Decentralized Finance is a term for investing in tools that are not run by centralized parties. To understand DeFi better, let’s learn about some important terms in DeFi!
What is a DAO?
DAOs are digitized organizations that have no central focus of power. Ever dreamed of how much happier the folks in your company would be without your blowhard of a boss? While there aren’t really any managers or upper-level management members to deal with, the promise of these virtual organizations is to put the power of decision making into the hands of communities.
A group of people who may or may never have run a company before will be in charge of running a DAO? This sounds..kinda dangerous?
To keep things in order, DAOs have rules and regulations encoded into the platform that will establish boundaries. In order for any decision on a DAO to be made, it must first be voted on in a democratic election system.
This allows for the company to set aside earnings to be spent on a new feature or activity depending on how the community votes.
What is Impermanent Loss in DeFi?
In decentralized exchanges, anyone in the world can raise funds and earn returns on clearing fees. Establishing a globally accessible liquidity protocol is probably one of the most important developments for DeFi to become widespread in recent years. Now any DeFi protocol can take advantage of DEX’s unauthorized automatic token exchange to provide liquidity for its applications or products.
How Does Impermanent Loss Occur?
To understand how impermanent loss occurs, we first need to understand how AMM pricing works on decentralized exchanges such as Uniswap and the role arbitrageurs play.
In its simplest form, AMMs are disconnected from centralized exchanges or foreign markets such as Binance and FTX. While crypto prices vary according to the balance of supply and demand in foreign markets, AMM does not automatically adjust its prices. In this case, it creates a financial opportunity for an arbitrator to come and sell the overpriced asset or buy the underpriced asset until the prices offered by AMM match foreign markets.
During this process, the profits made by arbitrageurs are effectively extracted from the pockets of liquidity providers, resulting in an impermanent loss.
What is DeFi Yield Farming?
Simply and clearly, without considering the nuances and complexities, yield farming can be described as a way to make more cryptocurrencies using your existing cryptocurrency through lending. Earning is easier with smart contracts. You will earn some interest in the form of crypto to lend your funds.
To understand profitable yield farming, we must examine the liquidity pool more deeply. It is a smart contract responsible for blocking large amounts of crypto funds. However, these funds cannot be created from anywhere. Therefore, the liquidity pool must depend on users to add these funds. These users are named liquidity providers.
As these liquidity providers try to create liquidity, they receive a reward from the underlying Defi platform’s interest.
Most liquidity pools that make their payments have more than one coin. Liquidity providers deposit these tokens in other liquidity pools to receive rewards. This domino effect of deposits and rewards makes high-yielding farming a profitable strategy.
What is Flash Loan?
Flash loan is a form of financial technology used through decentralized finance. On decentralized platforms, users can apply for a flash loan and pay back large amounts of assets within seconds. In case of applying for flash credit in cryptocurrency transactions, the user must pay back the money received in the same transaction.
We can say that in flash loans three different actions come into play in a single action. The actions of receiving, executing the transaction, and refunding the money received are requested in a single transaction and within seconds.