Academy School · Chapter 8 of 14
DeFi
How decentralized finance works and where its main risks come from.
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Return to Academy SchoolDeFi Primitives
DeFi uses smart contracts instead of traditional intermediaries to provide financial functions. Common primitives include lending, swapping, staking, and stablecoins, each with its own rules and assumptions.
The appeal is openness and programmability. The tradeoff is that users must understand the system well enough to evaluate the contract, the market design, and the risks before interacting.
- Smart contracts replace intermediaries.
- Lending, swaps, staking, and stablecoins are core primitives.
- Programmability increases responsibility.
DeFi is finance organized by code, not by institutions.
Lending and Borrowing
Lending markets connect depositors with borrowers and use collateral to manage risk. Liquidation rules help protect lenders when markets move against a borrower’s position.
Rates are not fixed by magic; they respond to utilization and demand. Understanding how a lending market balances incentives is essential before placing capital into it.
- Collateral supports borrowing.
- Liquidation rules manage risk.
- Rates respond to market utilization.
Lending markets work because incentives and safeguards are built into the contract design.
AMMs, Liquidity, and Stablecoins
Automated market makers use pools and pricing formulas instead of traditional order books. This can make trading more accessible, but it also creates specific risks for liquidity providers and traders.
Stablecoins provide a familiar unit of account inside crypto markets. They help with pricing and movement between protocols, yet their reliability still depends on design, reserves, and governance assumptions.
- AMMs use pools and formulas.
- Liquidity providers face distinct risks.
- Stablecoins help with pricing and transfers.
DeFi liquidity is powerful, but every design introduces tradeoffs.
DeFi Security Basics
Security in DeFi starts with contract awareness. Approvals, phishing, malicious interfaces, and hidden permissions can create losses even when the market itself is calm.
The safest approach is cautious and systematic. Read interactions, limit permissions, and remember that yield should never distract from basic operational security.
- Approvals can be risky.
- Interfaces can be malicious.
- Yield never overrides security.
In DeFi, understanding the contract matters as much as understanding the asset.