DeFi Concepts

[brianwalden]

What are some concepts that are universal across DeFi ecosystems? The type of things that you'll see no matter what network you're on. Staking, liquidity pools, collateralized loans, etc.

[brianwalden]

Staking.

At its most literal, staking means to give your funds to a validator on a proof of stake network. If they perform well, you'll earn a share of their rewards. If they don't, you'll share in the amount that they get slashed. This is why it's called staking, at stake means at risk.

By analogy, many dapps will let you stake their native token. It's not really at stake, there's no risk, but by staking it, it will earn even more yield. They're basically paying you to lock up your token with them. Sometimes there's a literal lock up period, othertimes they're just counting on the fact that the staking pool will on average get people to hold longer.

Staking is so prevalent that people use it to refer to anything that gets you a yield on your asset. For example, if someone asks how to stake XRP on Flare, they're asking how to convert their XRP to FXRP to earn the F-asset rewards on it.

[brianwalden]

Liquidity pools.

The technical term is automated market maker (AMM), which I find a bit too specific, because a trading bot is also an automatic market maker but it's not usually what someone means if they ask about AMMs.

A liquidity pool is where people put in equal values of two (or sometimes more) assets into a pool, for example $100 of ETH and $100 of USDT, so that other people can trade the assets back and forth. The pool collects fees from each trade and returns those profits to the pool participants.

Often times the liquidity pool will give you an LP token to represent your share in the pool. You can then go and stake your LP tokens to earn even more yield. Sometimes this is done automatically for you, so you don't have to manually do it whenever you put more funds into the pool.

In a liquidity pool, you have to be careful of impermanent loss. If the relative value between the two assets changes faster than the pool can collect trading fees, the participants can lose money compared to if they had just held the two assets separately.

Another thing to be careful of is that many pools pay rewards in the pool's own native token. This token may be volatile and if it goes down after it's been paid to you, so does the value of your rewards.

Edited July 28, 2021 by brianwalden
Added paragraph about LP tokens

[brianwalden]

Collateralized Loans.

The world of DeFi doesn't really have identity (although its coming and will be a game changer when it finally achieves widespread adoption). You can't take out a loan based on personal credit because no one trusts you. So in the crypto world, the way to take a loan is to borrow against your own collateral.

Why would you pay interest to take out a loan against your crypto instead of just selling it? First, if you think your asset is going to go up in value, you may not want to sell. A loan lets you spend money without spending your crypto. Another reason is that taking out a loan isn't taxable, but selling your crypto triggers capital gains taxes. If your tax rate is 20%, but the interest rate is 8% and you think you can pay it back in a year, the loan may be better in the long run.

The way it typically works is you need to overcollateralize your loan. So you if you want to borrow $100, you might put up $200 worth of ETH. But if the value of your collateral falls to say $120 you might get liquidated. That means your collateral is sold to pay back some or all of your loan. Realistically, if the market is crashing and you got your liquidation point, you're going to get almost completely liquidated. The good news is your loan will have repaid itself from the collateral, the bad news is your collateral will have gotten sold near the bottom.

Be careful with loans, the way people get in trouble is they take out loans when the bull is pumping and their collateral is worth its most, then they use that to buy more crypto. Suddenly the market turns, the value of your collateral is crashing, but so is the value of the crypto you bought with your loan. One safer way to take a loan to get the feel for how it works is to keep your borrowed amount as a stablecoin and put it in something that pays out a higher yield than the interest rate you're paying to borrow it. That way if the value of your collateral falls too low for your comfort, you've always got the funds there to repay the loan.

When you get way out into DeFi, you'll even find dapps that will pay you interest to take out a loan. It's a whole new world out there.

[brianwalden]

Composability.

This is also called Money Legos. It basically means that you can use different DeFi products together to build on each other. A simple example is the way that you can stake your tokens from liquidity pools - you're not earning in two ways from your same investment into the pool.

This can also be done on the backend. A whole ecosystem has developed so that, for example, one dapp may use two others in conjunction behind the scenes, but they do all the work so all you have to do is deposit your funds with them.