Glossary and Definitions
This will be a list of definitions that we will gradually add on to help readers understand the various terms.
Synthetic assets are tokenized derivatives, which are contracts that represent the underlying value of an asset, without requiring actually holding the asset itself.
Synthetic assets can be stocks, tokens, indices, NFTs, or other financial products and are produced to mimic the original asset, typically in the form of its price. For example, a synthetic asset of a stock would mimic the price fluctuations of the stock, while a synthetic asset of a token would mimic the price fluctuations of the token.
A subset of synthetic assets. Mirrored assets are synthetic assets that mirror existing assets in the marketplace, including crypto and traditional financial assets.
Financial derivatives in DeFi. An all-encompassing term for all potential derivative contracts that exist or can exist in the DeFi environment.
DEX is an acronym for a decentralized exchange.
Decentralized Exchanges are online platforms that allow users to trade directly, peer-to-peer, permissionless, without an intermediary or centralized market maker, usually leveraging smart contracts, automated market maker (AMM) algorithms, and liquidity pools.
AMM is an acronym for automated market makers.
In traditional markets, there are buyers and sellers and the trades are listed in order books that keep track of who wants to buy and sell at what price. With DEXs, one of the ways to avoid using an order book is to use an AMM, which balances the assets between trading pairs using an algorithm.
Most trades are done between trading pairs, where there is one asset on each side of the trade (i.e. BNB-HZN).
A liquidity pool is a pool of cryptocurrencies or tokens used to facilitate trades between assets on a decentralized exchange (DEX). This is often where farming and yields can happen.
Liquidity pools are managed by smart contracts and are typically crowdsourced. Participating in liquidity pools generates yield as the liquidity pool is used to trade between trading pairs and every trade pays a fee to the liquidity pool.
Liquidity Pool Tokens
When investing in a liquidity pool, a user will typically get a liquidity pool token that is representative of the combined value of the trading pair assets of the pool.
When divesting from the liquidity pool, the liquidity pool token is traded back and the user gets back the trading pair assets they invested initially. The return may vary depending on how the smart contract for the liquidity pool is implemented.
When investing in liquidity pools, it is common for the trading pairs of the liquidity pool to not increase and decrease their market value at the same rate. When this happens, there can be impermanent loss.
Impermanent loss is when a token's price change causes your share in a liquidity pool to be worth less than the present value of your deposit. It is considered impermanent loss because the loss is not realized until you divest from the liquidity pool. Therefore, it is possible to recover the loss if the token pair returns to the initial exchange rate.
The only way to avoid impermanent loss is to invest in liquidity pools where both trading pairs are 100% aligned in market value changes. This might be in the form of a token and wrapped token (i.e. BNB-zBNB) or a stablecoin and another stablecoin that are based on the same currency (BUSD-zUSD).
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