Breaking down Defi terms for Beginners.
Published: 2023-04-05 09:39:30


Let’s start by defining what **Defi** is

**DeFi** is a segment of blockchain technology that comprises financial products and services that are accessible to anyone with an internet connection and operates without the involvement of banks or any other third-party firms.

**Decentralized Exchange (Dex)**

This is a peer-to-peer marketplace where transactions occur directly between crypto traders without the need for an intermediary to facilitate the transfer and custody of funds. Decentralized exchanges rely on smart contracts to allow traders to execute orders without an intermediary. On the other hand, centralized exchanges are managed by a centralized organization such as a bank that is otherwise involved in financial services looking to make a profit. The most popular decentralized exchange is Uniswap with a daily average trading volume of over $4 billion dollars.

**AMM**

An automated market maker (AMM) is a system that allows digital assets to be bought and sold automatically at market price on a decentralized exchange (DEX), without an intermediary. This can happen with the concept of liquidity pool and liquidity providers on an AMM.
In an AMM, anyone can become a liquidity provider. These liquidity providers need to deposit an equivalent value of each asset in the trading pair and in turn are incentivized by earning trading fees on their cryptocurrency holdings. If they attempt to deposit more of one asset than the other, the smart contract behind the pool invalidates the transaction.
AMM enables essentially anyone to create markets seamlessly and efficiently. While they do have their limitations compared to order book exchanges, the overall innovation they bring to crypto is invaluable.

** Liquidity**

Liquidity in cryptocurrency simply means the ease with which a digital currency or token can be converted to another digital asset or cash without impacting the price and vice-versa. In simple terms, liquidity describes how quickly and easily an asset can be bought or sold. In this sense, an assets with good liquidity means that the asset can be quickly and easily bought or sold without having much effect on its price.

** Liquidity pool**

Liquidity pools are one of the foundational technologies behind the current DeFi ecosystem. They are an essential part of automated market makers (AMM). A liquidity pool is a collection of crypto assets locked in a smart contract on a DeFi platform to ensure liquidity of assets in decentralized trading. They help to ensure sufficient liquidity to facilitate decentralized trade at any time. Liquidity pools are created when users lock their cryptocurrency into smart contracts and enable them to be used by others.

![Liquidity Pool](https://dev-to-uploads.s3.amazonaws.com/uploads/articles/3ecfvmyof8qh9z6muxx9.png)

**Liquidity provider **

A Person who provides liquidity in a liquidity pool is called a ‘liquidity provider’. In exchange for providing their liquidity, they earn trading fees from the trades that happen in their pool. These fees are distributed proportionally to liquidity providers based on the amount of capital they contributed to the pool. Liquidity providers earn fees through LP tokens, which are tokens that represent their share of capital contributed to the pool.

![Liquidity Provider](https://dev-to-uploads.s3.amazonaws.com/uploads/articles/bsblpkpyoto3oxu15onn.gif)

** Trader **

A trader is simply an individual who wants to buy or sell crypto assets in a decentralized exchange. Traders are different from Liquidity providers. A trader makes use of the liquidity provided by Liquidity provider to trade/swap cryptocurrencies in a decentralized exchange, while a liquidity provider provides liquidity for these tokens and earn trading fees as incentive.

**Slippage **

Slippage is a very important issue in decentralized exchanges. Slippage simply means the difference between the price that you see on the screen when initialing a transaction and the actual price the swap is executed at. This difference appears because there’s a short (and sometimes long, depending on network congestion) delay between when you send a transaction on the blockchain and when it gets mined. Due to the volatility of cryptocurrency, during these waiting time, the price environment in which the transaction will eventually be executed will change, as other trades will be taking place.
Price impact and slippage can both change while a transaction is pending, alot of decentralized exchanges like Uniswap put safety checks into their protocol to protect end-users from drastic changes in the execution environment of their swap/transaction.
Setting a high slippage tolerance will leave a trader open to sandwich or front-running attack which is beyond the scope of this topic

** Fees **

When a trader makes a swap on a decentralized exchange, They are charged a trading fee ranging from 0.01% –1%. These fees are then distributed to liquidity providers according to their share in the pool as an incentive for providing liquidity in the pool. Basis points are commonly used to calculate fee percentages in Defi and across various financial markets but this is beyond the scope of this thread. 

** Arbitrage **

Arbitrage is a common trading practice in Defi that exploits price discrepancies in one asset across multiple exchanges. For instance, a trader could buy a particular asset in one market and quickly sell the same asset in another market, at a higher price.

![Arbitrage](https://dev-to-uploads.s3.amazonaws.com/uploads/articles/mjq1flmkmwr89cx8jkmm.jpg)

** Impermanent Loss**

Providing liquidity to a liquidity pool can be a profitable venture, but we’ll need to keep the concept of impermanent loss in mind. 
Impermanent loss happens when you provide liquidity to a liquidity pool, and the price of your deposited assets changes compared to when you deposited them. The bigger this change is, the more you are exposed to impermanent loss. In this case, the loss means less dollar value at the time of withdrawal than at the time of deposit. The more volatile the assets are in the pool, the more likely it is that you can be exposed to impermanent loss.
It doesn’t matter which of the two currencies in the pool undergoes an increase or decrease in price. The result will be an impermanent loss.
It’s called impermanent loss because the losses only become realized once you withdraw your assets from the liquidity pool. At that point, however, the losses very much become permanent. The fees you earn may be able to compensate for those losses. 

**TVL**

Total locked value (TVL) is an important metric for assessing DeFi protocols. Many of traders and investors use this simple measure to understand a protocol’s strength and potential. TVL is the value of all the assets contained within a DeFi protocol. It has become a key metric for appraising DeFi projects because it provides a useful measure of a protocol’s general health. DefiLiama is a good platform to check the TVL in various Defi protocol. 

Thats it for now, Hope you find this helpful. you can add more in the comment section.