Diving Deep into Decentralized Finance: Your Comprehensive Guide to DeFi Key Terms

Decentralized Finance, or DeFi, is rapidly reshaping the financial landscape, offering a permissionless and transparent alternative to traditional banking. Built on the revolutionary blockchain technology, DeFi aims to empower individuals by removing intermediaries and placing control back into the hands of users. For those embarking on their DeFi journey, understanding the foundational terminology is crucial. This guide breaks down the essential concepts and terms you'll encounter in this innovative space.

The DeFi Foundation: Core Concepts Unpacked

At its essence, DeFi champions decentralization, meaning power and decision-making are distributed across a network rather than residing with a single entity. This is made possible by the blockchain, a secure, distributed, and immutable ledger that records all transactions, ensuring transparency and integrity.

The true workhorses of DeFi are smart contracts. These are self-executing agreements, with the terms directly embedded in code on the blockchain. They automate processes, enforce rules, and eliminate the need for third parties, fostering a trustless environment where users rely on code, not institutions. The inherent permissionless nature of DeFi means anyone with an internet connection can access and utilize these protocols without needing approval.

One of DeFi's most exciting characteristics is composability, often referred to as "money legos." This signifies the ability of different DeFi protocols to seamlessly connect and build upon one another, enabling the creation of complex and innovative financial services. This modularity fuels rapid innovation within the ecosystem.

Navigating the DeFi Ecosystem: Key Components and Services

The DeFi landscape is rich with applications and services designed to replicate and enhance traditional financial offerings:

• dApps (Decentralized Applications): These are software applications that run on a decentralized blockchain network, typically powered by smart contracts.

• DEXs (Decentralized Exchanges): Unlike centralized exchanges, DEXs enable peer-to-peer trading of digital assets without an intermediary holding funds. Many DEXs utilize AMMs (Automated Market Makers), which rely on algorithms and liquidity pools to facilitate trades.

• Liquidity Pools: These are collections of digital assets locked within a smart contract to enable trading on DEXs. Users who contribute assets to these pools are called Liquidity Providers (LPs) and earn a share of the trading fees.

• Yield Farming (Liquidity Mining): A popular strategy where users contribute assets to DeFi protocols to earn rewards in the form of tokens or fees, often by strategically moving assets across different protocols to optimize returns.

• Lending & Borrowing Protocols: These platforms allow users to lend their cryptocurrency to earn interest or borrow assets by providing collateral. DeFi loans are often over-collateralized to mitigate price volatility.

• Stablecoins: Designed to maintain a stable value, stablecoins are typically pegged to a fiat currency (like the USD) or other stable assets, reducing price fluctuations. Popular examples include USDT, USDC, and DAI.

• DAOs (Decentralized Autonomous Organizations): These organizations operate under rules encoded in smart contracts, with governance decisions often made by token holders through a voting process.

• Oracles: Crucial for DeFi, oracles are external data feeds that bring real-world information (e.g., asset prices) onto the blockchain for smart contracts to use.

• Gas Fees: These are the transaction fees paid on blockchain networks (e.g., Ethereum) to compensate network participants for processing and validating transactions.

Understanding Digital Assets in DeFi

Various types of digital assets drive the DeFi ecosystem:

• Fungible Tokens: Interchangeable tokens where each unit is identical (e.g., Ether (ETH), Bitcoin (BTC)).

• Non-Fungible Tokens (NFTs): Unique digital assets where each token is distinct and non-interchangeable (e.g., digital art, collectibles).

• Governance Tokens: These tokens grant holders voting rights in a protocol's governance, allowing them to participate in its future development and decision-making.

• LP Tokens (Liquidity Provider Tokens): Received by liquidity providers, these tokens represent their share and claim on assets within a liquidity pool.

• Wrapped Tokens: A cryptocurrency token on one blockchain that represents another cryptocurrency from a different blockchain (e.g., Wrapped Bitcoin (wBTC) on Ethereum), enabling interoperability.

Essential Tools and Considerations for DeFi Users

To engage with DeFi, a wallet is indispensable - it's a software application or hardware device for securely storing your cryptocurrencies and interacting with dApps. Your private key is the cryptographic key that grants you access to your funds and data; it must be kept absolutely secret. Your public key, often referred to as your wallet address, is what you share to receive funds.

Other important terms to be aware of include:

• Slippage: The difference between the expected price of a trade and the price at which it is actually executed, often due to market volatility or low liquidity.

• TVL (Total Value Locked): The total amount of digital assets locked within a DeFi protocol, serving as a key metric for its size and adoption.

• Flash Loan: An uncollateralized loan that is borrowed and repaid within the same blockchain transaction, often used for arbitrage opportunities.

• Aggregator: A DeFi protocol that scans multiple platforms to offer users the best rates for various services, such as lending, borrowing, or swapping.

While DeFi presents exciting opportunities for financial innovation and inclusion, it's crucial to understand the inherent risks, including smart contract vulnerabilities, market volatility, and the nascent regulatory environment.

By grasping these fundamental terms, you'll be well-equipped to explore the dynamic and rapidly expanding world of Decentralized Finance.

CoW Protocol Glossary

Now that you’ve grasped the basics, here are some CoW specific terms that can help you navigate the CoW ecosystem.

CoW Swap - What started it all. CoW Swap is our version of what a DEX should look like: a powerful, open-source, and permissionless DEX aggregation protocol that anyone can integrate for a variety of DeFi purposes. It provides MEV protection, a simple user interface, advanced trading tools across multiple networks, all wrapped up in one ;

CoW Protocol - the backbone of the CoW world. It’s the leading intents-based DEX aggregation protocol. What does that mean? It leverages intents, batch auctions, and the largest solver network in DeFi to bring surplus-capturing, MEV-protected trades to users. It’s our secret sauce.

CoW AMM - our very own automatic market maker (AMM) but with a twist. This is the first MEV-capturing AMM, it protects LPs from LVR so they can provide liquidity with less risk and more return.

CoW Widget - The widget is the simplest way you can integrate CoW Swap on your platform. If you want to bring seamless, MEV-protected trading to your website or dApp (and add an extra revenue stream in the process), this is the fastest way to do it.

CoW Explorer - a handy little tool that lets you explore any order ID, ETH Address, ENS Address or Tx hash.

Specific terms we use around here

There are a few unique terms you might see in our documents and our project pages that might seem technical at first glance. Below we break down some of the most common ones.

Intent to Trade: When users submit orders on CoW Swap, they are not actually initiating a blockchain transaction, like they would on Uniswap. Instead, orders are submitted as signed “intent to trade” messages which include the details of the intended trade, but are not actually submitted to the blockchain. From here, independent parties known as “solvers” find the best execution path for the specified trade and execute the trade on-chain on behalf of the user. If a trade route cannot be found for any reason, the transaction will not execute and the user will not be charged a fee for the failed transaction.

Delegated trade execution: When it’s time to actually execute a settlement (which can contain multiple trades), solvers lock in the execution path and submit the transaction to the blockchain.Note here that it is the solvers who are completing the transaction on behalf of the user, meaning that they determine the correct slippage tolerance to use, the right amount of gas fees, as well as taking on the risk of negative price movements or MEV.

The delegated trading model also means that traders using CoW Swap do not have to spend ETH to cover gas. Instead, gas fees come out of the sell token when making trades.

AMM: Automated Market Makers, also known as “DEXs,” are trading mechanisms that allow traders to buy and sell assets in real-time. Unlike traditional “orderbook” trading, which relies on counterparties for every transaction (you need a seller in order to buy and a buyer in order to sell), AMMs work by maintaining a constant ratio between the prices of two assets. For example, ETH and COW. AMMs use the formula “x*y = k” to determine a fair price based on the ratio between two assets (x and y) in the liquidity pool.

Any time a trade alters this ratio by depleting the supply of one asset and increasing the other, the prices of the assets adjust in order to preserve the established ratio. For instance, if a trader buys COW and sells ETH, the COW price rises and the ETH price falls. The opposite happens when traders sell COW and buy ETH.

Price Impact: Crypto markets, like all markets, are based on supply and demand. AMMs maintain “liquidity pools” of assets which they use to fill trades. Each trade drains some amount of this liquidity and moves the asset's price. This price movement is known as “price impact.”

The larger the trade, the bigger the price impact. A trade of $100 ETH will not move the price of ETH very noticeably, since it only makes up a tiny fraction of the available liquidity. A trade of $1,000,000 ETH, however, will noticeably move the price of ETH.

Transaction Reordering: Blockchain transactions do not always enter the block in the order that they were submitted. Searchers can “bribe” the validators responsible for creating the block to get them to arrange transactions in a specific sequence. This transaction reordering is what makes all of MEV possible.

EOA Wallets: Externally owned accounts (EOAs) are Ethereum accounts controlled by private keys. EOA wallets — for example: MetaMask, Rainbow, and Rabby Wallet — allow users to (1) send, hold, and receive Ethereum-native tokens, and (2) interact with smart contracts. Unlike smart contract wallets, EOA wallets are usually generated with a seed phrase and do not have any code associated with them.

Milkman: The Milkman smart contract ensures trades are executed for the real-time price or better by utilizing a price checker, such as a Uniswap pool or an oracle. Instead of setting a fixed slippage tolerance based on the current market price, DAOs can utilize Milkman to determine a maximum percentage deviation from a real-time price sourced from a price checker, guaranteeing that their trade will finalize at a fair market price. If a trade can’t be executed within the defined price or better, the order remains pending until the price condition is met, or until the trader cancels the order.

The different types of trades available on CoW Swap

Last, but certainly not least, some of the trades you can execute on CoW Swap. What they’re called, how they work, why you might want to use them.

• Market orders - buy or sell tokens as soon as possible at the current market rate.

• Limit orders - set your own parameters for how much you are willing to buy and sell.

• TWAP orders - allows traders to spread their trade over a specified period of time.

• Programmatic orders - create conditional orders that execute when certain on-chain conditions are met (such as asset prices, wallet balances, time elapsed, and much more)

• Milkman orders - delayed execution trading: set and forget your trades for optimum conditions.

• CoW Hooks - allow users to pair any Ethereum action (or set of actions) with an order on CoW Protocol, leveraging the solvers to execute the actions together in the sequence.

In summary

DeFi can often feel like it thrives on complexity. But in reality, many of the tools and systems that have been built were imported from the world of trad-fi, reimagined and renamed into something new. The language might be new, but the ideas have been around for a long time.

By mastering these terms, you can start to understand how the world of DeFi works, and how to navigate safely, and securely.

Next Steps

Ready to experience the power of DeFi for yourself? Head over to CoW Swap and try a trade!

Related Reading:

• How Money Flows in DeFi: Unpacking the Decentralized Financial System

• Understanding DeFi Lending

• Finding the Right DEX for You: Why DEXes Aren’t All Built the Same