DeFi Basics

What Is DeFi?

DeFi (Decentralized Finance) is an ecosystem of financial applications built on blockchains that offer services like trading, lending, borrowing, and earning interest — without banks, brokers, or other traditional intermediaries. Instead of a bank deciding whether to approve your loan, a smart contract automatically processes it based on code. DeFi is open 24/7, available to anyone with an internet connection and a crypto wallet, and fully transparent since all transactions are on-chain.

Decentralized Exchanges (DEXs)

A DEX lets you swap one cryptocurrency for another directly from your wallet, without creating an account or trusting an exchange with your funds. Uniswap (on Ethereum) and Jupiter (on Solana) are among the most widely used. Instead of matching buyers and sellers like a stock exchange, most DEXs use "liquidity pools" — shared pots of tokens that enable instant swaps using a mathematical formula to determine prices.

Lending and Borrowing

DeFi lending platforms like Aave and Compound let you deposit crypto to earn interest (like a savings account) or borrow crypto by providing collateral. The interest rates adjust automatically based on supply and demand. Because there is no credit check, most DeFi loans are over-collateralized — you usually deposit more value than you borrow (flash loans, covered below, are one exception because they must be repaid within a single transaction).

Yield Farming and Liquidity Pools

Yield farming is the practice of depositing crypto into DeFi protocols to earn returns. The simplest form is providing liquidity to a DEX: you deposit a pair of tokens (e.g., ETH + USDC) into a liquidity pool, and you earn a share of the trading fees every time someone swaps between those tokens. Many protocols also distribute their own governance tokens as additional incentives to liquidity providers.

Liquidity pools use Automated Market Maker (AMM) algorithms — most commonly the constant product formula (x * y = k) — to price assets. When someone swaps ETH for USDC, they add ETH to the pool and remove USDC, which changes the ratio and automatically adjusts the price. Liquidity providers earn fees but face impermanent loss risk when the token ratio diverges from their deposit ratio.

Understanding TVL

TVL (Total Value Locked) is the most-cited metric in DeFi, representing the total dollar value of assets deposited in a protocol's smart contracts. A lending protocol with $2 billion TVL has $2 billion worth of crypto deposited by users. TVL indicates adoption and trust, but it is not the same as revenue or profit — high TVL can be driven by unsustainable token incentives rather than genuine demand.

Key DeFi Protocol Types

• DEXs (Uniswap, Jupiter, Curve) — token swapping via liquidity pools
• Lending/Borrowing (Aave, Compound, Morpho) — deposit to earn interest, borrow against collateral
• Stablecoins (MakerDAO/Sky, Ethena) — protocols that create decentralized stablecoins
• Yield Aggregators (Yearn, Beefy) — automatically move funds to the highest-yielding strategies
• Liquid Staking (Lido, Rocket Pool) — stake ETH and receive a liquid token (stETH) usable in DeFi

Concentrated Liquidity and Advanced AMM Design

Uniswap V3 introduced concentrated liquidity, allowing LPs to allocate capital within custom price ranges rather than across the entire price curve (0 to infinity). This dramatically improves capital efficiency — a concentrated position can provide the same depth as a V2 position with a fraction of the capital. However, it increases impermanent loss risk and requires active management, as positions earn zero fees when the price moves outside the selected range.

Curve Finance pioneered the StableSwap invariant, optimized for assets that should trade near 1:1 (stablecoin-stablecoin or wrapped asset pairs). By concentrating liquidity around the peg, Curve achieves extremely low slippage for same-peg swaps. Curve V2 extended this to volatile pairs with an internally updating price oracle. Other designs include Balancer's weighted pools (custom token ratios), Trader Joe's (now LFJ) Liquidity Book (discrete bins), and Maverick's directional LPing.

Flash Loans and Composability

DeFi's most unique property is composability — protocols can interact with each other within a single transaction. Flash loans epitomize this: a user borrows millions of dollars from Aave, uses the funds to execute an arbitrage across Uniswap and Curve, repays the loan plus fees, and keeps the profit — all atomically in one transaction. If any step fails, the entire transaction reverts, meaning the borrower risks nothing but gas fees.

Protocol Revenue vs. Token Emissions

A critical distinction in evaluating DeFi protocols is the difference between real yield (revenue from actual usage, like trading fees) and emission-subsidized yield (from inflationary token rewards). During DeFi summer (2020-2021), many protocols offered sky-high APYs funded entirely by token emissions, which collapsed once emissions slowed. Sustainable DeFi protocols generate enough organic revenue to reward participants without relying on inflation. DeFi Llama's "Fees" and "Revenue" dashboards are essential for this analysis.