DeFi Fundamentals
Explore the world of decentralized finance. Learn about lending, staking, yield farming, and how to participate safely in DeFi protocols.
What is Decentralized Finance?
Finance Without Intermediaries
Decentralized Finance (DeFi) refers to financial services built on blockchain technology that operate without traditional intermediaries like banks, brokerages, or exchanges. Instead, smart contracts — self-executing code on the blockchain — automate financial operations.
DeFi enables anyone with an internet connection to access services like lending, borrowing, trading, and earning interest. There's no application process, no credit checks, and no geographic restrictions. If you have a wallet, you can participate.
The total value locked (TVL) in DeFi protocols has grown from essentially zero in 2019 to tens of billions of dollars today. This rapid growth reflects genuine utility: people worldwide using these protocols to manage and grow their assets.
Key DeFi Concepts
Smart contracts are the foundation of DeFi. These are programs stored on the blockchain that execute automatically when conditions are met. Once deployed, they operate exactly as programmed without human intervention.
Composability, often called 'money legos,' describes how DeFi protocols can be combined. A token earned in one protocol can be deposited in another, which can be used as collateral in a third. This interoperability creates complex financial strategies.
Permissionless operation means anyone can use DeFi protocols or build on top of them. There are no gatekeepers deciding who can participate. This openness drives innovation but also means users must take responsibility for their own decisions.
Liquidity Pools Explained
The Engine of Decentralized Trading
Liquidity pools are collections of cryptocurrency locked in smart contracts that enable decentralized trading. Instead of matching buyers with sellers (order book model), traders swap against the pool itself.
Automated Market Makers (AMMs) use mathematical formulas to set prices based on the ratio of assets in the pool. The most common formula, x*y=k, automatically adjusts prices as the pool balance changes with each trade.
Anyone can contribute to liquidity pools and earn a share of trading fees proportional to their contribution. This democratizes market making, previously reserved for large financial institutions.
Impermanent Loss
Impermanent loss occurs when the price ratio of pooled assets changes from when you deposited. If you had simply held the assets instead of providing liquidity, you'd have more value. The loss becomes permanent only when you withdraw.
The name 'impermanent' reflects that if prices return to your entry ratio, the loss disappears. However, in practice, prices often don't return, making this a real consideration for liquidity providers.
Trading fees earned can offset impermanent loss, and pools with highly correlated assets (like stablecoin pairs) experience minimal impermanent loss. Understanding this risk is crucial before providing liquidity.
Staking and Yield Opportunities
Native Staking
Staking involves locking tokens to support blockchain operations (on Proof of Stake networks) and earn rewards. On Solana, you can stake SOL with validators and earn approximately 5-7% APY in additional SOL.
When you stake, your tokens remain yours but are delegated to a validator. You choose which validator receives your delegation, and your rewards depend partly on their performance and commission rate.
Liquid staking alternatives (like mSOL or jitoSOL) give you a tradeable token representing your staked position. This lets you earn staking rewards while still using your assets in DeFi protocols.
Yield Farming Strategies
Yield farming involves strategically moving assets between protocols to maximize returns. This might mean providing liquidity, lending assets, or collecting multiple reward tokens simultaneously.
Returns in yield farming can be high but come with proportional risks: smart contract vulnerabilities, impermanent loss, token price volatility, and protocol changes. APYs over 20% should be scrutinized carefully.
Start with established protocols and modest amounts while learning. Complexity often correlates with risk — simple strategies in proven protocols are usually better for those still learning.
DeFi Risk Management
Understanding the Risks
Smart contract risk is the possibility that code contains bugs or exploits. Even audited contracts have been hacked. Diversifying across protocols and limiting exposure to any single protocol reduces this risk.
Oracle risk involves the external data feeds protocols use for price information. If oracles provide incorrect data, protocols may execute transactions based on wrong prices, causing losses.
Economic attacks exploit protocol mechanics rather than code bugs. Flash loan attacks, governance manipulation, and market manipulation have all caused significant losses in various protocols.
Safety Practices
Research before depositing: How long has the protocol operated? Is it audited? How much TVL does it have? What's the team's reputation? Active communities and transparent communication are positive signs.
Never invest more than you can afford to lose, and never put all your assets in DeFi. A reasonable approach allocates a percentage to DeFi experimentation while keeping the majority in safer storage.
Stay informed about the protocols you use. Follow official accounts, join Discord communities, and monitor for any suspicious activity or warnings. Quick awareness of issues can help you exit before major losses.
Key Takeaways
- What is DeFi?
- Liquidity pools
- Yield farming
- Risk management
Course created by
Solana Faucet Education Team
Our education team develops structured cryptocurrency courses drawing on practical experience with blockchain protocols, DeFi platforms, and the Solana ecosystem. All course material is regularly reviewed for accuracy and updated to reflect changes in the rapidly evolving crypto landscape.
Last reviewed and updated: February 2026
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