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For those new to DeFi, we've compiled a short introduction to the main principles and concepts in this space. It can be weird and a bit mind-bending at first, but it's worth the effort to persevere and learn about these things. This is by no means an exhaustive treatise on DeFi, and we encourage you, dear reader, to search online and read about many different protocols. Hopefully, however, what follows will give you be a good place for you to start.
The most basic components of DeFi are liquidity pools, or smart contracts that accept funds for the purpose of providing liquidity of some sort of asset. These liquidity pools can be used to offer two of the main products offered in DeFi: currency arbitrage (trading) and lending.
Automatic Market Makers (AMMs)
Arbitrage, or trading currencies to take advantage of price differentials in the market, are a core part of DeFi. One of the most popular mechanisms for currency arbitrage is called an Automated Market Makers (AMM), and it is based fundamentally on a liquidity pool. An AMM accepts deposits into its liquidity pool of two or more currencies, for example ETH and USDT. The AMM then allows a customer to trade ETH for USDT, or USDT for ETH. The price of ETH in USDT is determined algorithmically (and automatically) by the ratio of ETH to USDT in the AMM’s liquidity pool, and same vice-versa. If there is less of one asset relative to the other—meaning that one asset is less liquid than the other—the price of that asset will increase. In general, asset price is inversely related to liquidity.
It may be surprising that these AMMs are pretty good at keeping prices stable and consistent with market prices in centralised exchanges. The reason for this is that if the price is different than general market prices, trading bots can use that to their advantage to make money. As it turns out, doing so drives the price toward the market price, and there are enough bots scouring the blockchain for price differences that it does so very quickly.
Lending Cryptocurrency
Liquidity pools can also be used to lend out capital at interest. To borrow from these pools, a customer has to provide collateral that exceeds the value of their loan to guarantee the loan under currency price fluxuations in the market. We call these loans overcollateralised. There are generally no fixed repayment schedules that the borrower has to adhere to, but if the value of their loan exceeds a certain percentage of the value of the collateral, their collateral will automatically be sold off to guarantee the loan.
While borrowing money can be a little bit risky, generally speaking lending money in this way is fairly low risk (by DeFi standards). Because loans are overcollateralised—there is no credit system that can determine when a borrower is trustworthy—it takes significant market fluctuations for a loan to not get repaid. Best of all, due to these mechanisms being decentralised, you get to keep most of the interest and you can make hefty gains on your money.
Annual percentage yield (APY) is the main metric you'll see in DeFi to calculate gains. Generally speaking, what is displayed is not a guarantee, but can fluctuate a fair amount. Actual APY depends on a lot of things—including whether or not your money is actually getting borrowed out from the liquidity pool—and it is generally calculated using very recent data.
Last modified 9mo ago
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