You bought some crypto and are ready to embark on a journey exploring the world of DeFi? Congrats!
“Alice asked the Cheshire Cat, who was sitting in a tree, “What road do I take?”
The cat asked, “Where do you want to go?”
“I don’t know,” Alice answered.
“Then,” said the cat, “it really doesn’t matter, does it?”
Unlike for Alice, which road you take really does matter when experimenting with DeFi. That’s why in this post, we’ll be sharing a few concepts to familiarize yourself with to make the most out of DeFi.
You will need a wallet to receive and connect with DeFi protocols no matter where you got your crypto. Broadly we differentiate between hot and cold wallets.
Hot vs. cold wallets
In general, all types of crypto wallets help you store the private key that enables you to do anything with your crypto.
The difference between hot and cold wallets is straightforward. All wallets connected to the internet to function are considered “hot.”
Hot, because whenever something is online, it’s a potential target for malicious actors, and if you are active on Crypto Twitter, you might have seen some users post about hacks. Hot wallets include Browser extensions like Meta Mask and wallet apps such as Edge or TrustWallet.
Cold wallets store your private keys offline and are considered a safer option. They include paper wallets, where the private key is printed on paper, and the more popular hardware devices such as Ledger, Trezor, or the ColdCard.
These hardware-based cold wallets store your private key on a secure element, a hardened microcontroller (chip) with very few interfaces to the outside world to mitigate attack surfaces. Such secure elements are also used for credit cards and SIM cards — making these wallets highly safe from attacks. Yet, of course, they are not safe from getting lost. This brings us to the next concept.
Seed phrase 🌱
Whenever you use a non-custodial wallet (can be hot or cold; and means that you will be keeping control of your own private key), it will generate a so-called seed phrase during the setup process. The seed phrase, also known as the recovery phrase, is a 12–24 words long combination of words that will give you access to the crypto in that wallet.
So even if you lost your wallet, as long as you have your Seed Phrase, you would be able to regain access to your funds. Some people write their seed phrase down and store it in a vault, others split it up and distribute it among friends, yet others engrave it into metal or memorize it entirely.
If you don’t want to deal with the storage of your private key or seed phrase, you can opt to rely on centralized exchanges or custodial wallets.
Ready to DeFi?
Now you have your wallet set up and some crypto ready to deploy, here are a few popular types of activities you might want to try in DeFi and a few terms that’ll help you avoid making expensive mistakes: such as the Trader who lost $135,000 by accident in trading fees.
Trading
Arguably, what has made crypto famous among retail investors is trading. Whatever niche coin you want to trade, the chances are good that you’ll find a platform in DeFi to do so. The go-to platform for trading in DeFi are decentralized exchanges.
DEX
Decentralized exchanges let anyone trade any asset without intermediaries. Instead of having to deposit to an exchange account, you connect directly with your wallet. And instead of trading with a human counterparty, what you interact with on DEXs is a smart contract and liquidity pools that hold token pairs, and execute the swaps. For a more in-depth explanation of how DEXs function, check out this post.
All these interactions are ruled through automated market makers, special algorithms that help define the price of tokens. Here is an exemplary process.
- Alice wants to trade her dog coins for cat coins.
- She connects her wallet to a decentralized exchange
- She enters how many of her dog coins she wants to trade and presses to confirm.
Before pressing confirm, there are a few things she might want to check. Remember the trader we mentioned above who had lost $135k in a DEX? Without going into too much detail on how that happened, checking the liquidity provided prior to signing the transaction could have prevented that.
You might be thinking:
Liquidity
Liquidity describes how easy it is to buy and sell an asset. High liquidity means that you can easily buy and sell your dog coins, and you can do so without big price fluctuations.
Imagine you own 100 dog coins. You go to a marketplace trying to sell them for cat coins. But nobody really wants these dog coins, so there is very little demand. Chances are that you will have to go down a lot in price from your initial ask to sell your coins; if you can find a buyer.
In a liquid market, you would go to the marketplace and immediately find someone who’d want to buy them off you at the market price. This is why liquidity matters.
Where does the liquidity on a DEX come from? Mostly from traders (institutional and private) who deposit their tokens into the DEX’s liquidity pool. Currently, traders have locked more than $14 bn worth of assets on Curve (a leading stablecoin DEX), and over $8 bn assets on Uniswap (leading DEX).
Why do they deposit their valuable holdings into a smart contract? Because DEXs offer traders attractive rewards for providing liquidity. They receive a share of trading fees and the platform-native governance token at times.
Back to Alice’s transaction, how can she check the liquidity?
Most DEXs have a dashboard listing all the existing liquidity pools including how liquidity looks like in those pools. Below is an example of a liquidity distribution. As you can see around the current price in the middle liquidity is highest, whereas it drops off towards the edges. If Alice wants to buy at market price and liquidity is high there, she shouldn’t have any issues.
Another value worth looking at is the so-called Slippage.
Slippage
Slippage describes the difference between the price you entered upon order creation and the price your order was executed at. Differences in these arise either due to low liquidity, or because crypto is generally very volatile.
Most DEXs have a default slippage, which traders can change to reflect their own preferences. When trading highly volatile assets, they might have to increase slippage for the orders to be executed, on stablecoin trades one can likely lower it.
After checking Liquidity and adjusting (if necessary) slippage, Alice can finally confirm her transaction and sell her dog coins for cat coins.
DEX aggregators
Suppose Alice wanted to execute various trades and would like to get the best price possible on the market, what could she do?
Either, she checks for every DEX individually what prices are quoted. In a volatile crypto market, this might be a difficult endeavor. Alternatively, she can use a “DEX aggregator”.
When placing an order on a DEX aggregator, the system will automatically check prices across a range of DEXs and pick the most cost-efficient route to execute a trade. Just like on a DEX, a trader’s funds remain in their wallet until the order route is defined, and the trader agrees to the quoted price.
On top of not having to check quotes manually across platforms, DEX aggregators provide a higher level of liquidity, which is useful especially for traders trading more frequently.
This post introduced important concepts that anyone doing their first steps in DeFi will come across including hot and cold wallets, and what to look out for when making one’s first trade on a DEX.
While Minima is currently still in the test net, we’re expecting to see a flourishing DeFi ecosystem once we go live in Q2 2022. We’re looking forward to bringing true Decentralization to the space, and until then encourage you to stay curious.