whytheblockchain

DeFi explained: how it works and its risks

THE SHORT ANSWER

DeFi brings together financial services built with smart contracts, including swaps, lending and liquidity provision. It shifts some trust to code, collateral and oracles. Returns vary and funds can be lost.

What is DeFi?

In a lending app, one user supplies assets to a contract and another borrows under its rules. The service depends on code, liquidity, price data and sometimes administrative powers.

Features and risks

  • Services accessible under protocol and interface rules
  • Transactions viewable on public blockchains
  • Possibility of using a personal wallet
  • Risks involving code, collateral, oracles and liquidity

Liquidity Pools

A pool holds assets used for swaps. Providers may receive fees but face contract risks and changes in relative asset prices.

  • The contract uses pool assets to execute swaps under its rules.
  • A position’s composition changes with trades and prices. It can be worth less than simply holding the original assets.
  • Fees earned may not offset this difference, network costs or a contract failure.

Reading an advertised yield

Yield farming involves seeking rewards across protocols. Rewards vary and may conceal losses on assets or provided liquidity.

  • Identify the source: borrower interest, swap fees or token emissions.
  • Distinguish APR from APY: APY assumes compounding at a given frequency and under specified assumptions.
  • Account for reward-token prices, fees and withdrawal conditions.
  • Understand liquidation: on Aave, a health factor below 1 makes a position eligible for liquidation. Parameters depend on the market.

Protocol examples, without ranking

Aave

Lending and borrowing with market-specific risk and collateral parameters.

Curve

Swap pools, including assets with similar values. A loss of peg can materially change pool risk.

Sky, evolved from MakerDAO

The ecosystem historically associated with DAI evolved into Sky and the USDS stablecoin. Collateral spans several asset categories; describing it as backed only by ETH is inaccurate.

Understand before using

An advertised yield is not a promise of profit. Examine the mechanism, fees and possible losses.

Sources and further reading

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