Blockchain & Decentralized Finance (DeFi) Terms for Beginners
Use this guide to educate yourself or help others better understand Blockchain and Decentralized Finance
By Marshall Swatt (@marshallswatt)
The original whitepaper for Bitcoin, by Satoshi Nakamoto: https://bitcoin.org/bitcoin.pdf
"Layer 1": Networks - these are the underlying blockchain networks, like Bitcoin, that facilitate transactions, maintain one or more tokens, and facilitate additional functionality such as data storage, computation or customizable behavior. There are literally hundreds - if not thousands - of layer 1 blockchain networks, offering a wide array of different benefits and capabilities, with the aim of targeting a specific market opportunity, to provide competition and spur innovation, for pure experimentation and research, to improve on existing networks, and other strategic business or novel technical differentiation theses. Who knows how this ultimately shakes out, but my bet is that Ethereum is guaranteed to have long-term healthy competition, and networks that target and optimize for specific business and use cases. Dapper Lab's Flow network, which is optimized exclusively for NFT's, is just one such example.
Examples: Bitcoin, Ethereum, Cardano, Polkadot, Cosmos, Avalanche, Flow Numerous other networks
"Layer 2, 3+" - These are currently a bit fluid and opinions abound. These refer to layers that extend a base layer's capabilities (such as scalability), provide interoperability between two or more Layer 1's, and that consist of real consumer applications on those networks.
"Decentralized Finance (DeFi)" - Describes software that performs banking and financial activities that were traditionally performed by banks and financial firms. DeFi software provides loans, enables the exchange of financial assets and offers other services without the need for human intervention, manual processes or third parties. The service is performed exclusively by a computer program (known as a smart contract) running on a blockchain network.
“Blockchain Ledger” - A blockchain ledger is simply a computer ledger or record of transactions that take place on a network. Transactions are typically batched and added to the ledger in a block, hence the term blockchain ledger. The ledger is just a file on the computer. It’s as simple as that!
Analogy: An accounting ledger or running bank statement consisting of a complete history of all transactions
Example: Bitcoin, Ethereum
“Mining” - Mining for gold is a process of digging in the earth, often by trial and error, with the aid of technology and knowledge of geology. Mining for cryptocurrency is also in fact a process of trial and error, often employing costly and highly specialized hardware to perform a mathematical calculation. Cryptocurrency miners compete to book transactions and earn transaction fees, just as gold miners competed to be the first to find a vein of gold in the ground.
Consider another analogy: Any computer or electronic network requires dedicated computers to perform work to maintain its overall operation, whether that network is the internet itself, a credit card processing network, a telephone network, bank transfer networks, Bitcoin, or others. Each computer on a network is called a node. In traditional networks, the businesses running those nodes earn revenue by collecting wire transfer fees, credit card processing fees, phone subscription fees, or data transmission fees.
In the case of Bitcoin and cryptocurrencies, each node is compensated for its share of the work performed for the network. The computer node earns transaction fees for each transaction it books and may also be rewarded by the network with a specific quantity of newly minted cryptocurrency. The work the computer node does to earn the right to book transactions on the blockchain is called ‘mining.’ Networks that utilize mining are known as “proof of work” networks.
Analogy: Mining for gold by expending labor and resources to compete against other miners. Computers that “mine” bitcoin compete with other computers to solve calculations quickly and earn transaction fee revenues. The revenue they earn is paid in bitcoin.
Analogy: a credit card processing network charges fees to facilitate transactions. Bitcoin’s network charges fees for processing transactions.
"Proof of Work" - blockchain networks that utilize mining as the primary mechanism to regulate how they book transactions. The terms refers to a mathematical proof performed by a node on the network, that every other node is able to independently verify. This offers many benefits and represents a key piece of the innovation that is blockchain technology. Among other things, it ensures that no single node can behave maliciously because their work will be validated by all the other nodes, and if incorrect, it will be rejected.
“Staking” - Similar to mining, computers work to maintain a network and book transactions. Each computer node pledges a certain amount of capital to join the network and participate. That capital sits in reserve, but in return gives the computer node permission to participate and book transactions. In exchange, the computer may earn transaction fees and newly minted tokens. The stake refers to the capital committed by the computer node. If the computer node behaves maliciously, it also runs the risk of losing some or all of its staked capital as punishment. Networks the require staking are called “proof of stake” networks.
Analogy: Attorneys, bankers, brokers, contractors and many other professionals are often required to put up their own capital to secure a bond in order to perform their work. The bond acts as an incentive to ensure they will behave professionally. If they make a mistake or behave unprofessionally, they risk losing some of the capital secured by the bond. Staking crypto assets acts as a bond that permits a computer to operate as a node on a blockchain network and earn its share of revenue from the network’s transaction fees. If the computer misbehaves, the network may confiscate some or all of its staked capital (known as ‘slashing’).
Examples: Cosmos, Ethereum V2, Zilliqa
"Proof of Stake" - to blockchain networks that utilize staking as the mechanism to regulate how they book transactions. This is one of many variations to proof of work, and an attempt to address some of its shortcomings. Staking is more energy efficient, does not force each node to compete against other nodes, and therefore does not require expensive custom hardware, among other benefits. Proof of stake implementations can present their own trade-offs, such as tying up a large quantity of the network's own tokens for staking, or giving one node with a large quantity of staked tokens too much power. These can be mitigated, and some implementations make adjustments to address these trade-offs.
"Burning a token" - Burning a token is essentially the process of removing it from the overall supply of tokens. This can be done deliberately or accidentally. Some blockchain networks deliberately burn tokens in order to reduce supply and put upward pressure on its value or price due to increasing scarcity. This may bring trade-offs, however, for networks that require a large liquidity supply of tokens in order to facilitate transactions.
Analogy: Removing currency from circulation, which is performed by the US Federal Reserve
Example: Binance Token, Avalanche token
“Yield Farming” - Imagine you want to deposit your money into a bank that offers the highest interest rate, or annualized rate of return. Periodically you check with all the banks in the market and move your funds to the bank offering the highest return. That is known as ‘yield farming’ in cryptocurrencies. With yield farming, you look for and select the platform offering the highest interest rate for your crypto assets. You can manually do the work of checking periodically for the platform offering the best rate or you can use an application that automatically finds the best rate of return and allocates your token assets accordingly.
Analogy: shopping around for the banks offering the highest interest rate for your money
Examples: BlockFi, Celcius, Yield
"Liquidity Mining" - This is a form of yield farming where the lender and/or borrower is rewarded for their participation with a token. The token reward may be in addition to interest earned via yield farming. These tokens may offer holders the ability to vote and participate in the governance of the liquidity platform itself.
Examples: Compound, which distributes a COMP token to both lenders and borrowers
"Liquidity Provider" - This is someone who lends capital to facilitate trades on a decentralized exchange, a role that is traditionally known as market making. They deposit assets in order to provide "liquidity" and facilitate exchange transactions. The provider earns a fee for each transaction that takes place. The provider often receives a quantity of tokens from the exchange that can be used to redeem their original capital. The redemption tokens represent the provider's contribution of liquidity in the exchange's asset pool. The provider is not guaranteed to get back the same ratio of assets, however, and that can result in a loss when they go to redeem.
Analogy: A market maker on a traditional exchange is a liquidity provider. The same applies to a decentralized exchange.
Example: Uniswap, Sushiswap
More detailed Explainer: https://pintail.medium.com/uniswap-a-good-deal-for-liquidity-providers-104c0b6816f2
"Flash Loan" - A loan that is made and paid off in a very short time frame, usually within the time it take to book a transaction on a blockchain network. Flash loans can facilitate complex financial transactions, often between multiple tokens, on a blockchain network. The borrower takes out the loan, uses funds for the calculation, and returns the loan as part of a transaction. Flash loans usually do not require collateral.