Crypto course · Section 5: Futures, Leverage and DeFi
DeFi and Staking Risks: Where Crypto Yield Comes From
How DeFi lending, liquidity pools and staking generate yield, with worked examples of impermanent loss and loan liquidation, and the risks behind high APYs.
Advanced6 min read·6:49 video·Lesson 20 of 26·quiz: 4 questions
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DeFi (decentralised finance) lets you lend, borrow, swap and earn yield through smart contracts instead of through a bank or company, and staking means locking coins to help secure a proof-of-stake network in return for rewards. Some of these yields are real, but they carry risks that bank deposits do not: code bugs and hacks, falling token prices, lock-up periods, depegs and outright scams. As a rule, an unusually high yield is a sign of unusually high risk.
The building blocks
- Decentralised exchanges (DEXs) let you swap tokens from your own wallet using pools of tokens instead of an order book.
- Liquidity pools are those pools. Anyone can deposit a pair of tokens and earn a share of trading fees as a liquidity provider (LP).
- Lending protocols let you deposit crypto to earn interest, or borrow against it.
- Bridges move tokens between different blockchains.
- Staking locks a network's coin to support validators who secure it.
Risk 1: the code
Smart contracts are programs, and programs have bugs. When a DeFi contract is exploited, funds usually move out in minutes and there is no bank, regulator or deposit insurance to make users whole. Bridges have been especially vulnerable: in 2022 the Ronin and Wormhole bridge hacks each took hundreds of millions of dollars.
Audits by security firms reduce risk but do not remove it; audited contracts have been exploited too. Oracles, the services that feed prices into contracts, can also be manipulated or fail, triggering wrong liquidations.
Risk 2: impermanent loss in liquidity pools
Most pools keep the two tokens at equal value. When one token's price rises, the pool automatically sells some of it for the other. You end up with less of the token that rose than if you had just held. This shortfall versus holding is called impermanent loss; it becomes permanent when you withdraw.
Example
You deposit 1 ETH and 3,000 USDC when ETH is $3,000, a $6,000 position. ETH doubles to $6,000.
- The pool rebalances so you now hold about 0.707 ETH and 4,243 USDC. Value = 0.707 x 6,000 + 4,243 = $8,485.
- If you had simply held 1 ETH and 3,000 USDC: 6,000 + 3,000 = $9,000.
- Impermanent loss = 8,485 / 9,000 - 1 = about -5.7%.
If ETH had quadrupled, or fallen to a quarter, the loss versus holding would be 20%. Trading fees earned can offset this, but only if the pool is busy enough.
Risk 3: borrowing and liquidation
DeFi loans are over-collateralised: you deposit more than you borrow. If your collateral falls in value, a contract sells it automatically, often with a penalty.
Example
You deposit 2 ETH at $3,000 ($6,000) and borrow 3,000 USDC. Suppose the protocol liquidates when your debt exceeds 80% of your collateral's value (parameters vary by protocol and asset). Liquidation happens when 0.8 x collateral value = $3,000, so collateral value = $3,750, which is $1,875 per ETH, a fall of 37.5%. A liquidation penalty, often several percent, comes on top. Crypto has fallen 37.5% in weeks many times.
Risk 4: staking is not a savings account
Staking rewards come from new coins issued by the network and from transaction fees. The risks:
- Price risk: rewards are paid in the token. If it falls, the rewards do not save you.
- Lock-ups and unbonding: many networks make you wait days or weeks to withdraw staked coins, so you cannot sell during a crash.
- Slashing: validators that break rules can lose part of their stake, and delegators may share that loss.
- Custodian risk: staking through an exchange means trusting the exchange.
- Liquid staking tokens: some services give you a token representing your staked coins so you can still trade. These usually track the underlying coin but can trade at a discount in stress; in June 2022, stETH traded noticeably below ETH as holders rushed for liquidity.
- Inflation: if a network issues 7% new coins a year and you earn 5%, your share of the network is shrinking.
Example
You stake a token paying 5% a year. Over the year the token falls 30%. Your position = 1.05 x 0.70 = 0.735, a loss of about 26.5% in dollar terms. The reward softened the fall slightly; it did not turn it into a gain.
Risk 5: centralised "yield" products
In 2022 several centralised crypto lenders that paid attractive yields on deposits, including Celsius and BlockFi, froze withdrawals and went bankrupt. Customers became creditors in long legal processes. A company paying you yield is lending your coins to someone else; if they cannot repay, neither can the company.
Where does the yield come from?
Ask this about every product:
| Source | Sustainable? |
|---|---|
| Borrowers paying interest | Yes, if loans are well collateralised |
| Trading fees in a pool | Yes, if the pool is busy, minus impermanent loss |
| Network staking rewards | Partly; check inflation and token price |
| Newly printed project tokens | Usually not; depends on new buyers |
| "Trading bot profits" with fixed returns | Almost certainly a scam (see lesson 5) |
Red flags
- Yields far above what lending or staking elsewhere pays, especially if fixed.
- Rewards mostly in a new token the project prints itself.
- Anonymous team, no audits, unverified contracts.
- Deposits that cannot be withdrawn for a long time.
- Pressure to bring friends in for bonuses.
Safer practice
- Use a separate wallet for DeFi with only the money you are prepared to lose; keep savings in a hardware wallet that never connects to DeFi apps.
- Prefer protocols with a long history, multiple audits and large, steady deposits.
- Approve only the amount you need and revoke approvals afterwards, as explained in Crypto Wallets and Seed Phrases.
- Bookmark official sites; never use links from ads or direct messages.
- Record every reward for tax; see Crypto Taxes and Record Keeping.
Risk
There is no deposit insurance in DeFi. Treat any amount you put in as fully at risk, and size it like a speculative trade, not like savings.
You have finished the Advanced section. The Pro section starts with a complete system: Crypto Trend Following Strategy: Donchian Breakouts.
Key takeaways
- DeFi replaces banks and exchanges with smart contracts; staking locks coins to help secure a proof-of-stake network.
- Smart contract bugs, bridge hacks, oracle failures and scams can wipe out deposits, and nobody guarantees them.
- Liquidity providers suffer impermanent loss when prices move: about 5.7% versus holding if one asset doubles.
- Staking rewards are paid in a token that can fall; a 5% reward does not help if the token drops 30%.
- If you cannot explain where a yield comes from, assume the yield is your own money at risk.
Quiz: check what you learned
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⚠ Not financial advice — educational signals only. Read the disclaimer.