DeFi 101: lending, DEXs and the risks

Decentralised finance (DeFi) is a set of financial services — trading, lending, borrowing — that run on smart contracts instead of through banks or brokers. Anyone with a crypto wallet can use them, without opening an account or passing a credit check.

Decentralised exchanges (DEXs)

A traditional exchange matches buyers and sellers in an order book. Most DEXs instead use an automated market maker (AMM): a smart contract holding a pool of two tokens, say ETH and a stablecoin. Traders swap against the pool, and a formula adjusts the price based on how much of each token remains.

The tokens in the pool come from liquidity providers, who deposit pairs of tokens and earn a share of trading fees. In exchange they face impermanent loss: if the prices of the two tokens move apart, the provider can end up with less value than if they had simply held the tokens.

Lending and borrowing

Lending protocols pool deposits from lenders and let borrowers take loans against collateral. Because there is no credit check, loans are over-collateralised — you might need $150 of ETH to borrow $100 of stablecoins.

If the value of your collateral falls below a set threshold, the protocol liquidates it automatically, selling some or all of it to repay the loan, usually with a penalty. Interest rates float with supply and demand, so they can change quickly.

Why people use DeFi

• Open access — no sign-up, no opening hours, no geographic gatekeeping at the protocol level.
• Transparency — balances and contract code are visible on the blockchain.
• Self-custody — you keep control of your funds until you choose to deposit them.
• Composability — protocols plug into each other like building blocks.

The risks

DeFi removes some risks of traditional finance but adds new ones:

• Smart contract bugs — exploits have drained billions of dollars from DeFi protocols. Audits reduce but don’t remove the risk.
• Oracle manipulation — protocols rely on price feeds; if a feed is manipulated, attackers can trigger unfair liquidations or borrow against inflated collateral.
• Liquidation risk — a sharp market drop can liquidate borrowers in minutes.
• Unsustainable yields — very high advertised returns are often paid in a protocol’s own token, whose value can collapse.
• Rug pulls and scams — anonymous teams can launch tokens and pools, then withdraw the funds.
• No safety net — there is usually no deposit insurance or customer support to reverse a mistake.