How to DeFi

Crypto swaps are direct exchanges of one cryptocurrency for another through smart contracts on decentralized platforms (DEXs), bypassing traditional intermediaries. These swaps are automated, ensuring a trustless and efficient exchange of assets between parties.

The loss produced by providing tokens as liquidity to an AMM instead of just holding them, if the tokens diverge in price. Divergence loss is the difference between the value of an LP position vs the same account holding fixed amounts of those same tokens

Starting with Bitcoin, cryptocurrencies have introduced a truly novel form of money (and more) to the world. The thing which unites and makes this asset class special is the technology referred to as blockchain; a set of algorithms and rules that constitute a distributed digital network where each participant (e.g. holder of a cryptocurrency) can be sure that their balances are correct and accessible — without trusting a central intermediary, like a bank. Ethereum, the second biggest cryptocurrency today, proved that blockchains are useful for more than just simple money transfers; it allows people to build decentralized apps, which, in less than a decade, has resulted in an explosion of Decentralized Financial (DeFi) protocols, and tokens of all kind, including NFTs. There are thousands of cryptocurrencies today with many created each day — it is important to understand the purpose and background of a token before buying it.

Layer 2 (L2) is a collective term to describe various types of scaling solutions for the base blockchains or Layer 1s (L1). A Layer 2 is a separate blockchain that extends their native L1 and inherits the security guarantees of it. Examples of Layer 2s are the Lightning Network for Bitcoin, and the numerous "rollups" for Ethereum such as Optimistic Rollups and Zero-Knowledge Rollups. Blockchain systems offer great technological benefits for money transfers and record-keeping in general; the main properties most often considered are decentralisation, trust– and permissionlessness, censorship resistance and immutability. These desired properties of decentralised networks come at the cost of limited throughput, however. Scaling solutions to blockchains are an advanced topic with much ongoing research and development. The technical descriptions and differences between each is beyond the scope of this explainer, but they are well worth researching for the curious.

The simple acts of Lending and Borrowing are prominent financial primitives that form the basis of many more complex financial products. Just as there are DEXes operated by Automated Market Makers that allow people to swap their coins seamlessly with each other, there are numerous lending platforms in DeFi.

Broadly speaking, leverage in finance refers to using borrowed funds to purchase something, with the expectation that the profits on the purchase exceed the borrowing costs. Leverage can come in various forms: financial derivatives like futures and options, mortgages for private persons. There are numerous platforms that give people access to leverage, both centralised and decentralised.

Providing liquidity refers to the act of depositing assets into a liquidity pool, which is a collection of funds locked in a smart contract used to facilitate trading by providing liquidity on decentralized exchanges (DEXs). These pools allow users to trade cryptocurrencies without the need for traditional market makers, as the liquidity (i.e., the available funds for trading) comes from the assets pooled by the liquidity providers. In essence, when you provide liquidity, you are lending your cryptocurrency to a pool to enable others to trade with it, while the pool relies on algorithms to determine prices based on supply and demand.

Staking crypto essentially means locking it up for future rewards — much like a savings account. The complexity of staking one's crypto, as well as the risks and rewards can vary depending on the coin and the place where it is staked.Bitcoin's blockchain relies on a consensus mechanism called Proof of Work, where the validity of the network is maintained by having people use their computers for solving math problems, roughly speaking. Proof of Stake is an alternative consensus mechanism that aims to alleviate the computational burden from a blockchain network via having people put their coins on the line instead. PoS networks include Solana, Avalanche and ETH2.0, amongst others. Setting up a Proof of Stake client can be quite technical and does not fit in the scope of this explainer. However, staking in the broader sense has been widely utilized by DeFi apps for various purposes, in which case it is as easy as clicking a button and paying some fees; like a savings account in the bank, but more transparent!

Insurance is a way for people to protect themselves from potential risks. You buy insurance from an insurance company for some fee, and if an accident occurs, the company compensates you. Insurance companies are essentially a way for people to socialise their risks (e.g. illness, by pooling their money together. In DeFi, just as there are decentralised protocols built for people to lend out and/or exchange their tokens, there are insurance protocols where one can buy insurance against accidents on the blockchain — or put their funds in the insurance pools to cover others from losses in exchange for rewards.

An option is a financial contract that give its buyer the right, but not the obligation, to buy or sell an underlying asset for a specific price (called _strike price_) on (or possibly before) a specific time. The most widely used exchange for trading crypto options is Deribit. They offer European style options for Bitcoin and Ethereum. There are also several DeFi protocols that allow people to buy or sell options of smaller cryptocurrencies, as well as protocols that automatically execute various options strategies in order to generate yield on people's deposits.

Crypto bridges are tools that allow the transfer of assets or information between two different blockchain networks, enabling interoperability. These bridges can be centralized, relying on trusted entities, or decentralized, using smart contracts for automation and security.