How Decentralized Finance Works: Smart Contracts, Lending, and Real Risks
Decentralized finance (DeFi) replaces banks with automated smart contracts running on blockchain networks. Instead of submitting a loan application to a bank, you deposit collateral into a smart contract; instead of a savings account earning interest, you provide liquidity to a decentralized exchange and earn transaction fees. DeFi operates on the premise that financial infrastructure can be transparent, permissionless, and governed by code rather than institutions. The mechanisms are real and operational, handling tens of billions in assets. The risks are equally real: smart contract bugs have erased hundreds of millions in user funds, 'rug pull' scams have vaporized billions, and impermanent loss is a mathematical cost of providing liquidity to automated trading pools. This article explains how DeFi works mechanically and examines the structural risks that distinguish it from traditional finance.