Navigating the complex world of finance, DeFi, and blockchain can be daunting for new auditors.
Feeling the challenge myself, I created a dynamic document, that I'm continuously updating with terms that I encounter on a daily basis.
APY or Annual Percentage Yield is a financial measure that calculates the return on investment (ROI) of an asset over a given time period. For instance, if you invest $1,000 at 5% APY, you can expect to earn $50 in interest after one year, assuming there's no compounding of the interest earned. With a constant APY rate, the monthly ROI in this example would be 0.42%.
An Automated Market Maker (AMM) refers to a decentralized pool for trading assets that allows market participants to buy or sell cryptocurrencies without the need for intermediaries. AMMs operate on a non-custodial and permissionless basis, allowing users to retain full control of their assets. While there are various market-making formulas that AMMs utilize, the most prevalent is the constant product market maker, with Uniswap being the most notable example. This formula maintains the product of the reserve assets, which enables liquidity provision for any trade size.
Rebalancing to an agreed upon value algorithmically.
How do we allocate products to the right participant. Example: auction market, voting.
Balancer Pool is an automated market maker that possesses specific properties that allow it to operate as a self-balancing weighted portfolio and price sensor. In contrast to traditional index funds where investors pay fees to managers for portfolio rebalancing, Balancer operates on a different principle: traders who capitalize on arbitrage opportunities rebalance the portfolio and pay fees to the pool's liquidity providers.
Balancer utilizes a Constant Mean Market Maker (CMMM) that allows for non-equal weights in pools, such as 80/20 or 50/50, and enables liquidity providers to offer single-sided liquidity. This market-making formula ensures that the pool remains close to the desired portfolio weights while enabling traders to benefit from price inefficiencies.
Collateralization is the act of borrowing deposit assets for the purpose of conducting business activities. By providing collateral for the borrowed funds, individuals can engage in various investment strategies. However, this practice also involves risks as it can amplify both gains and losses. Thus, collateralization is generally considered a riskier option than conducting business activities without borrowing funds.
Delegation involves granting permission to an individual, company, or organization to borrow funds by utilizing the deposited collateral of another owner. This practice enables individuals who do not have their own collateral to participate in various business activities, such as borrowing or trading. However, it is important to note that delegation involves risk, as the borrower is responsible for managing the borrowed funds and any associated losses.
Disbursal or token distribution in DeFi refers to the process of distributing tokens to users who have participated in a specific DeFi protocol or event, allowing them to receive their share of the protocol's rewards, incentives, or governance tokens. This distribution process can take various forms, such as airdrops, yield farming, staking, or liquidity provision, depending on the specific protocol.
Delta-neutrality is a term used in finance to describe a portfolio or position where the overall value of the position does not change when the value of the underlying asset changes.
The goal of delta-neutrality is to profit from other market factors, such as changes in implied volatility, time decay, or interest rates, while minimizing the impact of changes in the underlying asset's price.
Dutch Auction is a type of auction mechanism used in various financial contexts, including token sales, initial public offerings (IPOs), and decentralized finance (DeFi). In a Dutch Auction, the price of the asset being auctioned starts at a high level and gradually decreases over time until a buyer (or multiple buyers) agrees to purchase it at the current price.
In the context of DeFi and token sales, a Dutch Auction can be an effective way to determine the fair market value of a new token. As the price lowers, potential buyers place their bids, indicating their willingness to purchase the token at that price. Once the total demand for the token matches the available supply, the auction concludes, and the tokens are distributed to the winning bidders at the final price
A contract that gets its value from the assets in the contract.
A cryptocurrency protocol based on the Ethereum blockchain. An ERC-20 coin, by definition, uses this protocol.
English Auction, also known as an ascending-price auction or an open outcry auction, is a widely-used auction mechanism in which the price of the item being auctioned starts at a low level and gradually increases as bidders compete against each other by placing progressively higher bids. The auction continues until no participant is willing to place a higher bid, at which point the highest bidder wins and purchases the item at the highest bid price.
In the context of DeFi, English Auctions can be employed for selling digital assets or tokens, as well as for determining the market value of new tokens during token sales. Participants place bids by submitting the amount they are willing to pay for the asset, and as the auction progresses, the competition among bidders drives the price up. The auction ends when there is only one bidder willing to pay the highest price, and that bidder is then awarded the asset.
English Auctions provide a transparent price discovery process, allowing the market to determine the value of the asset being auctioned based on supply and demand. However, they can also be susceptible to certain strategic behaviors, such as sniping (placing a bid just before the auction ends to outbid other participants) or collusion among bidders to suppress the final price.
A Flash Loan is a unique loan that is exclusive to the world of cryptocurrencies. In this type of loan, an asset such as Ethereum or an ERC-20 coin is loaned out only for the duration of one transaction block on the blockchain. Provided the loan is repaid before the next block begins, the borrower is not charged an interest fee.
Flash Loans facilitate new forms of investments, as they allow for instantaneous algorithmic scripts to run in Smart Contracts. These scripts can be stacked upon each other to create innovative yet sometimes risky investments. However, it is essential to note that Flash Loans may have vulnerabilities. Malicious actors can exploit existing system vulnerabilities and use them in novel ways, which can cause significant risks to the system.
Futures are standardized financial contracts that obligate the buyer to purchase and the seller to sell an underlying asset at a predetermined price and time in the future. They are traded on exchanges and used for hedging, speculation, and gaining market exposure. Futures involve high leverage and require a good understanding of the market and risk management.
"Futures size delta" refers to the change in the number of futures contracts held by a trader or investor at different points in time. This metric is used to measure the difference between the current position and the previous position, and it can be positive or negative depending on whether the trader increased or decreased their position.
Forced Liquidation in the world of cryptocurrencies occurs when an investor or trader cannot meet the margin requirements for a leveraged position. In this context, liquidation pertains to both futures and margin trading. This means that if the value of a trader's position falls below a certain threshold, the exchange may force liquidate the position to cover the losses.
Forced Liquidation is a risk that traders take when engaging in leveraged positions. It is important to manage the risks associated with such positions, as failure to do so can result in significant losses. As such, it is critical to ensure that adequate precautions, such as setting stop-loss orders and regularly monitoring positions, are taken to minimize the risks of Forced Liquidation.
A Governance Token is a cryptocurrency token used to control the operations and influence the direction of a coin, token, and/or project. Holding these tokens can be profitable, as their popularity and price appreciation often result in significant returns for investors. In addition, governance token holders may be eligible for other benefits, such as voting rights and rewards
The rules by which people (or tokens) have to play by when in a space (e.g. digital ecosystem, game, theme park, country).
Hedging is a risk management strategy used in finance to protect against potential losses by taking a counterbalancing position in a related investment or financial instrument. The primary objective of hedging is to reduce or mitigate the risk associated with an existing investment, rather than to generate profits. Hedging can be accomplished using various financial instruments, such as futures, options, swaps, or other derivatives.
A hedge is a counterbalancing position or investment that is taken to offset potential losses in another investment. It is the actual execution of the hedging strategy. When an investor takes a hedge, they are essentially placing a bet that the market will move in a direction opposite to their existing investment. If the original investment suffers a loss, the hedge will help minimize or compensate for the loss by generating gains, thus providing protection against adverse market movements.
Impermanent Loss is a temporary loss of funds that occurs when liquidity providers deposit their assets into a liquidity pool and the price of the assets in the pool changes. The loss is called "impermanent" because it only occurs when the liquidity provider removes their assets from the pool. Impermanent loss can be mitigated by utilizing strategies such as single-sided liquidity provision, high-fee pools, and dynamic fees.
The riskiest of the tranches in DeFi, these offer the highest potential returns but also carry the highest level of risk.
Leverage refers to the use of multipliers on exchanges or markets that enable leveraged trading. This means that a trader can use a deposit of 1 BTC to invest in trades with the equivalent power of 10 to 100 BTC, assuming a 10x to 100x leverage ratio. While leveraged trades have the potential to generate significant gains, they also come with increased risk, as any losses are amplified in the same way as gains. In the event of a margin call during times of high volatility and insufficient reserve funds, a liquidation event could result in the loss of the entire deposit. Therefore, leveraging should be approached with caution and proper risk management techniques should be utilized to minimize the risks.
Liquidation refers to the process of selling collateral to repay a debt. It occurs when all the collateral in a vault is sold to cover the costs of repaying a debt, typically by someone other than the owner of the collateral.
A lien is a legal claim or right that a creditor has over a debtor's property or assets until a debt is fully paid or settled. It serves as a form of security for the creditor, ensuring that they have a means of recovering their funds if the debtor fails to meet their obligations. Liens can be placed on various types of property, including real estate, vehicles, and personal property.
For example, in a DeFi lending platform, a user might deposit Ethereum (ETH) as collateral to borrow a stablecoin like DAI. In this case, the deposited ETH serves as a lien on the loan. If the borrower fails to repay the loan or if the value of the collateral falls below a certain threshold (known as the liquidation ratio), the platform can liquidate the collateral (ETH) to recover the borrowed amount (DAI).
A long position is a trading strategy where an investor buys an asset with the expectation that its price will increase. The investor will profit if the price of the asset goes up. Long positions are commonly used in trading and can be contrasted with short positions.
Liquidation surcharge refers to a penalty fee that is imposed on a user's collateral when their position is liquidated due to falling below the required collateralization ratio.
In decentralized lending protocols like MakerDAO, users can borrow stablecoins by locking up their cryptocurrency as collateral. The required collateralization ratio is typically set at a level that provides a buffer against price volatility and prevents the value of the collateral from falling below the value of the borrowed stablecoin.
If the price of the locked-up cryptocurrency falls significantly, the user's position may be liquidated, and their collateral will be sold off to repay the outstanding loan. To incentivize users to maintain a healthy collateralization ratio, a liquidation surcharge may be added to the amount of collateral that needs to be sold off in the event of liquidation. This surcharge can help compensate the protocol for the risk of liquidating undercollateralized positions and encourage users to maintain a safe collateralization ratio.
The specific rules and rates of liquidation surcharges can vary between DeFi protocols and may be subject to change based on the protocol's risk management strategies and market conditions.
The ease of changing an asset into cash.
A Liquidity Pool (LP) is a pool of deposited funds used to provide liquidity to a currency, network, or Smart Contract. Liquidity is vital to any currency, exchange, or financial network, and rewards or incentives are provided to those who provide liquidity to LPs.
Liquidity Providers are investors who deposit assets to provide liquidity on an exchange or network with the aim of gaining an ROI on their investment. They deposit their digital assets into decentralized Liquidity Pools (LPs) to provide liquid capital to exchanges and Smart Contracts. Liquidity Providers often provide multiple types of assets, and sometimes incur Impermanent Loss.
A Liquidity Token is a token issued via Smart Contracts to a depositor in exchange for their deposit(s), which can be used for other purposes such as yield farming. Liquidity tokens can be exchanged back into the deposited asset at any time.
Liquid staking is like putting your toys in a toy box and getting a ticket in return. You can still play with your toys whenever you want, but you can also trade the ticket for other things you might want, like candy or stickers.
In the same way, when you stake your ETH in a staking pool, you get a special token (like a ticket) in return that represents your staked ETH. You can still use your staked ETH whenever you want, but you can also trade the token for other things in the crypto world, like more ETH or other tokens.
Margin is a high-risk avenue of borrowed capital that requires collateral to secure the loan. A margin loan amplifies gains for investors or traders, but is also subject to liquidation risk during a margin call.
A Margin Call occurs when an investor or trader cannot meet the debt obligations on their leveraged trading positions, which may trigger Forced Liquidation or a Liquidation Event. Margin Calls can result from rapidly changing market conditions and high volatility on exchanges and markets.
The market cap of a coin, company, or project can provide an indication of its overall value and performance in the market.
An Oracle is a data feed that provides high-confidence services to users and other services by supplying current market prices of an asset or assets. The data source must be timely, accurate, and untampered, and may come from singular or decentralized sources dispersed geographically. Accurate and timely information is essential for exchanges and markets to operate efficiently. One of the most well-known oracle protocols is Chainlink (LINK).
A Pool is a Smart Contract containing shared amounts of assets provided by depositors. Pools are used in Automated Market Makers (AMMs).
Perpetual futures trading allows traders to buy or sell an underlying asset without a pre-specified delivery date, reducing the need to repeatedly create a long or short position. However, due to the absence of an expiration date, the counterparty risk is high in the case of such financial instruments. 1, 2
Perpetual-like derivatives are financial contracts that track the price of an underlying asset (such as Bitcoin, Ethereum, or other cryptocurrencies) and offer investors exposure to the price movements of the asset without actually owning it.
Rebalancing refers to making changes to a portfolio or pool of funds for various reasons, including to gain profits through arbitrage, take or secure profits, or reduce risks to investors or pooled funds. During periods of high volatility, the latter is particularly relevant when margin or leveraged funding is used by traders, investors, or controllers in charge of pooled funds. If market conditions pose a risk to invested funds, mitigation efforts are implemented either autonomously or through manual intervention to reduce risks to invested funds.
Return On Investment (ROI) refers to the gains or losses on an investment. For instance, if an individual invests $100 in a stock and sells it for $150, the ROI would be 50%. On the other hand, if they sell it for $50, the ROI would be -50%. ROI provides investors with a clear understanding of the performance of an investment, enabling them to make informed decisions about their investment strategy.
In DeFi, these tranches are considered the safest and have the highest priority in terms of receiving interest or yield payments. They generally offer lower returns compared to other tranches, as the risk involved is lower.
In trading, slippage refers to the difference between the expected price of an asset and the actual executed price. For instance, if a trader places a buy order for a cryptocurrency at $10 and the asset is executed at $11, then the slippage would be 10%. Slippage can occur due to various reasons, such as limited liquidity and high market volatility.
A stablecoin is a type of cryptocurrency designed to maintain a stable value. For example, if an individual holds $100 worth of a stablecoin, they can expect that the value of their holdings will remain relatively stable over time. This stability is typically achieved through various mechanisms such as overcollateralization, algorithmic stabilization, or a peg to a stable asset like the US Dollar.
Stablecoins are often used in cryptocurrency trading as a way to hedge against market volatility or as a means of exchange.
Staking refers to the act of holding cryptocurrency in a wallet or platform in order to support the network's operations and earn rewards. For example, a user may stake their coins to support the Proof of Stake consensus algorithm and earn a share of the block rewards.
Staking is the process of holding cryptocurrency to earn rewards. For example, a user may stake their coins in a liquidity pool to earn yield on their holdings or participate in a governance token staking program to influence the development of a project.
A short position is a trading strategy where an investor sells an asset that they do not own, with the expectation that the asset's price will decrease in the future. The investor will profit from a short position if the asset's price falls below the price they sold it for.
In a short position, the investor borrows the asset from a third party and sells it on the market, with the promise to buy it back and return it at a later time. If the asset's price falls in the meantime, the investor can buy it back at a lower price and profit from the difference.
Superfluid staking is like sharing a toy with a friend, but instead of getting the toy back later, your friend gives you some candy each time they play with it.
In the same way, when you stake your tokens in a superfluid staking contract, you receive a continuous stream of rewards as long as your tokens are staked. These rewards are paid out in real-time, so you don't have to wait until the end of a staking period to receive them.
This means that you can use your staked tokens to participate in other activities like trading, lending, or borrowing, while still earning rewards on your stake. And just like getting candy from your friend, you can enjoy the rewards from your staked tokens without having to give them up permanently.
Imagine you are a financial trader and you use two monitors. The main monitor is for you to do your regular work and the side monitor shows the graphs and details of the market. You can move your window from the side monitor to the main monitor, and they are all connected in the overall computer system. Similarly, sidechain is like the side monitor. It is a separate set of blockchain networks and allows transactions and tokens to be used. You can move the tokens and transactions to the main chain (aka main monitor) whenever you want. We usually use sidechains for scalability solutions or to increase throughput speeds.
- We have security from the main chain (aka whatever virus-free software is on your computer systems)
- We have speed from the side chain (e.g. your side monitor runs specific programs very quickly like a Raspberry Pi)
An individual splits themselves up by creating identities on a P2P network. Imagine a person creating multiple Facebook accounts to like their own post.
Instead of keeping a physical cup, imagine smashing it on the floor and giving each friend a small piece of the cup. One scalability solution is sharding, which is to break information into small pieces and having different validators keep these pieces. Only the owner of the data can retrieve the information through the private key held.
A token is a type of digital asset that is often built on top of an existing blockchain network. Tokens can be used for a variety of purposes, such as representing ownership in a project or providing access to a particular service or feature. For instance, a user may hold a token that grants them access to a decentralized prediction market or a token that represents a share in a decentralized autonomous organization (DAO).
TVL, or Total Value Locked, is a metric that measures the total value of assets that have been deposited into a particular protocol or platform. For example, if a user deposits $100 worth of cryptocurrency into a yield farming platform, then the TVL of that platform would increase by $100. TVL is often used as a measure of the success and adoption of a particular protocol or platform.
TWAP (Time-Weighted Average Price) is an algorithmic trade execution strategy that aims to achieve an average execution price close to the time-weighted average price of the user-specified period. A TWAP strategy is often used to minimize a large order’s impact on the market by dispersing the large order into smaller quantities and executing them at regular intervals over time.
TWAP is favored to provide a better execution price in the following scenarios:
- Order size larger than the available liquidity on the order book.
- Anticipation of a high price volatility period with no clear up or downward trend.
Tranches are a financial term referring to the division of a larger pool of assets, such as loans, mortgages, or bonds, into smaller portions based on specific characteristics, such as risk level, maturity, or credit rating. These smaller portions are then sold as separate securities to investors. The word "tranche" is derived from the French word for "slice" or "portion."
In the context of DeFi, tranches are employed in innovative ways to create structured financial products with varying risk and return profiles. These products aim to cater to a broad range of investor preferences and risk tolerances within the DeFi ecosystem.
DeFi tranches are often applied to yield-generating products, such as those involving liquidity provision or lending, to create tiered investment opportunities. Assets within a DeFi protocol may be divided into tranches based on risk exposure, liquidity, or other factors.
Volatility refers to the degree of price variation of an asset over time. For instance, a highly volatile asset may experience significant price swings over short periods of time, while a less volatile asset may experience more stable and predictable price movements. In cryptocurrency, volatility is often attributed to factors such as market sentiment, regulatory changes, and technological developments.
A cryptocurrency wallet is a digital tool used to store, manage, and transact cryptocurrencies. Wallets can be either hardware or software-based and can be used to securely store private keys and other important information related to an individual's cryptocurrency holdings.
Yield Farming is a process that involves staking or lending cryptocurrencies in DeFi protocols to earn rewards. Yield farming enables users to earn returns on their assets by providing liquidity to various DeFi applications, such as automated market makers, lending protocols, and liquidity pools. The rewards offered to yield farmers typically come in the form of governance tokens or the protocol's native token, which can be sold or reinvested to compound returns.