DeFi Basics

Decentralised finance, or DeFi, recreates financial services such as trading, lending, borrowing and derivatives using smart contracts on public blockchains, mainly Ethereum and similar networks. Anyone with a wallet can use these services without an account or approval, and the rules are written in open code. DeFi grew from a few hundred million dollars of deposits in 2019 to more than $100 billion at its peaks. It offers new opportunities, but its risks, from code bugs to liquidation cascades, are just as real.

The building blocks#

Total value locked (TVL)#

TVL measures the value of assets deposited in DeFi protocols. It rises with deposits and with token prices, so it is a rough gauge of DeFi activity rather than a precise measure. Analytics sites such as DefiLlama track TVL across chains and protocols.

How DeFi lending works#

1. Lenders deposit tokens into a pool and earn interest.
2. Borrowers deposit collateral worth more than they borrow (overcollateralisation).
3. Interest rates adjust automatically with supply and demand: when most of a pool is borrowed, rates rise.
4. If collateral value falls below a threshold, anyone can liquidate the position, repaying part of the debt and receiving collateral at a discount.

Where DeFi yields come from#

If a yield seems very high, ask where it comes from. Yields paid in newly printed tokens can collapse as token prices fall.

Liquidity providing and impermanent loss#

Liquidity providers deposit two tokens into a pool and earn fees. If prices move a lot, they end up with more of the token that fell and less of the token that rose, compared with simply holding. This is impermanent loss. For a 50/50 pool, if one token doubles in price relative to the other, the loss compared with holding is about 5.7%; if it rises fourfold, about 20%. Fees must exceed this loss to profit.

The risks of DeFi#

• Smart contract bugs: hacks have drained billions. See Bridge and Smart Contract Risk.
• Oracle manipulation: bad price feeds can trigger wrong liquidations. See Oracles.
• Liquidation cascades in sharp market falls.
• Stablecoin depegs.
• Governance attacks: attackers buy or borrow voting tokens to change protocol rules.
• MEV: bots extract value from users' transactions. See MEV.
• Regulatory uncertainty.
• User error: wrong addresses, malicious approvals, phishing sites.

Getting started sensibly#

1. Start small and use well audited, established protocols.
2. Understand the source of yield before depositing.
3. Monitor collateral ratios on loans.
4. Use a separate wallet for experimenting.
5. Revoke approvals you no longer need.

Frequently asked questions#

What is DeFi?#

Decentralised finance: financial services like trading, lending and borrowing provided by smart contracts on public blockchains instead of banks or brokers.

How do DeFi lending protocols work?#

Lenders deposit assets into pools to earn interest, and borrowers lock collateral worth more than their loans; if collateral value falls too far, the loan is liquidated.

Is DeFi safe?#

It carries significant risks, including smart contract hacks, oracle failures, liquidations and scams, so users should start small and use established protocols.

Next, learn how blockchains get price data in Oracles.