DeFi

DeFi explained: decentralised exchanges, liquidity pools and the risks

CryptoSurge HQ · Updated 18 October 2026 · How we write

Decentralised finance, or DeFi, is a set of financial services built from smart contracts on blockchains such as Ethereum. Instead of a bank or broker, code handles trading, lending and borrowing. Anyone with a wallet can use it, which is both the appeal and the danger.

Decentralised exchanges and automated market makers

A traditional exchange matches buyers with sellers using an order book. Most decentralised exchanges work differently. They use an automated market maker: a smart contract holding a pool of two tokens. You trade against the pool, and a formula sets the price based on the ratio of tokens in it. Each trade shifts the ratio, so large trades in small pools move the price a lot. That difference between the expected and actual price is called slippage.

Liquidity pools

The tokens in those pools come from users called liquidity providers. They deposit pairs of tokens and receive a share of the trading fees. In return they take on several risks:

Impermanent loss. If the price of one token moves a lot relative to the other, the pool rebalances and the provider can end up with less value than if they had simply held both tokens. Fees may or may not make up for it.
Smart contract risk. A bug or exploit can drain the pool.
Token risk. If one of the tokens collapses, the provider can be left holding mostly the worthless one.

Lending and borrowing

DeFi lending protocols let people deposit tokens to earn interest and let others borrow against collateral. Loans are usually over-collateralised: you must lock up more value than you borrow. If the value of your collateral falls below a set level, the protocol sells it automatically to repay the loan. This is called liquidation, and it can happen quickly in a falling market.

Where "yield" comes from

DeFi apps often advertise a yield. It is worth asking where it comes from. Genuine sources include trading fees and interest paid by borrowers. Some yields are paid in a project's own newly created tokens, which can lose value as more are issued. A very high advertised rate is usually a sign of high risk, not a bargain.

The main risks in one place

Code bugs and exploits, including in bridges that move tokens between blockchains.
Price oracles being manipulated, so a protocol acts on a false price.
Projects where the developers can change the rules, mint tokens or withdraw funds.
Fake front-end websites that copy a real app to steal approvals.
No deposit protection, no ombudsman and, in most cases, no one to complain to.

Questions to ask before using a DeFi app

Who runs it, and can they change the contracts or pause withdrawals?
Has the code been audited, and by whom? Remember an audit is not a guarantee.
Where does the return come from?
What happens to my funds if one of the tokens falls sharply?
Am I using the real site? Type the address yourself or use a bookmark.

If you do experiment, the advice in our self-custody guide about separate wallets and reviewing token approvals applies doubly here.

Sources and further reading

Not financial advice. This article is for general information and education only. It is not financial advice or a recommendation to buy, sell or hold any cryptoasset. Cryptoassets are high risk and largely unregulated in the UK: you could lose all the money you put in, and you are unlikely to be protected by the Financial Ombudsman Service or the FSCS.