DeFi and DEXs in plain words
Lesson 32 of 39 in the course “Crypto”. Free, with animations and a quiz.
Swapping with no middleman
DeFi (decentralized finance) means financial services built on smart contracts, programs on the blockchain, with no bank or exchange in between. A DEX is a decentralized exchange. Example from the picture: you put 1 ETH into a pool and get 2,400 USDC (an illustrative price, minus fees). No sign-up or KYC: you connect your own wallet and sign the trade yourself.
Liquidity pools and yield
A liquidity pool is a shared stock of two coins, such as ETH and USDC, that the DEX uses for swaps. Regular people fill it, and they are called liquidity providers. In return they get a share of the fees from every swap. Sounds like passive income, but there are risks: impermanent loss, bugs in the code and contract hacks.
Impermanent loss
Impermanent loss: when the price of one coin in the pool moves a lot, you end up with more of the coin that got cheaper and less of the one that got pricier. Example: ETH doubles. Your share of the ETH + USDC pool is worth about 5.7% less than if you had simply held the same coins. Fees may cover that, or they may not.
Safety rules
Start with small amounts and well-known protocols, meaning DeFi services with a long track record. Check the smart contract address and do not sign approvals you do not understand. The protection in the picture matters too: 2FA on the exchange you withdraw coins from, and withdrawals only to your own addresses. The basics: a very high yield almost always means very high risk.
Red flags in a pool
Three flags from the picture. Very thin liquidity, for example $5,000 in the pool, so even a small trade moves the price a lot. LP tokens (receipts for a share of the pool) are not locked: the creator can pull the pool and leave you with a useless token. The top 10 wallets hold 70% of the tokens. One flag: be careful. Three: walk away.
Check yourself
- What is a DEX?
Correct answer: An exchange on smart contracts, no middleman. A DEX swaps coins through a smart contract and a liquidity pool. There is no central company holding your money. - What is the main DeFi risk besides a price drop?
Correct answer: Smart contract bugs and hacks. A smart contract is code, and code can have flaws. If the contract is hacked, the money in the pool can vanish. - A very high yield in DeFi usually means...
Correct answer: Very high risk. There is no free lunch: a high rate pays you for the risk of a hack, the token losing value or the creator draining the pool.