenue.

What is a liquidity pool?

Liquidity is the backbone of a financial system. Larger liquidity allows to absorb large trades without significantly moving the asset price.

In DeFi liquidity pools are tokens that are locked in a smart contract. Liquidity providers facilitate trading by providing the liquidity in exchange of receiving a trading fee that is being proportionally distributed to liquidity providers.

For example, a single liquidity pool holds 2 tokens and each pool creates a new market for that particular pair of tokens. DAI/ETH can be a good example of a popular liquidity pool on Uniswap.

When DAI/ETH is deposited to Uniswap, you will receive a LP token that represent your share in the pool. The trading fee is proportionally distributed among all the LP token holders. When someone buys ETH from a DAI/ETH pool then the ETH supply is reduced and the supply of DAI increases which results in an increase in the price of ETH and a decrease in the price of DAI.

The bigger the pool is in comparison to a trade, the lesser the price impact (slippage), so a large pool can accommodate bigger trades without moving the price too much.

What is impermanent loss?

Impermanent loss (IL) describes the percentage by which your tokens in liquidity pool is worth less than what one would have if they had instead just held the tokens outside of the pool.

Uniswap uses a constant product market maker to maintain a 50:50 ratio of tokens in the pool. The more ETH is being bought from the pool, the higher the price of ETH becomes. It attracts arbitrageurs who buy cheaper ETH on Uniswap and sells it in another exchange, incurring the loss to the liquidity provider.

The loss is said to be impermanent because if asset prices return to the level during withdrawal the loss is eliminated.

For example, if the price of ETH in LEND/ETH pool increases by 20%, and LEND price stays the same, then the liquidity provider will incur a 0.4141% impermanent loss. However, if the price of LEND also increases by 20%, the impermanent loss is eliminated.

What is liquidity mining?

Liquidity mining is an incentivization program to reward liquidity providers with extra tokens in exchange for providing liquidity.

A DeFi protocol's success depends on the liquidity deposited to its smart contracts. Being the backbone of the protocol, the protocol distributes a new token to its liquidity providers. That new token is most often a governance token, giving right to vote on the protocol's future decisions. It can also be sold to cover the possible impermanent loss or/and gas fees.

Liquidity mining is quite often called 'yield farming' by DeFi community.

What is a gas fee?

Gas refers to the fee, required to successfully conduct a transaction or execute a contract on the Ethereum blockchain platform. Priced in small fractions of the cryptocurrency ether (ETH), commonly referred to as gwei the gas is payed to the network's miners who secure the blockchain, so that decentralized applications such as smart contracts can self-execute is a secured fashion.

What is MetaMask?

Metamask is a popular browser extension & IOS/Android wallet allowing you to access the decentralized applications (called dApps) like Aave, Compound, Uniswap, Curve and FIREDAO.

The wallet allows you to store Ethereum's native token ETH and other Ethereum blockchain compatible tokens, send/receive them to/from other addresses, use it in decentralized applications and trade tokens all with one wallet.

What is a DAO ?

Decentralized autonomous organization (DAO) is a community driven governance where all rules of the organization are enforced by its code running on the blockchain. Most often decisions are taken upon voting by DAO members whose membership is represented by the share of governance tokens hold.

According to the community driven Wikipedia, DAO is an:

"organization represented by rules encoded as a computer program that is transparent, controlled by the organization members and not influenced by a central government. A DAO's financial transaction record and program rules are maintained on a blockchain."

When implemented well, a DAO allows for real world experiments in decentralized democratic organization and control, with more freedom of action and less regulatory oversight for DAO controlled projects and products when compared to legacy corporate structures and organizations.

What is a governance token?

Governance token is a token issued by the smart contract's team in order to decentralized the decision making of the platform. It gives the right & power to influence the development of the protocol, use of DAOs funds, adjusting key features of the protocol in order to growth adoption of the protocol.

In theory, a governance token holder is incentivized to take the most informed decisions, because with the growth of the protocol, the value of the governance token increases. Additionally, governance token holders can vote to distribute part of the protocol's fee accrual to be distribute to token holders, thus further increasing the token's value.

Examples of the governance tokens include: AAVE of Aave protocol, CRV of Curve, MKR of Maker and UNI of Uniswap.

What is a token valuation?

Price is the most common way of valuating a token, however, there are many more variables that need to be taken into account.

In contract to equities (like stocks) a token doesn’t represent any ownership in an underlying company therefore its valuation also requires a different method, especially in regards to the underlying platform. Most often tokens either have a certain use case in the protocol (governance) or is used as a medium of exchange in the project's ecosystem.

Since a token represents utility or currency in the protocol, token valuation must be based of the adoption that particular protocol (total value locked, total value staked, liquidity) and compared to the token fundamentals (market cap, circulating/total/max supply, fully diluted valuation).

What is a circulating/total/max token supply?

Circulating supply refers to the number of coins or tokens that are currently publicly available and circulating in the market.

The total supply is used to quantify the number of coins in existence minus the coins that were burned. So, the total supply is basically the sum of the circulating supply and the coins that are locked up in escrow.

Finally, the max supply is the maximum amount of tokens that will ever exist, including the tokens that will be mined or made available in the future.

What is a market cap?

Market capitalization refers to the total dollar market value of a token circulating supply. Commonly referred to as "market cap," it is calculated by multiplying the token's circulating supply by the current market price of one token.

If there are 1,000,000 ABC tokens in circulation and one token is worth $100, then the market cap of COMP is $10,000,000.

What is a fully diluted valuation?

Fully diluted valuation it is calculated by multiplying the token's maximum supply by the current market price of one token.

Because most of the tokens are being constantly issued to the market by programmed inflation, unlock of seed/private investors, advisors, team etc.

What is total value locked?

The size of the DeFi industry and individual project is measured by total value locked (TVL).

According to a TVL aggregator DeFi pulse "TVL represents the dollar value of all the tokens locked in the smart contract of a given decentralized lending project."

For example, depositing $1 000 of ETH and $1 000 of DAI into Uniswap will increase the TVL of Uniswap by $2 000 USD.