DeFi entry essentials: important DeFi words you need to know

The threshold for DeFi is very high. Although its goal is to build a financial system that everyone can participate in, it is not easy for ordinary users to accept complex concepts, and even if they do not understand these concepts, it will cause irreversible investment. loss. So I have sorted out some commonly used DeFi vocabulary and explained the meaning of these words in detail, hoping to help you.

Crypto Clearing

What is crypto clearing?

Liquidation is an asset processing method. In the field of cryptocurrency, liquidation mainly refers to the forced liquidation of all or part of the initial margin by a trader or asset borrower. This happens when they are unable to meet margin requirements for leveraged positions.

For example, when ETH is 2,000 US dollars, I use MakerDAO to deposit 100 ETH. In theory, I can lend 200,000 US dollars (Dai), but because MakerDAO’s design mechanism requires a pledge rate of more than 150% (borrowing 1 US dollar requires a mortgage of 1.5 US dollars). ETH) to maintain the stability of Dai. So we can only lend at most 100 ⁄ 1 .5*2000 ≈ $133,333, and the liquidation price at this time is $2000. If the ETH price falls below $2,000, your ETH will be liquidated, which is equivalent to buying 100 ETH at a price of $1,333. (Of course, you can also borrow less Dai to lower the liquidation line)

If you want to avoid 100 ETH being liquidated at $2,000, either return the $133,333 of Dai to the lending system (plus the cost of borrowing) before the liquidation triggers, or keep staking more ETH and lower the liquidation line.

OK, anyway, simple to understand. The value of the preferred collateral is greater than the value of the loan, you can lend more and more money when the price of the collateral keeps rising, and when the price of the collateral falls, it keeps increasing the risk of the collateral assets being liquidated. If you want to reduce the risk, you need to reduce the liquidation risk by covering the position, or close the position in advance to avoid the forced liquidation (liquidation).

What does the liquidation line mean?

In fact, DeFi pledged loans are generated every day in the digital currency market. Users do not want to sell their assets, pledge assets to the protocol platform in exchange for target assets, and make secondary investments, which itself is a leveraged behavior. However, some institutions or large households may have a particularly high or concentrated pledge and lending behavior on a certain day. For example, when ETH is $1,200, the market will liquidate 1 million ETH. These liquidated ETHs are bought at a discount by liquidators and sold in the market to earn the spread. Therefore, such a large number of liquidation events can be simply understood as a kind of “smashing” behavior, which triggers further liquidation until the market price stabilizes.

However, because the liquidation is dynamic, if the market price is close to the large-scale liquidation line, the pledger can choose to cover the position or repay in advance to reduce the liquidation risk and avoid the trigger of liquidation. So don’t over-interpret these indicators. I think it is good as a reference for the pressure level of the token price.

View tools for liquidation

In order to be able to forewarn the outbreak of large-scale liquidation in advance and allocate assets in advance, it is necessary to observe the dynamics of the lending market in advance with the help of some tools:

impermanent loss

What is impermanent loss?

The constant loss is the difference between the total value of the tokens deposited after the liquidity is injected into the bilateral pool compared to the total value of the tokens before the deposit.

Simply put, the money I make after injecting liquidity is not as much as what I earn without injecting liquidity.

Here’s an example to explain :

Suppose I currently inject 100 ETH and 100,000 DAI of liquidity into the Uniswap ETH <> DAI liquidity pool at the price of 1 ETH = 1000 DAI. x * y = k = 10,000,000.

But at this time, someone trades through the pool, hoping to buy 10,000 USD of DAI. At this time, there are 110,000 in the pool, and then according to x = k / y = 10,000,000 / 110,000, that is to say, there are about 90.9 ETH left in the pool. The user bought 9.1 ETH with $10,000, at this time 1 ETH ≈ 1099 DAI, which is also the fair price in the current market.

So here comes the problem, if I don’t inject liquidity, the total value of my 100 ETH and 100,000 DAI is now 100 * 1099 + 100,000 = 209,900. But because I injected liquidity, when I redeemed the liquidity with LP, I would have 90.9 ETH and 110,000 DAI in my hand. The total value is 90.9 * 1099 + 110,000 ≈ 209,899. One dollar lost is impermanent loss. As the price of ETH gets higher and higher and slowly becomes DAI, the impermanent losses suffered will become larger and larger.

How to correctly understand impermanent loss?

It is worth noting that impermanent loss is not a permanent loss, but a temporary one. The impermanent loss will also disappear as the price is leveled out, back to where the liquidity was injected. However, if the user cannot wait for the moment when the impermanent losses are equalized and redeem the liquidity, then they will suffer permanent losses, which is equivalent to hedging with the overall market trend (exchange high-value coins for low-value coins) .

Interestingly, Bancor previously published a study of impermanent loss on Uniswapv3 and found that more than 50% of the LP’s income could not cover impermanent loss. So everyone should pay attention to this issue.

Tools for calculating impermanence losses

value capture

What is value capture?

If you look up Wikipedia, you can get this definition ” Value capture is a form of public financing that recovers some or all of the value that public infrastructure generates for private landowners.”

But in the blockchain, it can be simply understood as “the means by which the project party (public chain, DeFi, etc.) obtains commercial profits from the user’s transaction behavior”. Whether the value capture method is healthy and benign will generally be reflected in the currency price. So to measure the value or valuation of a project, especially DeFi, will often study its value capture method.

In particular, why is it limited to transaction behavior when it comes to value capture above, because all value behaviors in the blockchain revolve around transactions. For transaction behavior, the most direct value capture method is the handling fee, such as:

  1. Layer1 → miner fee;
  2. DeFi → lending and profit sharing;
  3. CEX/DEX → transaction fee.

How to correctly understand value capture?

In Josh Kaufman’s book The Personal MBA, value capture is described as an activity where the benefits outweigh the costs. The key points of discussion lie in two aspects:

  • Maximization of value capture: that is, the project party should obtain the maximum value from each transaction of the user as much as possible.
  • Minimization of value capture (still profit): Project parties should capture as little value as possible to keep the business running.

The maximum value capture can obtain the maximum profit for the project party, but it will weaken the purchasing power of users, thus causing users to flee. For example, the mining fee of Ethereum is too high, causing many users to migrate to Binance Chain or other chains.

While minimizing value capture is not as good as maximizing short-term revenue, it retains the value that users see when the project side conducts business, and it will spread to other potential users. As long as the revenue from value capture can continue to maintain what the project party is doing, there is no need to increase value capture profits by squeezing users. Instead, it should create as much value as possible and obtain more value capture methods so that it can continue to operate. .

A typical example is the Binance Exchange, where transaction fees are an important means of capturing value. However, Binance’s profit did not start from increasing transaction fees, but instead chose to destroy BNB and expand a series of futures, margin, and spot transactions. business. The launched Binance Chain provides more application scenarios of BNB, links the project party to carry out ecological construction on its public chain, and network more users. As the number of users increases, the transaction volume expands again, resulting in more transaction fees. This is a more benign means of capturing value.

How do different tracks realize value capture?

For the public chain, the way to realize value capture is mainly reflected in three aspects:

  1. Adequate security (including degree of decentralization)
  2. A sense of transaction experience (including low handling fees, high throughput, etc.)
  3. Developer friendliness (difficulty of ecological construction)

Security is the most important, such as Ethereum, because of security and rich ecological construction, it has generated enough stickiness to maximize the capture of the value generated by user transactions. The more intuitive performance is like when ETH’s ICO was popular in 2017, because many projects will issue coins based on the Ethereum public chain, the assets received for investment and the miners’ fees consumed by transactions are all ether, resulting in a sharp increase in the currency price at that time. This is actually one of the manifestations of the success of public chain value capture.

But we also mentioned above that the high fees of Ethereum continue to squeeze the profits of users, so now more and more users are fleeing to BNB, SOL, Near and other chains to conduct transactions.

For DeFi or DEX, such as Uniswap, Compound, MakerDAO, etc., more value capture opportunities are obtained through openness:

  1. Anyone can participate in transactions and borrowing without permission;
  2. Anyone can list trading pairs;
  3. Anyone can inject liquidity without permission.

Through the above methods, more people can participate in the transaction, so as to obtain greater profits.

capital efficiency

What is capital efficiency?

In DeFi, capital efficiency refers to the use effect of funds when users use pledged loans or provide liquidity to DEX, including the effectiveness and adequacy of asset use.

It is worth noting that capital efficiency and capital utilization are not exactly the same. The former is mainly reflected in the rate of return, while the latter focuses on the adequacy of capital use.

How to improve capital efficiency?

When participating in the DeFi ecosystem, our market will find some problems, such as:

  • MakerDAO uses 150% over-collateralized lending, which means that by pledging \(1000 collateral, it can lend at most\) $666 of available assets, which means that only a maximum of 66% capital efficiency;
  • Another situation is that we add liquidity to DAI/USDC of UniswapV2. Generally speaking, the fluctuation of these two tokens is between 0.99 and 1.01, but the range of liquidity we add is much larger than this range, resulting in volatility The funds in the most frequent interval are only 0.5% of the overall, while the funds of most LPs are not used, and the income also decreases.
  • Another example is when using MakerDAO, if liquidation occurs, the hours-long auction process may further reduce the value of the collateral, resulting in low capital efficiency.

We can see from the above examples that if you want to improve capital efficiency, you can focus on two aspects:

  1. Improve capital utilization
  2. Improve the liquidity of capital

How can the DeFi ecosystem be improved?


As mentioned above, the capital utilization rate of UniswapV2 is very low, especially in some stable currency trading pairs. UniswapV3 adopts a user-defined liquidity range to concentrate liquidity and make its assets closer to the frequently traded price range, so that funds are more fully utilized and LPs get more transaction fees.


Unlike MakerDAO, Liquity has reduced the pledge-to-loan-to-collateral ratio, allowing 110% overcollateralization instead of MakerDAO’s 150%. In addition, Liquity also speeds up the liquidation process, enabling lower collateralization rates for borrowers.

flash loan

Platforms such as Uniswap, Aave, dYdX provide this service, and borrowers need to complete borrowing, trading and repayment operations in one transaction. Borrowing can be done without collateral. (But the repayment needs to be completed, the operation can be successful, and bad debts are avoided)

unsecured credit

The flash loan mentioned above is a type of unsecured credit, but it has strict restrictions and technical thresholds. At present, various DeFi platforms are exploring how to better evaluate user credit to achieve unsecured credit. Such as the introduction of KYC, digital identity (DID), etc.

A more interesting experiment is Aave’s unsecured lending protocol. Users who store assets in the Aave protocol can obtain the corresponding credit limit, and these users with credit limit can entrust their credit limit to others to borrow, so that the borrower Borrowing can be obtained without collateral. A user who appears to have a line of credit can become a guarantor for a borrower. There is a bit of DeFi + social meaning.

However, imagine that if DeFi ecological lending protocols can widely realize unsecured credit, then the capital efficiency of users will achieve a qualitative leap, and DeFi will move towards a real sea of ​​stars.


What is TVL?

TVL (Total Value Locked) refers to the total value of digital assets stored or mortgaged by users in DeFi projects. Usually denominated in U.S. dollars or other fiat currencies as appropriate.

Why is TVL important?

The important operation of DeFi mainly revolves around users’ pledge and lending or injection of liquidity, which requires users to pledge or deposit funds in the smart contract of the DeFi project party. So TVL shows the impact of capital on profits and availability for DeFi traders and investors.

better security

Since higher TVL means more capital locked in DeFi protocols, it usually (relatively) means that DeFi protocols are more secure. If we find a DeFi platform with a high APY but a relatively low TVL, then the platform is likely to be a pheasant platform and may have a Rug pull at any time.

better usability

The so-called availability, such as a DEX pool with a better depth, will result in a better transaction price. Another example is the pledge loan agreement, if the TVL of a certain token is higher, the loan interest rate will also be lower.

better liquidity

Projects with better TVLs tend to have better liquidity and are less prone to liquidity drying up.

better spread

Since TVL is an important indicator for measuring a DeFi project, projects with higher TVL will also receive more attention from DeFi practitioners or the industry, thus bringing more exposure and dissemination.

View TVL’s Tools


What is APY and APR?

APR (Annual Percentage Rate, stable annual rate of return) refers to the annual income that does not consider compound interest (reinvestment of profits) when making an investment.

APY (Annual Percentage Yield) refers to the annual return of compound interest when making an investment.

The formula for calculating APR is very simple, APR = Daily Interest Rate * Investment Days

APY is a bit more complicated, because the compound interest needs to be considered, APY = (1 + daily interest rate) ^ (investment days – 1)

For example, if I invest 100 yuan and invest in APR and APY investment products with a daily interest rate of 1%, then I can finally get:

APR: 100 * 1% * 365 = 365 yuan

APY: 100 * (1 + 1%) ^ (365 – 1) ≈ 3740 yuan

That is to say, the annual return of APR with a daily interest rate of 1% is 365%, while the annual return of APY with a daily interest rate of 1% is 3740%. The difference in return is 10 times. Does it look scary, but there are pitfalls here of.

The allure of high APY?

In DeFi, we often see thousands of years of annual returns. Just like the example I gave above, with a daily interest rate of 1%, there is also an APY of 3740% after one year of reinvestment. But there are two situations to be aware of here:

  1. Is there really a stable daily interest rate?
  2. Is the income calculated according to the invested currency or stablecoin?

Almost all DeFi returns are fluctuating. For example, if you see a DeFi protocol that tells you that APY is 3740%, the daily interest rate may only be 1% today. As the number of participants increases, the reward will be diluted. The daily interest rate dropped to 0.1%, the day after tomorrow, to 0.01%, and it continued to decrease. The final APY was only about 4%.

In addition, there are some DeFi projects whose returns are not calculated in terms of stablecoins or the tokens you put in. For example, if you see a project with 1000% APY, you need to pledge ETH, but the daily income for you is shitcoin, and shitcoin is a token whose price fluctuates greatly, and may even return to zero.

So don’t be blindly blinded by high APY.

How to choose between APY and APR?

At present, most DeFi products choose to use APY for three reasons:

  1. Under the same daily interest rate, APY will generate a greater return on investment than APR;
  2. Because of compound interest investments, APY will yield a larger percentage than APR for the same return;
  3. Many DeFi protocols will automatically invest with compound interest, and it is more reasonable to use APY.

However, we can see that UniswapV3 can only use APR, because the income of liquidity injectors is calculated separately and will not be compounded.

Active and passive market making

What is a market maker?

In the DEX ecosystem, market makers are mainly responsible for providing quotations and liquidity for transactions. The market maker can be a professional market maker team. For example, Tokenlon uses a professional market maker team to provide liquidity and quotation (PMM). In addition, there are automated market makers (AMMs), typically Uniswap. There is also the active market making that DODO uses independently developed, which is also a PMM. We will explain the meaning of active market making and passive market making in this below.

Active and passive market making in Uniswap

As we all know, Uniswap adopts the constant ride algorithm of x*y=k as price discovery, and users provide liquidity to the pool, and its behavior itself is the behavior of market makers. However, in Uniswapv2, users cannot set price ranges, but completely passively accept the full range of price fluctuations. However, in UniswapV3, users can set the price range independently, and only bear price fluctuations in some ranges.

So here, active market making is the market making behavior represented in V3 that can set a price range, while passive market making is the market making behavior that cannot set a price range in V2.

It is worth mentioning that the active market making in V3, although improving the capital utilization rate, will expose users to a higher risk of impermanent loss. Regarding the issue of impermanent loss, I plan to explain it in the future content.

Active and passive market making of DODO

In the semantic category of the DODO project side, the market making behavior of AMMs like UniswapV3 has also become passive market making. Why do you say that? Because the core idea of ​​PMM (Proactive Market Maker) adopted by DODO is to introduce price oracles to simulate the behavior of human market makers to guide prices and gather funds near the market price, which is a behavior with active price adjustment.

Compared with AMM’s passive market-making, PMM’s active market-making reduces impermanent losses, improves capital utilization, and makes market-making strategies less “rigid”.

Of course, as I understand it, Tokenlon also adopts an active market-making strategy under bidding. The corresponding professional market maker or AMM liquidity pool provides quotations behind it, and the one with the best price wins, which is also an active behavior.

Liquidity Gains and Net Market Returns

Liquidity pool gains

Liquidity pool income = fee income – impermanent loss income, after injecting liquidity, it is determined by fee reward and impermanent loss. Essentially, the currency standard is valued.

For example, if liquidity is injected into ETH <> UNI, and the final fee income cannot cover the cost of impermanent loss, then the income of the liquidity pool is negative. But does a negative liquidity pool return mean that I am losing money?

The answer is not necessarily, then look at another indicator – net market return.

Net market gains

Quite simply, it is determined by the rise and fall of the currency price. For example, I injected liquidity when ETH was $100 and UNI was $10. In the end, ETH rose to $5,000, and UNI rose to $300. Although I would suffer some impermanent losses, I still made money on the whole. Net market gains are usually denominated in stablecoins or fiat currencies.

Net market return = current liquidity pool token ratio price change decision.

Posted by:CoinYuppie,Reprinted with attribution to:
Coinyuppie is an open information publishing platform, all information provided is not related to the views and positions of coinyuppie, and does not constitute any investment and financial advice. Users are expected to carefully screen and prevent risks.

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