Decentralised Finance — DeFi — is financial services built as smart contracts on public blockchains. No bank, no broker, no intermediary required. The trade-off is that you take on smart-contract risk, oracle risk, and the responsibility for understanding what you are interacting with. We cover the three categories most users actually use: lending, DEX trading, and yield products.
Lending
DeFi lending protocols (Aave, Compound, Spark) let users deposit assets and earn interest, or borrow against deposited collateral. The largest protocol, Aave, holds roughly $13B of TVL across multiple chains in 2026.
How it works: you deposit USDC, earning the supply rate. Another user posts ETH as collateral and borrows USDC, paying the borrow rate. The protocol captures the spread. If the borrower’s collateral value falls below the required ratio, their position is liquidated to repay the loan.
What it’s good for: passive yield on stablecoins (typically 4–8% in current conditions). Leveraged exposure (borrow against ETH, buy more ETH). Cash flow management without selling holdings.
Risks: smart-contract risk (a protocol exploit could drain deposits), oracle risk (manipulated price feeds can trigger improper liquidations), and liquidation cascades in market crashes.
DEXes (Decentralised Exchanges)
DEXes let you trade tokens without depositing on a centralized exchange. The dominant design is the Automated Market Maker (AMM) — Uniswap is the canonical example.
How it works: liquidity providers (LPs) deposit two tokens (e.g., ETH and USDC) into a pool. Traders swap between the two; the pool prices each swap using a mathematical formula (x*y=k for Uniswap V2). LPs earn a fee on every swap (typically 0.3%).
What’s good: anyone can trade any token without KYC. New tokens get instant liquidity without needing exchange listings. Permissionless and global.
Risks: impermanent loss for LPs (if the two pooled tokens diverge in price, you end up with less of the appreciating one); slippage on large trades in thin pools; high gas fees on Ethereum L1 (mitigated on L2s).
Yield products
The third major DeFi category is yield optimisation — protocols that automate moving capital between opportunities. The largest is Yearn; Pendle offers yield-tokenisation (separate principal token / yield token for fixed-yield positions).
How it works: you deposit a base asset (USDC, ETH, LP token); the protocol routes your capital across lending, LP, staking opportunities and reinvests rewards automatically. Returns are reported net of fees.
Risks: compounded smart-contract risk (you are exposed to every protocol in the chain), strategy risk (the underlying strategy may underperform or fail), and protocol governance risk.
The composability problem
DeFi protocols build on each other. Your USDC might be deposited in Aave; the aUSDC receipt might be used as collateral on Morpho; the Morpho borrow might be deployed in a Pendle PT-aUSDC position. This is powerful — you stack yield — but each layer adds risk. A failure anywhere in the chain affects your position.
Common DeFi mistakes
- Approving unlimited spending. Always limit approvals to the amount you intend to spend. Revoke unused approvals at revoke.cash.
- Chasing high APYs. A 50% APY on a stablecoin pool is signalling either smart-contract risk, depeg risk, or both.
- Ignoring smart-contract risk. Even Aave has had near-misses. Audit reports are necessary but not sufficient.
- Mixing custody and DeFi. Hardware-wallet-signed transactions for everything above small amounts.
Starting points by use case
- Want yield on stablecoins? Start with Aave or Compound, top-tier protocols, audited, blue-chip.
- Want to swap tokens? Uniswap (Ethereum + L2s), Jupiter (Solana). Cross-chain: 1inch aggregator.
- Want to provide LP liquidity? Start with stablecoin pools on Curve — minimal impermanent loss, real yields.
- Want fixed yield? Pendle, in stablecoin or LST principal tokens.
What DeFi cannot do (yet)
- FDIC-equivalent insurance
- Customer service for lost funds
- Recourse if a protocol is exploited
- Identity-tied compliance for tax reporting (you do this yourself)