Decentralized finance (DeFi) is a set of financial services that run on public blockchains through smart contracts. Trading, lending, borrowing and earning yield all happen through code that anyone can inspect, with no bank or broker in the middle. Ethereum hosts the largest share of DeFi activity, and the ethereum.org DeFi overview is a good primary reference for the basic concepts.
How DeFi Works
A DeFi application is one or more smart contracts plus a website that talks to them. You connect a wallet, approve a transaction, and the contract does the rest. Your wallet keeps custody of your assets until the moment you deposit them into a contract, and you can usually withdraw without asking anyone for permission.
Three properties set DeFi apart:
- Open access: anyone with a wallet can use a protocol. There is no account application.
- Transparency: balances, rules and transactions are public on the chain.
- Composability: protocols plug into each other. A token you receive from one protocol can be used as collateral in another.
Composability is powerful, and it is also how problems spread. A failure in one protocol can hit every other protocol that depends on it.
The Main Building Blocks
Decentralized exchanges (DEXs) let users trade tokens directly from a wallet. Most use an automated market maker (AMM) in place of an order book. Liquidity providers deposit pairs of tokens into a pool, and a formula sets the price based on the ratio of the two. Traders pay a fee that goes to the providers. The Uniswap documentation explains the model that most AMMs follow. Jupiter on Solana and PancakeSwap on BNB Chain serve the same role on other networks.
Lending markets such as Aave and Compound pool deposits from lenders and let borrowers take loans against collateral. Loans are overcollateralized, which means you deposit more value than you borrow. If the collateral price falls below a set threshold, the position is liquidated: the collateral is sold to repay the loan, and the borrower pays a penalty. Interest rates move automatically with supply and demand. The Aave documentation describes how these rates and liquidations work.
Stablecoins are tokens designed to hold a steady value, usually one US dollar. USDC and USDT are backed by reserves held by a company. DAI is issued by a protocol against crypto collateral. Stablecoins are the main unit of account across DeFi.
Liquid staking protocols such as Lido stake your tokens and give you a tradable token in return, so the staked position can still be used elsewhere.
Yield aggregators such as Yearn move deposits between protocols to chase the best return automatically.
DeFi vs Traditional Finance
A bank or broker holds your assets, verifies your identity, and settles transactions on its own schedule. In return you get customer support, legal protections and, in many countries, deposit insurance.
DeFi replaces the institution with code. Markets run all day, every day. Settlement takes seconds or minutes. The cost is that there is no help desk and no insurance fund by default. If you send funds to the wrong address or a contract is exploited, there is usually no way to reverse it.
The Risks
- Smart contract exploits: bugs in code have cost users billions of dollars. Cross-chain bridges have been hit hardest. The Ronin bridge lost more than $600 million and the Wormhole bridge about $320 million, both in 2022.
- Stablecoin failure: the TerraUSD algorithmic stablecoin lost its peg in May 2022 and wiped out tens of billions of dollars in value within days.
- Liquidation: borrowed positions can be closed at a loss during fast price drops.
- Impermanent loss: liquidity providers can end up with less value than if they had simply held the two tokens.
- Oracle manipulation: protocols rely on price feeds, and a manipulated feed can drain a market.
- Rug pulls: new tokens and pools can be designed so the creators can remove the liquidity.
- Admin keys: many protocols can be upgraded or paused by a small group of key holders.
Audits lower the risk but do not remove it. Several exploited protocols had been audited.
Metrics That Matter
- TVL (Total Value Locked): the value of assets deposited in a protocol. Rising TVL suggests growing use, though token price moves also change it.
- APY: the annualized return on a deposit. Very high yields are usually paid in a newly issued token and tend to fall quickly.
- Fees and revenue: what users actually pay to use the protocol. Fees are harder to fake than TVL.
- Liquidity depth: how large a trade a pool can absorb before the price moves. Thin pools mean high slippage.
How to Start Carefully
Use a non-custodial wallet such as MetaMask for Ethereum or Phantom for Solana, and keep the seed phrase offline. Keep enough of the network's native token to pay transaction fees. Begin with small amounts on protocols that have operated for years and have public audits. Check the website address every time, because phishing copies of popular DeFi sites are common. Review and revoke old token approvals from time to time.
Nothing in this article is financial advice.
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The DEX page lists active liquidity pools with volume and liquidity, so you can check depth before you trade. Each coin has its own price page with market cap, supply and a chart, and the trending page shows which tokens are drawing the most attention.