Human Glossary.
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TLDR below. This is not financial advice.
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This video seeks to explain the 15 DeFi terms. Instead of explaining it technically, I try to make it as “human” as possible. After all, that’s the point. To understand, not to pretend to understand.
Here are 15 terms, split into 5 categories: (1) general blockchain classification, (2) general DeFi terms, (3) scalability problem and solution, (4) more technical elaboration of 3, and (5) other terms you hear often.
General Classification
You hear these terms often. These are general blockchain terms.
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You are a retail crypto-trader: does not affect you that much
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You are a developer: affects you depending on what are you building
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You are a regulator: affects you depending on what you want to regulate
1) Layer 1
Layer 1 is just the base layer.
If you imagine there’s blockchain has different a kind of blocks this is basic layer 1 as in a tech stack and then on top, you could have another kind of systems, processes and technological stack.
Crypto Examples: Bitcoin, Ethereum, and Polkadot. These are different kinds of layer 1 solutions and you could build things on top of them.
Tech world examples: IMAP protocol to send your email from gmail.com to yahoo.com.
Why is the distinction important? The economics involved in layer one is very different from the economics of layer 2 and the other kind of layers.
2) Layer 2
If layer 1 is the base layer, layer 2 is something that’s being built upon it. Layer 2 is usually the scalable solutions and that helps transactions faster.
Layer 1 is good. The objective is to send data in a distributed way and to make sure the other attacks don’t happen. That’s security. And usually, it means to sacrifice scalability. Layer 2 solves this.
Crypto Examples: Lightning network, Plasma chain, and zk-Rollups.
Tech world examples: 5G vs 2G
Why is layer 2 important? It helps with mainstream adoption for other digital products and services that need speed.
3) Dapp
Dapps are decentralised applications. They can be related to finance (DeFi), esports (usually NFT), art (also NFT). They are built on top of Layer 1 or Layer 2. These are applications that you can use.
Crypto Examples: Yearn, Nexus Mutual, and Axie Infinity
Tech world examples: iOS/Andriod is Layer 1. The Instagram app, Telegram app, and web browser are Dapp.
Why is Dapp important? You can hold $ETH or $BTC or $DOT. There’s nothing much you can do with it. Dapps are applications where you can have more use-cases with your tokens.
DeFi General Terms
Another set of terms you hear often. These are general finance terms specific to crypto.
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You are a retail crypto-trader: affects you. Basically your bread and butter.
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You are a developer: affects you depending on what are you building.
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You are a regulator: affects you depending on what you want to regulate.
4) DeFi
DeFi: decentralised finance.
DeFi looks to reduce intermediaries in the financial space by decentralising the operations. That is different from the capital market, aka traditional (centralised) finance. Sometimes, that is known as TradFi or CeFi.
What will be decentralised? The entire governance mechanism and technology layer will be completely decentralised. And the beginning for DeFi was Bitcoin, a peer-to-peer currency.
Now the cryptocurrency space has grown a bit more. We have lending platforms, d-exchanges, derivatives, insurance and the aggregators. So, decentralised finance has developed a lot of things beyond just p2p lending and Bitcoin.
DeFi Examples: P2P currency and technology to remove double-spending
CeFi examples: Currency issued by the central bank
Why is DeFi important? It opens up financial access to everyone without intermediaries.
5) Money Lego
Go back to being a child. You are playing with Lego. You can stack them up and create different types of Lego structure.
Now you are an adult. You play with a different type of Lego. It’s money Lego. That means the various technological pieces as lego bricks to build new financial product or infrastructure.
More specifically, it is to combine various products (lending, exchange, options, insurance) and connect them to other products.
For Example, we have ETH and want to trade/hedge. So that, we can mortgage ETH on Compound to receive DAI and transfer DAI to a pool on Uniswap to buy more ETH. Or we can go to derivatives platform and hedge our positions. This is Money Lego that you can stack many types of protocols.
DeFi Examples: Collateralise ETH on Compound to borrow DAI (lending) and exchange it for Cream (exchange) and use Cream to stake in various liquidity pools to get an annualised return.
CeFi world examples: A similar example is Repo.
Why is Money Lego important? This allows for each protocol to specialise in a specific financial instrument and allow anyone to use them as a tool to create new products.
6) Composability
Composability is a systems design principle. A protocol can be broken down by different functions and its functions can be used for other purposes. Compostability is very similar to Money Lego.
Different protocols are created with specific purposes, but you can use their functions to achieve your goals.
For example, you can combine the loan functionality of Compound + exchange from Uniswap and provide liquidity on Sushiswap = to create a decentralised derivative exchange with one click. Instead of building everything from scratch. That’s the general idea of DeFi, which is evolving very quickly.
Scalability Problem + Solution
These are Scalability solution terms. They are formed when scalability problems appear, usually in Layer 1. There are more Layer 2 solutions. We are only discussing 2.
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You are a retail crypto-trader: affects your latency rate and trading strategy because you might suffer price slippage or front-running attacks.
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You are a developer: affects you depending on what are you building.
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You are a regulator: not so much unless you are regulating the technology.
7) Scalability
There is a lot of development in crypto space. As discussed in keyword #2, scalability is usually the sacrificial lamb in the development space. The increase of use-cases and mass-adoption goal makes it more important to resolve this.
Problem: Around the summer of 2020, the number of transactions increased. This resulted in high transaction fees to transact. (Lisa spent more on transaction fees than food in summer 2020.)
What needs to be done: (1) increase transaction throughputs. (2) increase speed. (3) reduce transaction fees.
8) Sidechain
This is where Layer 2 comes to the rescue.
Solution 1: Sidechain.
Think of the main chain as a road where any vehicle can move. Another parallel road is called the expressway, which is only for cars and can move faster.
Similar to the side chain, instead of being updated directly every time transactions are performed, the transactions will be executed first and updated to the main chain afterwards.
The side chain is a layer 2 solution and one of them is called Plasma chain. It uses sidechain technology, which has a lot of different types of consensus and Crypto-economics that goes into it.
Problem with this: Timing issue. There will be a latency problem because there is still a time lag when transactions are being updated in Layer 1.
9) Roll-ups
Solution 2: Roll-up.
Roll-up has the same concept as a sidechain. It also aggregates the data on layer 2 and updates to layer 1.
Imagine, to carry 10 people moving from point A to point B, we have 2 options: use a 4-seater car with a cost per use of $4 and we will have to travel 3 times The total cost is $12 — $3 each. And a 20-seater plane costs $20, we only travel once and faster with 16 other people, it costs $1 per person.
Problem with this: The current solutions are only dealing with very basic financial products like p2p borrowing and lending.
More Technical Elaboration
What is ZK? What are the different types of roll-ups?
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You are a retail crypto-trader: new technology stack to reduce risks in your trade.
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You are a developer: finding the appropriate technology stack for your product.
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You are a regulator: affects you depending on what you want to regulate.
10) ZK Roll-up
ZK means Zero-Knowledge. It’s part of cryptography.
ZK Roll-up sends transactions using a cryptographic verification method called Zero-Knowledge Proof. It is a way for different parties to prove to each other that they have specific information without having to disclose what it is. A great advantage of this is that this process can happen almost instantly, and there’s virtually no chance for corrupted state submissions.
Application: Layer 2
Function: Scalability
Some smart people believe this is a good solution for the future and it will be one of the core technology platforms. Definitely agree with that. Currently, we are developing more and are testing the limits for all of these different types of technologies.
Right now, the limitation of ZK Roll-up is still doing a very fundamental Defi such as p2p and some disadvantages such as needing more processing power and being slower. Hopefully soon, we can trade other products like derivatives, flash loans, DEX and AMM with ZK roll-up.
11) Optimistic roll-up
Optimistic roll-up is the same concept as ZK Roll-up. Optimistic Rollups sacrifice some security for more flexibility. They allow for smart contracts to run on these secondary chains.
Application: Layer 2
Function: Scalability
On the other hand, there is no cryptographic proof that the state transition submitted to the main chain is correct. To mitigate this issue, there is a slight delay allowing users to challenge and reject invalid blocks submitted to the main chain. If bad actors are found, they will be penalised by burning staked tokens.
12) ZK-SNARKS
ZK-SNARK stands for “zero-knowledge succinct non-interactive argument of knowledge” is one of the update solutions in private transactions because the information itself is valuable.
Application: Layer 1
Function: Privacy
This is important if you are talking about layer 1 solutions we are talking about decentralised technology in the blockchain where information and data are transparent and privacy. You can submit your data and information without revealing too much. It uses ZK-SNARKS proof.
Other Terms
The newly formed concepts are directly related to DeFi.
13) Quadratic Funding
This is a new way of funding public goods. One of these issues with crypto and decentralisation is that we are creating public goods when we are looking at a collaborative future and p2p.
Extra funding based on crowdsourcing donation for public goods.
One of the ways for us to a successful ecosystem is to start producing more public goods that everyone can use. For example, public goods are having educational materials, good technological stacks (as Money Lego and Compostability) that we can grow the ecosystem. So, we need to fund from the public.
Quadratic Funding is an idea that there is a pool of donation money waiting to be distributed. For example, there is a poll for $100 ready to be allocated to 5 different projects. That is one way to allow the community to vote what they want in some way.
The basic idea is that this quadratic funding is now becoming a more efficient way of allocating these grants to different projects. In economic terms, it becomes very interesting and becomes an attractive binding mechanism to rewarding and funding the right kind of project based on what the community has voted for.
14) Flash loans
Uncollateralised loan provided that the loan amount must be returned to the lending platform in the same transaction.
Thus, Flash Loans users can leverage to execute a variety of executable orders as long as the borrowed funds are repaid at the end.
For example, you borrow 1000 USDC in Flash Loans, swap 1000 USDC to 2 ETH via Uniswap, and continue to swap 2ETH to 1010 DAI on Mooniswap, use 1010 DAI swap to 1020 USDC on Curve and the last pay 1000 USDC for the lending platform. So, you earn 20 USDC profit. And all of those executions will have to happen in 1 transaction.
A protocol using Flash Loan: Aave, dYdX.
15) Front Running
For example, I intend to do a big transaction, and someone knows this. He will make a transaction before me to get a profit after I do when the token increases in value. He does it by paying more gas fees than I do to have the advantage of making transaction before me because his transaction will be approved sooner than me. That is a concept of Front Running.
Bad for: traders. Because you get less value for your trade.
Good for: these front runners. Because you get more value for your trade.
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TLDR:
These 15 terms are used often in the crypto and DeFi space. I hope these explanations are easy for you to understand. If you have more terms you’d like a human explanation on, please comment in this newsletter or email them via replying to this newsletter.