The core building blocks
- Decentralised exchanges (DEXs): swap tokens directly from your wallet against a liquidity pool rather than an order book.
- Lending protocols: deposit assets to earn interest, or post collateral to borrow against it.
- Liquidity pools: user-supplied token pairs that make DEX trading possible, earning a share of trading fees.
- Yield farming: moving capital between protocols chasing the best return, usually with rising risk attached.
Why overcollateralisation is everywhere
DeFi lending has no credit checks, so it substitutes collateral for trust. To borrow $1,000 you might post $1,500 of ETH. If the collateral value falls toward the loan value, the position is liquidated automatically by the protocol — no negotiation, no grace period.
Example
You post 1 ETH at $4,000 and borrow $2,000 of USDC. ETH falls to $2,600 and your position crosses the liquidation threshold. The collateral is sold to repay the loan, plus a liquidation penalty.
The risks that are specific to DeFi
- Smart contract bugs — a flaw in the code can drain a protocol in a single transaction.
- Impermanent loss — supplying a liquidity pool can leave you worse off than simply holding the two tokens.
- Oracle manipulation — protocols rely on external price feeds, and a manipulated feed can trigger false liquidations.
- Governance and admin keys — 'decentralised' protocols sometimes retain upgrade powers that can change the rules.
- No recourse — there is no support desk, chargeback or regulator to appeal to.
Reading a yield honestly
A headline APY often blends trading fees with token emissions. Fee income is real and sustainable; emissions are paid in a token whose price can fall faster than the yield accrues. Always separate the two before judging whether a return is worth the risk.