Decentralised Finance: Lending, Swapping and Where Yield Comes From

Three primitives, everything else is a combination

Swapping, lending and providing liquidity. A swap exchanges one token for another against a pool rather than an order book. Lending deposits an asset for others to borrow against collateral. Providing liquidity supplies the pool a swap trades against, in return for a share of its fees.

Everything with a more elaborate name is these three arranged differently, sometimes several layers deep. That layering is genuinely powerful and it is also where risk compounds, because a product built on three protocols inherits the failure modes of all three.

1. Swap

   Trade against a pool holding both assets. The price comes from the ratio in the pool, so a large trade moves it. That movement is slippage, and it is the cost that scales with size.

2. Lend

   Deposit an asset, earn interest from borrowers who post collateral worth more than they take. If collateral falls below a threshold it is liquidated automatically, which is what keeps the system solvent.

3. Provide liquidity

   Supply both sides of a pool and earn a share of trading fees. You also take on impermanent loss, and whether the fees cover it depends entirely on how much the two assets move relative to each other.

Reading a yield figure

Ask where the money comes from. Fees from real usage are sustainable and usually modest. Interest from borrowers is real and varies with demand. Newly minted tokens distributed to participants are dilution, and a figure built mostly from them describes an emission schedule rather than a return.

The tell is size. A double-digit yield on a stablecoin, in a world where conventional rates are much lower, is not a market inefficiency somebody left lying around. It is either compensation for a risk that has not yet materialised, or it is token issuance, and both have a way of resolving suddenly.

The step where users actually get hurt

Most individual losses in this area do not come from a protocol failing. They come from the approval step: before a contract can move your tokens, your wallet grants it permission, and that permission persists until you revoke it. A malicious contract approved once, usually through a link that imitated a real interface, can wait, then empty the balance in a single transaction months later.

The defence is procedural rather than technical. Reach interfaces through addresses you have recorded yourself, grant approvals for specific amounts where the wallet allows it, and review standing approvals occasionally the way you would review direct debits. It is unglamorous, and it removes the failure mode that produces most of the individual-scale losses.

Impermanent loss, which is badly named

Supplying two assets to a pool earns a share of trading fees, and the headline yield usually quotes those fees alone. Sitting against them is an effect that the standard name actively obscures. As the price of one asset moves relative to the other, the pool rebalances by selling the one going up and buying the one going down, so a depositor ends up holding less of the winner than if they had simply kept both.

Impermanent describes the fact that the gap closes if the price returns to where it started. It does not, in any sense, mean small or temporary. Withdraw while the prices have diverged and the loss is realised in full, and for a volatile pair it can exceed everything the fees paid.

The consequence is that a pool yield is not comparable to an interest rate, though it is almost always presented next to one. An interest rate is the return. A pool yield is one side of a position whose other side depends on where two prices go. Pools of two assets that track each other closely reduce the effect sharply, which is why stable pairs pay less and why the difference between the two figures is doing more work than it appears to.

What decentralised actually describes

Rarely the whole system. A protocol can have permissionless usage and a single key controlling upgrades, an open interface and a front end hosted by one company, on-chain settlement and an off-chain price feed run by a foundation. Each of those is a point where somebody specific can act.

This is not hypocrisy; building otherwise is genuinely hard. It does mean the label carries much less information than it appears to, and that the useful question is always "decentralised in which respect, and who is left holding the keys".