Decentralised Finance (DeFi)

What DeFi Actually Means

“DeFi” is short for decentralised finance. Instead of a bank holding your money and deciding whether to lend it out, or a centralised exchange holding your crypto and matching your trades internally, DeFi protocols use self-executing code called smart contracts, running on a public blockchain such as Ethereum, to do the same jobs. Our What Is DeFi? lesson covers this foundational idea in more depth.

With a bank, you trust an institution: it keeps records, it decides who can borrow, and it can freeze an account or reverse a transaction. With a DeFi protocol, the rules are written into code that anyone can inspect, and transactions settle directly between wallets with no company sitting in the middle holding your funds. That removes a certain kind of institutional risk (a bank going bust with your deposits, for example) but it introduces a different kind of risk entirely — one rooted in code, incentives and the absence of anyone to call when something goes wrong. We come back to that in detail below.

It’s worth being precise about what DeFi is not. It is not a specific coin, a specific app, or a guaranteed way to earn money. It’s a category of financial infrastructure — and like any infrastructure, some of it is well built and heavily used, and some of it is fragile, untested or deliberately designed to separate you from your funds.

Decentralised Exchanges and Automated Market Makers

A decentralised exchange, or DEX, lets you swap one token for another directly from your own wallet, without creating an account or handing custody of your assets to a company. Our Decentralised Exchanges (DEX) Explained lesson introduces the idea, and Decentralised Exchanges & AMMs (Deep Dive) goes further into how prices are actually set.

Most DEXs don’t use an order book of buyers and sellers the way a traditional exchange does. Instead they use an automated market maker, or AMM: a smart contract holding a pool of two tokens, which prices trades using a formula based on the ratio of tokens currently sitting in the pool. As you buy one token from the pool, there’s less of it left and more of the other, so the formula pushes the price up — the same basic supply-and-demand logic as a normal market, just calculated mechanically rather than matched against other people’s orders. The practical effect is that large trades move the price more than small ones (known as slippage), and this is handled entirely by code, with no human market maker involved.

Liquidity Pools and Impermanent Loss

The tokens sitting inside an AMM don’t appear from nowhere — they’re deposited by ordinary users called liquidity providers, who contribute an equal value of two tokens to a pool in exchange for a small share of the trading fees everyone else generates by swapping through it. Our Liquidity Pools Explained lesson walks through this mechanism and has you estimate the numbers yourself on paper.

The specific risk worth understanding here is impermanent loss. Because an AMM automatically rebalances a pool’s two tokens as their relative price moves, a liquidity provider’s share ends up holding more of whichever token fell in value and less of whichever token rose, compared with simply holding both tokens separately. If the two tokens’ prices drift apart significantly, the value of your pooled position can end up lower than if you had just held the tokens in a wallet and done nothing — even before counting any fees earned. The loss is called “impermanent” because it only becomes permanent if you withdraw while prices are still out of line; but trading fees have to be enough to outweigh it, and that isn’t guaranteed.

Staking

On Proof of Stake blockchains, staking means locking up tokens to help validate transactions and secure the network, in return for a share of newly issued tokens or transaction fees. It’s a core piece of how networks like Ethereum run day to day, not a DeFi product in itself, but the two are closely linked because many DeFi protocols build staking-style products on top of it. Our Staking Explained lesson compares the main ways ordinary users can stake.

Staking isn’t risk-free. Depending on the method, your tokens may be locked for a period and unable to be sold during a price drop, the underlying protocol can be penalised (“slashed”) for misbehaviour by whoever operates the validator on your behalf, and third-party staking services introduce the same kind of counterparty trust you were trying to avoid by going on-chain in the first place.

Lending and Borrowing in DeFi

DeFi lending protocols let one person deposit crypto to earn interest while another borrows against collateral, with the smart contract handling matching, interest calculation and repayment automatically rather than a bank’s credit department. Our Lending & Borrowing in DeFi lesson walks through a liquidation step by step.

Because there’s no credit check or ability to chase someone for repayment, DeFi loans are almost always over-collateralised: you deposit crypto worth more than you borrow. If the value of your collateral falls too close to the value of your loan, the protocol automatically sells (“liquidates”) some or all of it to protect lenders — often with a penalty — and it does this without warning, negotiation or any grace period, because there is no person on the other end to ask for one. Borrowing against volatile collateral in a falling market is one of the more mechanically predictable ways people lose money in DeFi.

A related practice, yield farming, means actively moving funds between lending markets, liquidity pools and other protocols to chase the best available return. Our Yield Farming — Opportunity and Risk lesson looks at why an advertised yield number needs interrogating rather than taking at face value — a high return is compensation for a specific risk somewhere in the system, not free money.

Stablecoins

Almost every DeFi activity above needs a reliable unit of account — something that doesn’t swing in value the way Bitcoin or Ethereum can from one day to the next. That’s the role stablecoins play: tokens designed to track the value of a reference asset, usually the US dollar, through one of a few mechanisms, from holding real cash and short-term government debt in reserve, to being over-collateralised by other crypto assets, to purely algorithmic approaches with no reserve backing at all. Our Stablecoins Explained lesson has you classify real stablecoins by how they’re actually backed.

“Stable” describes an intention, not a guarantee. The backing mechanism matters enormously: a stablecoin backed one-for-one by audited cash reserves and one backed algorithmically by a second, more volatile token carry very different failure modes, even though both might display the same price most of the time.

The Risks Specific to DeFi

It’s easy to wave at “crypto is risky” in general terms. DeFi carries a more specific set of mechanical risks worth naming directly:

• Smart contract bugs. A DeFi protocol is software, and software can contain errors. A flaw in a contract’s code can let an attacker drain a pool or market entirely, and because blockchain transactions are generally irreversible, there’s no process to simply undo it afterwards.
• Impermanent loss. As explained above, supplying liquidity to an AMM pool can leave you worse off than simply holding the two tokens separately, if their prices move apart from each other by enough.
• Rug pulls. Some projects are set up deliberately so the people who created them can withdraw all the pooled funds, or mint and dump huge amounts of a token, leaving everyone else holding something close to worthless. A new, unaudited protocol with an anonymous team is a materially different proposition from an established one.
• Over-leveraged and liquidation risk. Borrowing against volatile collateral, or using products that amplify exposure, means a price move that would be uncomfortable if you simply held the asset can be enough to have your position automatically and irreversibly liquidated.
• No customer support and no chargebacks. There is no institution to call if you send funds to the wrong address, approve a malicious contract, or get caught out by a bug or a scam. Transactions on a public blockchain are final by design; that finality is a feature when things go right and has no safety net when they don’t.

None of this means DeFi has no genuine utility — permissionless access to financial tools, composability between protocols, and transparent, auditable rules are real and useful properties. It means the risks are different in kind from traditional finance, not simply “more” of the same risk, and they’re worth understanding mechanically rather than treating as a vague warning label. For the security practices that reduce your exposure to several of these risks — wallet hygiene, spotting phishing, and evaluating a protocol before you trust it with funds — see our crypto security guide. And if you’re still getting comfortable with how blockchains work underneath all of this, our blockchain basics guide is a good place to start first.

Continue Learning

This page only scratches the surface. The DeFi week of our 60-day course covers each of these topics properly, with a quiz at the end of every lesson to check you’ve actually understood it.