Decentralised finance rebuilds lending, trading and savings on public blockchains. Here's how the core building blocks work — and where the risks hide.
Decentralised finance — DeFi — is an attempt to rebuild financial services using smart contracts instead of banks and brokers. There’s no account manager and no opening hours: the rules live in code that anyone can inspect. This guide covers the three building blocks you’ll meet first: lending, automated market makers, and yield.
A smart contract is a program deployed to a blockchain that executes automatically when its conditions are met. In DeFi, contracts hold the funds and enforce the rules — who can borrow, at what rate, and what happens if a loan goes bad. There is no human approving each step, which is both the appeal and the risk.
DeFi lending markets like Aave or Morpho let users deposit assets to earn interest, while others borrow against collateral.
If a borrower’s collateral falls in value past a threshold, anyone can repay part of the loan and seize the collateral at a discount. This “liquidation” keeps the system solvent without a credit department — but it means volatile markets can wipe out borrowers quickly.
Traditional exchanges match buyers and sellers through an order book. AMMs like Uniswap replace that with a pool of two assets and a formula.
Anyone can deposit a pair of tokens — say ETH and a stablecoin — into a pool. Traders swap against that pool, and the price adjusts automatically according to the ratio of the two assets. Depositors (“liquidity providers”) earn a share of trading fees.
When the price of the pooled assets diverges, liquidity providers can end up worse off than if they had simply held the tokens. This gap is called impermanent loss, and it is the most misunderstood risk in DeFi. Fees can offset it, but not always.
“Yield” is the catch-all term for returns earned by putting crypto to work — lending interest, trading fees, or token incentives. The critical question is always: where does the yield come from?
If you can’t explain the source of a yield in one sentence, treat it as a red flag.
Start by reading, not depositing. Pick one protocol, find its documentation, and trace where your money would go and how it could be lost. DeFi is genuinely open and composable — but that openness means there’s no one to call when something breaks. Understanding the mechanics is the protection.