EP 32: ELI5 15 DeFi and Crypto Terms
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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 in a technical way, 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.
You hear these terms often. These are general blockchain terms.
You are a retail crypto-trader: does not affect you that much
You are a developer: affects you depending on what are you building
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.
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. Instagram app, Telegram app, and web broswer 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.
You are a retail crypto-trader: affects you. Basically your bread and butter.
You are a developer: affects you depending on what are you building.
You are a regulator: affects you depending on what you want to regulate.
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.
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.
What Else Did You Miss?
Scalability Problem + Solution
More Technical Elaboration
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These 15 terms are used often in the crypto and DeFi space. I hope these explanation is 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.
PS: The book "Economics and Math of Token Engineering and DeFi" is out on 13th Dec! Pre-order them today.