This is not financial advice. DeFi involves significant risks. Never invest more than you can afford to lose, and always do your own research (DYOR). Read our full disclaimer.
Essential terminology and concepts every DeFi user should understand
Understanding these fundamental concepts is crucial for navigating the DeFi ecosystem safely and effectively. This guide covers the most important terms, mechanisms, and principles you'll encounter.
What it is: Self-executing contracts with terms directly written into code.
Why it matters: Smart contracts eliminate the need for intermediaries, automatically executing transactions when conditions are met. They're the foundation of all DeFi protocols.
Example: A lending protocol automatically liquidates collateral when its value drops below a certain threshold.
What it is: Organizations governed by smart contracts and community voting rather than traditional management.
Why it matters: DAOs give users control over protocol decisions, fee structures, and future development.
Example: MakerDAO token holders vote on stability fees and collateral types for the DAI stablecoin.
What it is: Tokens that give holders voting rights in protocol decisions.
Why it matters: Governance tokens distribute control among users rather than centralizing it with a company.
Example: UNI tokens allow holders to vote on Uniswap protocol upgrades and fee changes.
What it is: Protocols that use mathematical formulas to price assets instead of order books.
Why it matters: AMMs enable 24/7 trading without requiring buyers and sellers to be matched directly.
Example: Uniswap uses the formula x × y = k to determine token prices based on pool ratios.
What it is: Collections of tokens locked in smart contracts that provide liquidity for trading.
Why it matters: Liquidity pools enable decentralized exchanges to function without traditional market makers.
Example: An ETH/USDC pool contains equal values of both tokens, allowing users to swap between them.
What it is: Users who deposit tokens into liquidity pools to earn fees.
Why it matters: LPs earn trading fees in exchange for providing the liquidity that makes DeFi trading possible.
Example: Someone deposits $1000 of ETH and $1000 of USDC into a pool and earns a portion of all trading fees.
What it is: The difference between expected and actual trade prices due to market movement.
Why it matters: High slippage can significantly impact trade profitability, especially for large orders.
Example: You expect to buy ETH for $2000 but actually pay $2010 due to price movement during execution.
What it is: Providing assets as security for a loan.
Why it matters: Collateral protects lenders from default risk in trustless environments.
Example: Deposit $1500 of ETH to borrow $1000 of USDC (150% collateralization ratio).
What it is: Automatic sale of collateral when its value falls below required thresholds.
Why it matters: Liquidations protect lenders but can result in losses for borrowers.
Example: If ETH drops in value, your collateral might be sold to repay the loan automatically.
What it is: The cost of borrowing or reward for lending, usually expressed as APR/APY.
Why it matters: Interest rates determine the profitability of lending and cost of borrowing.
Types:
What it is: Uncollateralized loans that must be repaid within the same transaction.
Why it matters: Flash loans enable complex arbitrage and liquidation strategies without requiring capital.
Example: Borrow $1M, arbitrage between exchanges, repay loan + fees, all in one transaction.
What it is: Moving funds between protocols to maximize returns through various reward mechanisms.
Why it matters: Yield farming can generate higher returns but requires active management and carries additional risks.
Example: Providing liquidity to earn trading fees + governance tokens + additional protocol rewards.
What it is: Earning governance tokens as rewards for providing liquidity to protocols.
Why it matters: Protocols distribute tokens to incentivize usage and decentralize ownership.
Example: Compound distributes COMP tokens to users who supply or borrow assets.
What it is: Locking tokens to support network operations or protocol functions.
Types:
APR: Simple interest without compounding APY: Compound interest including reinvestment effects
Why it matters: APY provides a more accurate picture of actual returns when rewards are reinvested.
What it is: Temporary loss experienced by liquidity providers when token prices diverge.
Why it matters: IL can erode profits from trading fees, especially during high volatility.
Example: Provide ETH/USDC liquidity, ETH doubles in price, you end up with less ETH than if you just held it.
What it is: Risk of bugs, exploits, or vulnerabilities in protocol code.
Mitigation strategies:
What it is: Risk from price feed manipulation or oracle failures.
Why it matters: DeFi protocols rely on oracles for accurate price data; failures can cause incorrect liquidations or arbitrage opportunities.
What it is: When developers abandon a project and drain funds.
Warning signs:
What it is: Fees paid to execute transactions on Ethereum and other blockchains.
Components:
What it is: Profit extracted by reordering, including, or censoring transactions within blocks.
Why it matters: MEV can impact your transaction outcomes through front-running or sandwich attacks.
What it is: The total value of assets deposited in a DeFi protocol.
Why it matters: TVL indicates protocol adoption and can affect token prices and yield opportunities.
What it is: The ability to combine different DeFi protocols like building blocks.
Why it matters: Composability enables complex strategies and innovations by connecting multiple protocols.
Example: Use Aave to borrow DAI, swap for ETH on Uniswap, stake ETH on Lido, all in one transaction.
What it is: Protocols that enable moving assets between different blockchains.
Risks:
What it is: Secondary blockchains that process transactions off the main chain to reduce costs and increase speed.
Types:
What it is: Standard for fungible tokens on Ethereum.
Examples: USDC, LINK, UNI
What it is: Standard for non-fungible tokens representing unique assets.
Examples: Digital art, domain names, gaming items
What it is: Multi-token standard supporting both fungible and non-fungible tokens.
What it is: Tokens that represent other assets (like Bitcoin) on different blockchains.
Example: WBTC (Wrapped Bitcoin) allows Bitcoin to be used in Ethereum DeFi.
What it is: Regularly buying fixed dollar amounts regardless of price.
Benefits: Reduces impact of volatility, removes timing decisions.
What it is: Profiting from price differences between markets.
Example: Buy ETH on one exchange for $2000, sell on another for $2005.
What it is: Borrowing at low rates to invest in higher-yielding assets.
Example: Borrow USDC at 5% to provide liquidity earning 8%.
Important Disclaimer: DeFi protocols are experimental and carry significant risks including total loss of funds. This guide is for educational purposes only and does not constitute financial advice. Always do your own research, start with small amounts, and never invest more than you can afford to lose.
Next Steps: After understanding these concepts, explore our guides on Setting Up Your First Wallet and Understanding Liquidity Pools.
Remember: In DeFi, knowledge is your best protection. Take time to understand each concept thoroughly before putting real money at risk.