The DeFi Standard’s DeFi Glossary is meant to be a place for users to learn about the basics behind the seemingly complex terminology used in decentralized finance. While the learning curve in the DeFi industry can be steep, taking the time to learn just a little each day will help compound your knowledge over time.
Automated Market Maker (AMM)
AMM is a decentralized exchange (DEX) protocol that facilitates the swapping of assets without a counterparty via an algorithmic formula. This algorithmic formula is utilized to price the assets being swapped rather than an order book, which relies on the bid/ask spread to determine asset price ratios. Uniswap is one of the pioneering protocols utilizing an AMM on Ethereum.
In regards to the FlareX protocol, it uses the constant product (k) model, which ensures that liquidity remains the same at all times. The constant product formula can be defined as k = x * y, where x is the supply of one asset and y is the supply of the other asset in a dual-token liquidity pool.
Decentralized Exchange (DEX)
A DEX is a protocol that facilitates the trade of assets without a central counterparty. Decentralized exchange can also be used to describe a peer-to-peer transaction (P2P). The XRP Ledger utilizes an order book DEX that allows users to post bid and ask prices for the trading of assets. FlareX will be utilizing another form of DEX called an automated market maker (AMM), which prices assets with an algorithmic formula.
Impermanent loss can be defined as the opportunity cost of participating in a liquidity pool versus having just held the assets in the user’s wallet. It is important to note that these are only paper losses and are not realized until the user actually removes their assets from a liquidity pool. Impermanent loss only occurs if the price ratio between the assets staked in a liquidity pool changes. Additionally, the more inversely correlated assets in a liquidity pool are the more exposed to impermanent loss a user becomes. Therefore, the profitability of participating in a liquidity pool is determined by the difference between impermanent loss upon exit and any fees or yield earn by utilizing the LP tokens associated with a users stake in a liquidity pool. Protocols and strategies for hedging against impermanent loss are being developed everyday; however, the lack of derivative products in the DeFi industry has made this tougher for users.
A liquidity pool is simply an aggregation of assets provided by either retail or institutional users with no capital barriers to entry. Users providing liquidity to a liquidity pool are deemed liquidity providers as they allow their assets to be utilized in the swapping of assets. In essence, liquidity providers are acting as the market makers in DeFi. Liquidity providers earn fees from every asset swap that takes place in a liquidity pool. Additionally, liquidity providers are issued liquidity pool (LP) tokens that represent the value they have staked in the pool. LP tokens can often be utilized for collateral in lending protocols and even used to unlock the benefits of liquidity mining like in the FlareFarm protocol.
While liquidity pools can offer a source of daily yield to liquidity providers, the algorithmic formulas underpinning these pools result in changes to the claim of staked assets these providers have. It is important to understand the effects that impermanent loss can have on a user’s staked assets in a liquidity pool before participating in them. Users wishing to swap assets through the use of a liquidity pool will also want to understand the possible slippage effects on their trades as well. Generally, the more liquidity in a pool the less slippage users will suffer.
Slippage is the difference between where the price the user expects a trade to be executed at and where the price of the trade is ultimately executed at. In terms of liquidity pools, slippage occurs more often in pools with insufficient liquidity provided and with larger trade orders. Therefore, liquidity pools can be excellent tools for everyday swaps, but not as effective for the movement of large amounts of capital. However, if a liquidity pool did have enough value to cover extremely large trades, then the slippage would not be much of an issue. Users should pay attention to any slippage that may occur before swapping assets via a DEX that utilizes automated market makers.
Collateral is the asset(s) that a user posts or lock ups in order to take out a loan (often in the form of stablecoins) or create a synthetic asset. Some lending protocols may automatically drain the posted collateral if the user cannot maintain the minimum required amount. Users can generally retain their collateral by returning the borrowed assets back to the protocol plus any interest accrued.
A collateralization ratio is the rate at which a user needs to maintain a minimum collateral amount to be in good standing with the protocol they are borrowing assets from. If the collateral ratio is 100%, then users can borrow up to the amount collateralized. In the case that the assets collateralized fall in value, a borrower would be required to post more collateral, so that it is at least equal to the amount borrowed. Additionally, collateral is now being used for the backing of newly created assets and a collateralization ratio would apply the same in that case. Users unable to maintain the collateralization ratio may be at the risk of defaulting on their position, which could include liquidation of their collateral. Many lending protocols require users to overcollateralize their borrowing activities.
Liquidation occurs when a user who has either borrowed or created a synthetic position defaults on the required collateral ratio maintained by a protocol. Users may lose all of their assets posted as collateral during liquidation as it is a means to ensure the solvency of a protocol.
A stability pool is utilized to maintain the solvency of a stablecoin or lending protocol. Users pool funds together usually in the form of a stablecoin to pay back bad debt from users defaulting on their collateral ratios. Users contributing to a stability pool are normally paid out through user liquidations after they cover the bad debt. This is all autonomous through DeFi protocols powered by smart contracts.