Who This Is For

Anyone curious about or considering DeFi (decentralized finance) needs to understand what it is and what risks it involves. This guide explains DeFi concepts and risks without encouraging participation or promising profits.

What Is DeFi?

DeFi (Decentralized Finance) refers to financial services built on blockchain technology, operating without traditional intermediaries like banks or brokers.

Traditional Finance vs. DeFi

Traditional Finance:

• Banks, brokers, exchanges act as intermediaries
• Centralized companies control services
• Regulated by government authorities
• Customer service available
• Insurance (FDIC, SIPC) protects deposits
• Reversible transactions in many cases
• Know-your-customer (KYC) required

DeFi:

• Smart contracts on blockchain perform functions
• No company controls the protocol (ideally)
• Often operates in regulatory gray area
• No customer service (usually)
• No insurance (usually)
• Transactions irreversible
• Often no KYC (pseudonymous)

How DeFi Works

Core technology: Smart contracts

Smart contract: Code running on blockchain that automatically executes when conditions are met.

Example: Traditional loan: Bank reviews application, approves, manages loan, collects payments.

DeFi loan: Smart contract holds collateral, automatically provides loan, automatically liquidates if conditions met.

No human intervention needed. Everything happens automatically based on code.

DeFi Services

Common DeFi offerings:

1. Decentralized Exchanges (DEXs): Trade crypto without centralized exchange (Uniswap, SushiSwap, PancakeSwap)
2. Lending/Borrowing: Lend crypto to earn interest or borrow against collateral (Aave, Compound)
3. Stablecoins: Crypto-backed stablecoins (DAI via MakerDAO)
4. Yield Farming: Provide liquidity to earn rewards
5. Derivatives: Options, futures, synthetic assets
6. Asset Management: Automated investment strategies (Yearn Finance)

These replicate traditional financial services but with code instead of companies.

DeFi Concepts Explained

Decentralized Exchanges (DEXs)

What they are: Platforms for trading crypto without centralized company.

How they work:

• Liquidity pools instead of order books
• Users trade against pool
• Prices determined by algorithm
• Trades execute via smart contract

Example: Uniswap

Traditional exchange: Coinbase holds your funds, matches buy/sell orders, processes trades.

DEX: You keep funds in your wallet, trade directly with liquidity pool, no company involvement.

Advantages:

• You control your funds
• No account needed
• Trade anytime
• No KYC
• More tokens available

Disadvantages:

• You're responsible for security
• No customer support
• Gas fees can be high
• Slippage on large trades
• Smart contract risk
• More complex to use

Liquidity Pools

What they are: Pools of tokens locked in smart contract to enable trading.

How they work:

1. Users deposit pairs of tokens (e.g., ETH and USDC)
2. Pool holds both sides of trading pair
3. Traders swap between tokens using the pool
4. Providers earn fees from trades
5. Providers can withdraw their share anytime

Why they exist: Enable trading without order books or market makers.

Risks for liquidity providers:

• Impermanent loss (can lose value vs. holding tokens)
• Smart contract risk
• Token price volatility
• Pool-specific risks

Complexity: Requires understanding of mechanisms and risks.

Yield Farming

What it is: Moving crypto between DeFi protocols to maximize returns.

How it works:

1. Provide liquidity to protocol
2. Earn rewards (trading fees, protocol tokens)
3. Take those rewards to another protocol
4. Compound returns across platforms

Example:

• Deposit ETH/USDC to Uniswap pool, earn fees + UNI tokens
• Stake UNI tokens elsewhere to earn more rewards
• Reinvest everything to compound

The appeal: High advertised yields (sometimes 50%+, even 100%+).

The reality:

• Most high yields are temporary
• Paid in volatile tokens (value can drop)
• Requires active management
• Gas fees eat into returns
• High complexity
• High risk

Many yield farming opportunities have ended badly.

Lending and Borrowing

How it works:

Lending:

• Deposit crypto into lending protocol
• Earn interest from borrowers
• Can withdraw anytime (usually)

Borrowing:

• Provide collateral (often 150%+ of loan value)
• Borrow different asset
• Pay interest
• If collateral value drops too much, liquidated

Use cases:

• Borrow without selling (tax considerations)
• Leverage (borrow to buy more)
• Access stablecoins without selling crypto

Risks:

• Liquidation if collateral drops
• Protocol hacks or failures
• Interest rate volatility
• Smart contract risk

Staking and Governance

Staking:

• Lock tokens in protocol
• Earn rewards for participating
• May lose ability to trade during staking period

Governance:

• Token holders vote on protocol changes
• Decentralized decision-making
• Voting power based on token holdings

Risks:

• Locked tokens can't be sold during volatility
• Governance exploits possible
• Voting may not represent all users' interests

Major DeFi Risks

1. Smart Contract Risk

What it is: Bugs or vulnerabilities in code can be exploited.

Why it matters:

• Code controls your funds
• Bugs can allow theft
• Once exploited, funds usually gone
• No reversal mechanism

Historical examples:

• The DAO hack (2016): $60M stolen due to code vulnerability
• Poly Network hack (2021): $600M stolen (some returned)
• Dozens of smaller DeFi exploits annually

Even audited code has been exploited.

Mitigation (partial):

• Use well-established protocols
• Look for multiple audits
• Smaller amounts in newer protocols
• Understand you're accepting code risk

Can't eliminate: Even best protocols can have undiscovered bugs.

2. Impermanent Loss

What it is: Loss from providing liquidity when token prices diverge.

How it happens: You provide ETH and USDC to liquidity pool when ETH = $2,000.

• If ETH rises to $3,000, you'd have been better just holding ETH
• Pool rebalances, leaving you with less ETH than you started
• Called "impermanent" because it goes away if prices return to original ratio
• Becomes permanent when you withdraw

Impact:

• Can lose value vs. simply holding
• Fees may not compensate for loss
• Complex to calculate ahead of time

Important concept for liquidity providers to understand.

3. Liquidation Risk

What it is: Your collateral is sold if value drops below threshold.

How it happens:

1. You deposit $15,000 ETH as collateral
2. Borrow $10,000 USDC
3. ETH price drops
4. Your $15,000 collateral now worth $12,000
5. Protocol automatically sells your ETH to protect lenders
6. You lose ETH and still owe fees

Often happens during:

• Market crashes
• Flash crashes
• Network congestion (can't add collateral in time)

Can lose more than initial collateral in extreme cases.

4. Oracle Risk

What it is: DeFi protocols rely on "oracles" to provide external data (like prices).

Why it matters:

• If oracle provides wrong price data, protocol makes wrong decisions
• Oracle manipulation can exploit protocols
• Single point of failure

Historical examples:

• Flash loan attacks manipulating oracles
• Incorrect price feeds causing erroneous liquidations

Mitigation: Use protocols with robust, decentralized oracle solutions.

5. Rug Pulls and Exit Scams

What it is: Developers abandon project and steal funds.

How it happens:

1. New DeFi protocol launches
2. Promises high yields
3. Users deposit funds
4. Developers drain funds and disappear

Red flags:

• Anonymous team
• No audit
• Unrealistic yield promises
• Code not verified
• Centralized control points

Very common in DeFi: Hundreds of rug pulls have occurred.

6. Regulatory Risk

What it is: Unclear legal status of DeFi protocols.

Concerns:

• Protocols may be deemed illegal
• Developers could face legal action
• Users might face tax complications
• Platforms could be shut down
• Tokens deemed securities

Reality:

• Regulation is evolving
• Legal clarity lacking in most jurisdictions
• Future changes could impact access or legality

7. Complexity Risk

What it is: DeFi is too complex for most users to fully understand.

Why it matters:

• Can't assess risks you don't understand
• Easy to make expensive mistakes
• Hard to verify protocol safety
• Difficult to evaluate documentation

Common user errors:

• Approving malicious contracts
• Misunderstanding tokenomics
• Not recognizing scams
• Incorrect transaction parameters

Can lead to total loss of funds.

8. Composability Risk

What it is: DeFi protocols interact with each other; failure of one affects others.

How it works:

• Protocol A uses Protocol B's services
• Protocol B gets hacked
• Protocol A also affected

Creates cascade risk: One failure can trigger multiple failures.

Examples:

• Stablecoin de-pegging affecting lending protocols
• Oracle failure affecting multiple platforms

9. Gas Fee Volatility

What it is: Transaction costs (gas fees) on Ethereum can spike dramatically.

Impact:

• $5 transaction can suddenly cost $50+
• Small positions become uneconomical
• Can't exit positions profitably
• Arbitrage opportunities disappear

Especially problematic during market stress when you most want to act.

10. Centralization Risk (in "decentralized" protocols)

What it is: Many "DeFi" protocols have centralized control points.

Examples:

• Admin keys that can change contract
• Centralized oracle providers
• Team controls majority of governance tokens
• Upgradeable contracts controlled by few

Why it matters:

• Not truly decentralized
• Single points of failure
• Potential for abuse
• Defeats purpose of DeFi

DeFi Scams and Common Traps

Fake Yield Farms

Scam:

• Promises extraordinary yields
• Users deposit funds
• Can't withdraw (contract prevents it)
• Developers drain funds

How to spot:

• Unaudited code
• Anonymous team
• Too-good-to-be-true yields
• Pressure to invest quickly

Copycat Protocols

Scam:

• Clone of legitimate protocol
• Slight name variation
• Malicious code added
• Steals approved funds

How to spot:

• Verify URL exactly
• Check contract addresses
• Use official links only
• Too many "official" versions

Ponzi Schemes

Scam:

• "Guaranteed" high returns
• Uses new deposits to pay old depositors
• Eventually collapses

Red flags:

• Unsustainable yields
• Referral bonuses
• Pressure to recruit
• Complex explanations of yield source

Token Dumps

Scam:

• Project gives you tokens as "rewards"
• Tokens have no real value or use
• Insiders dump on retail

Reality:

• "1000% APY paid in FARM tokens"
• FARM token price crashes 99%
• Actual return: massive loss

Many yield farms work this way.

When DeFi Might Make Sense (With Caution)

DeFi might be appropriate if:

• [ ] You have strong technical understanding
• [ ] You can read and understand smart contracts
• [ ] You're using only funds you can afford to lose completely
• [ ] You've researched the specific protocol thoroughly
• [ ] You understand all the risks involved
• [ ] You have time to actively monitor positions
• [ ] You're using established protocols with good track records
• [ ] You have separate wallet for DeFi (not main holdings)

Even then, recognize you're accepting significant risks.

When to Avoid DeFi

Don't use DeFi if:

• [ ] You're new to crypto
• [ ] You don't understand smart contracts
• [ ] You need the money for anything important
• [ ] You can't explain how the protocol makes money
• [ ] You're chasing advertised high yields
• [ ] You don't have time to monitor constantly
• [ ] You're uncomfortable with complexity
• [ ] You're following "advice" from Discord/Telegram

For most people, avoiding DeFi is the prudent choice.

DeFi Safety Practices

If you do use DeFi:

1. Start Small

• Test with amounts you don't mind losing
• Learn before scaling up
• Most people lose money learning

2. Research Thoroughly

• Read documentation
• Check for audits (multiple, from reputable firms)
• Review code if possible
• Understand tokenomics
• Check team and history

3. Use Separate Wallet

• Don't use wallet with main holdings
• Limits damage if compromised
• Easier to manage risk

4. Understand What You're Signing

• Read transaction details
• Understand token approvals
• Verify contract addresses
• Don't blindly approve

More: Safe Transaction Habits

5. Monitor Positions

• Check regularly
• Watch for liquidation risk
• Stay aware of protocol changes
• Have exit plan

6. Revoke Unused Approvals

• Periodically clean up token approvals
• Use tools like revoke.cash
• Reduces attack surface

7. Be Suspicious of High Yields

• Understand source of yield
• If it seems too good, it probably is
• Sustainable yields are typically low single digits

8. Have Exit Strategy

• Know how to withdraw
• Understand unstaking periods
• Account for gas fees
• Plan for various scenarios

DeFi Red Flags

Avoid protocols with:

• [ ] Anonymous team with no accountability
• [ ] No code audit or audit from unknown firm
• [ ] Unverified smart contracts
• [ ] Yields that seem too good to be true
• [ ] Complex, unexplained mechanisms
• [ ] Centralized control despite "defi" branding
• [ ] Pressure to invest quickly
• [ ] Heavy marketing/shilling
• [ ] Copycat of existing protocol with slight changes
• [ ] No clear documentation
• [ ] Recent launch with no track record

Key Differences: CEX vs DEX

Centralized Exchange (Coinbase, Kraken):

• Company holds your funds
• Customer support available
• Easier to use
• Some insurance
• Regulated
• KYC required
• Can freeze accounts

Decentralized Exchange (Uniswap, etc.):

• You hold your funds
• No customer support
• Steeper learning curve
• No insurance
• Regulatory gray area
• Often no KYC
• Can't freeze funds (but can't help if you make mistake)

Neither is perfect: CEX has counterparty risk, DEX has complexity and smart contract risk.

More: Wallets Explained: Custodial vs Non-Custodial

DeFi Risk Checklist

Before using any DeFi protocol:

• [ ] Do I understand exactly how this protocol works?
• [ ] Can I explain where the yield comes from?
• [ ] Has the code been audited by reputable firms?
• [ ] How long has this protocol been operating?
• [ ] What is the total value locked (TVL)? (Higher generally better)
• [ ] Who are the developers? Are they public/accountable?
• [ ] What are the specific risks (liquidation, impermanent loss, etc.)?
• [ ] Can I afford to lose this entire amount?
• [ ] Do I have time to monitor this position?
• [ ] Have I tested with a small amount first?
• [ ] What is my exit strategy?

If you can't confidently answer all these, don't use that protocol.

Key Takeaways

• DeFi is financial services using smart contracts instead of companies
• Offers trading, lending, yield farming, and more without intermediaries
• Carries significant risks: smart contract bugs, liquidations, rug pulls, complexity
• High advertised yields usually come with high hidden risks
• Many DeFi projects have failed or been exploited
• No customer service, no insurance, no reversals
• Requires technical understanding and constant monitoring
• Not appropriate for most users, especially beginners
• If you use DeFi, start small, research thoroughly, use separate wallet

Remember: DeFi is experimental technology. It offers interesting capabilities but with risks that most traditional finance doesn't have. Approach with extreme caution or avoid entirely.

Further Reading

• Stablecoins Explained: What They Are and Key Risks
• Safe Transaction Habits
• Common Crypto Scams: How to Avoid Them
• Wallets Explained: Custodial vs Non-Custodial