Decentralized finance (commonly referred to as DeFi) is an experimental form of finance that does not rely on central financial intermediaries such as brokerages, exchanges, or banks, and instead utilizes smart contracts on blockchains, the most common being Ethereum.
DeFi revolves around applications known as DApps (decentralized applications) that perform financial functions on digital ledgers called blockchains. Rather than transactions being with and through a centralised intermediary, transactions are directly between participants, mediated by smart contract programs. It aims to create a financial system that’s open to everyone and minimizes one’s need to trust and rely on central authorities.
Decentralized exchanges (DEX) are a type of cryptocurrency exchange which allows for direct transactions to take place online securely and without the need for an intermediary on a distributed ledger.
An automated market maker (AMM) is a type of decentralized exchange (DEX) protocol that relies on a mathematical formula to price assets. Instead of using an order book like a traditional exchange, assets are priced according to a pricing algorithm. This formula can vary with each protocol.
Liquidity Pools (LP)¶
DeFi is changing how finance is working in many ways. One of the most interesting ways is the ability to power the financial market with liquidity pools.
Collective liquidity or monetary pools are not DeFi’s creation, but in traditional finance, pools like these often mean under-the-table operations and non-transparency. However, with blockchain technology, everything is coded in smart contracts and open to the public. Pools can be as transparent as they need to be, and it is a cost-efficient and effective way to boost liquidity.
There are different kinds of pools elaborately programmed for liquidity in DeFi in various scenarios, and the application is ever-growing. Lending pools, market-making pools and options collateral pools are among the best known.
DeFi Yield Farming/Mining¶
Yield farming, also referred to as liquidity mining, is a way to generate rewards with cryptocurrency holdings. In simple terms, it means locking up cryptocurrencies to provide liquidity or locking up circulation, and getting rewards.
The precise mechanics of yield farming depend on the terms and features of the individual DeFi application. The most common yield farming method is to use a DeFi application and earn the project token in return.