How Does DeFi Work?

What Makes DeFi Different?

DeFi is short for decentralized finance. It refers to applications where transactions such as swapping, lending, or collateralized borrowing are executed through smart contracts on the blockchain. Most of the time, instead of managing a balance in a corporate account, users interact with the contract directly from their own wallets.

However, the fact that an interface opens with a wallet does not mean that every part of the system is decentralized. Price data providers, websites, administrative keys, and liquidity sources can create various dependencies. To understand DeFi, one should look at who performs which task rather than just relying on the “no middleman” slogan.

How Does a Smart Contract Execute a Transaction?

A contract enforces predefined rules. For example, when you deposit tokens into a pool, your balance is recorded; when you perform a swap, the pool’s reserves change. The transaction is verified on the network, and the result is written to the chain. Even if the contract works correctly, the economic outcome may differ from what you expect due to market movements.

The amount, fees, and permissions displayed by the wallet before a transaction are critical. For a token to be used by the contract, you may first need to grant spending approval. This permission and the actual swap are two separate transactions. While “unlimited” approval can make future use of the application easier, it increases the scope of the risk involved.

Most Common Use Cases

On decentralized exchanges, tokens can be swapped via order books or liquidity pools. In lending protocols, users aim to earn interest by depositing assets or borrow other assets by providing collateral. Liquid staking applications can offer tokens representing participation in network validation.

These products do not share the same risk profile. Swapping a token is different from depositing that same token into a lending pool. In the latter, funds may remain in the contract for a longer period, creating a dependency on the pool’s liquidity. Using multiple applications on top of each other (composability) can compound these risks.

Steps of a Swap

First, the correct network and official application are selected. After the wallet is connected, the contract addresses of the tokens to be given and received are verified. When an amount is entered, the estimated return, price impact, minimum amount to be received, and network fee should be visible. The necessary permission may be approved separately; then, the swap is submitted.

For example, if you expect approximately 50 of another token in exchange for 100 tokens, you should understand why the minimum amount to be received might be lower. This limit is related to slippage tolerance. A tolerance that is too wide can lead to a poor price, while one that is too narrow can result in a failed transaction. Before confirming the amount, you should know the range within which the result may occur.

How Is Borrowing Possible?

In many DeFi lending models, the user deposits collateral with a higher value than the loan they receive (over-collateralization). The application monitors the price of the collateral using a data system called an oracle. If the value of the collateral drops too low relative to the debt, liquidation may occur; a portion of the collateral is sold to cover the debt.

Hypothetically, imagine you borrow $400 against $1,000 in collateral. If the collateral value drops while the debt remains the same, the debt-to-collateral ratio rises. If the threshold set by the protocol is exceeded, a liquidation risk arises. Specific thresholds vary by asset and market; a single ratio cannot be applied to all applications.

Where Does the Yield Come From?

The source of the yield can be interest paid by borrowers, fees from those performing swaps, or newly distributed incentive tokens. These have different sustainability conditions. A high APY (Annual Percentage Yield) offers no meaningful comparison without explaining the source of income. APY may also include compounding assumptions.

If the reward is paid in another token, the dollar yield shown on the screen depends on the price of that token. When the incentive ends, the rate may drop. As the pool grows, the same reward may be divided among more participants. Assuming today’s rate will remain constant for a year can lead to misleading personal income calculations.

TVL and Security Are Not the Same Thing

TVL (Total Value Locked) is the total value of assets considered to be deposited in the protocol. It can provide a clue about the scale of usage but is not a security certificate. When prices rise, TVL can increase without any new money entering. When some asset representations are counted in multiple protocols, the totals can also become skewed.

A large TVL can also mean that the amount of funds affected in an attack would be large. Audit reports, code versions, administrative privileges, and previous incidents should be examined separately. The phrase “everyone is using it” is not a substitute for technical due diligence.

Distinguish the Primary Risks

Contract vulnerabilities, external price data errors, the breaking of a stablecoin’s peg, and insufficient liquidity are different pathways to loss. The compromise of an administrative key or a malicious update can also affect the application. Some of these are independent of the token’s market price.

A user providing liquidity may achieve a lower result compared to simply holding the assets in a wallet if the price ratio changes. This is known as impermanent loss. A borrower, on the other hand, may face collateral liquidation. It is necessary to know which loss mechanism applies to products presented under the same “yield” heading.

Small and Understandable Transactions for First Use

First, understand the entire cycle of a single transaction: depositing an asset, viewing the position, and withdrawing. Keep the native fee asset on the target network. Learning the exit path is as important as a successful deposit. Withdrawal may require pool liquidity, a waiting period, or additional approval.

Instead of trying new applications with the wallet where your main savings are located, a separate setup with a limited balance could be considered. This distinction does not remove all risk; you must know how backups and keys are actually segregated. A leak of the same backup can affect multiple accounts.

What to Follow After the Transaction?

Record the transaction ID, the amount deposited, the receipt token received, and the exit conditions. In a debt position, it is necessary to track the collateral ratio and interest changes. Official security and update announcements from the application are also important. Even if the interface goes down, it should be understood in advance how funds will be managed.

DeFi makes financial transactions programmable; it does not eliminate economic risk or user error. If you cannot explain what a product does in simple sentences, using it just because you see a high rate is acting on incomplete information. The primary goal is not to grow the yield figure, but to understand the outcome of the transaction and the exit path.

Sources

• Ethereum: Decentralized Finance
• Ethereum: External Data Sources (Oracles)
• Ethereum: Smart Contract Security