Part IV · 1 — DeFi: finance without an intermediary

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If Ethereum is a world computer, DeFi is what got built on it the most: rebuilding financial services — swapping, lending, yielding — as open contracts, with no bank or broker in the middle. Here are the pieces and why they fit together.

1.1 What changes without an intermediary

Traditional finance relies on a trusted institution that custodies assets and executes orders. DeFi (Decentralized Finance) replaces the institution with smart contracts (Part III): the code custodies and executes, publicly and auditably, without permission.

Three properties come for free — and they define the genre:

  • Permissionless — anyone can use it, with no registration or approval.
  • Composable — protocols snap together like "money legos": the output of one

    is the input of another, composing complex products out of simple pieces.

  • Non-custodial — you control your assets with your key; the contract does not

    "hold" your money, it only executes rules.

DeFi as "money legos": composable pieces over the smart contract

The brutal trade-off: code is law. A bug moves real, irreversible money; there is no manager to reverse it.

1.2 AMM: swapping without an order book

The most elegant piece of DeFi is the AMM (Automated Market Maker). Instead of matching buyers and sellers in an order book, a liquidity pool holds two assets and prices them by a formula. The most common is the constant product:

The pool maintains x · y = k (constant). Buying asset X means returning enough Y to keep the product — the price emerges from the ratio of the reserves.

Constant-product AMM: the pool prices by the ratio of the reserves

Whoever deposits both assets is a liquidity provider (LP) and earns fees from swaps — but bears impermanent loss: if relative prices change, holding the pair in the pool yields less than simply holding the assets. Uniswap popularized the model.

1.3 Lending, stablecoins and the rest of the pieces

  • Lending — protocols (Aave, Compound) where you deposit collateral and borrow

    against it. If the collateral's value falls below a threshold, the position is liquidated automatically. Everything is over-collateralized (you lock more than you take), because there is no credit analysis.

  • Stablecoins — tokens pegged to a currency (usually the dollar). There are the

    collateralized ones, backed by fiat reserves (USDC) or by over-collateralized crypto (DAI), and the algorithmic ones — which try to hold the peg purely through incentives and have collapsed spectacularly (Terra/UST, 2022).

  • Oracles — DeFi needs real-world prices on-chain; oracles (Chainlink, Pyth)

    deliver them. They are a critical point: a manipulated oracle breaks an entire protocol (a common attack vector).

Dense reference: AMMs, stableswap, lending, stablecoins, liquid staking and oracles in 09-defi. Next: NFTs, RWA and beyond — when the token represents something that is not money.