DeFi services can be combined like financial building blocks. A token received from one protocol may be used in another, linking lending, exchange, collateral and rewards. This archived explanation describes the mechanisms and their dependencies; historical products and parameters are examples, not current recommendations.
1. Stablecoins
A stablecoin seeks to track a reference value, often a conventional currency. USDC and USDT are familiar historical examples of dollar-linked tokens. The intended peg does not mean that the market price, liquidity or redemption rights are guaranteed.
Centralised issuers use reserve arrangements, while other designs rely on crypto collateral or different mechanisms. It is too simplistic to assume that every token is backed by an identical dollar sitting in a bank account. The reserve composition and holder's rights must be checked for the actual product.
The original article also discussed Lugh's euro-linked EUR-L and MakerDAO's DAI. These references describe the products as presented at the time. Names, collateral types and services may subsequently change.
In an overcollateralised system, a user deposits assets worth more than the debt issued. Liquidation can occur when a defined threshold is breached, potentially while collateral still exceeds the debt. There is no universal rule that an ETH price must fall by 50% before liquidation.
2. Decentralised exchanges
A decentralised exchange can let users swap tokens through smart contracts. Many use automated market makers, while other designs use order books or different execution arrangements. An AMM is therefore one mechanism, not a definition of every DEX.
Centralised exchanges commonly operate order books and may hold assets for customers. It would be inaccurate to describe every trade as the exchange itself buying from one user and reselling to another.
Using a wallet to interact with a DEX changes custody and execution dependencies but does not remove contract, interface, liquidity or governance risks. Assets committed to a protocol are subject to that protocol's rules.
3. Liquidity provision
A liquidity provider contributes assets to a pool used for swaps. Depending on the design, the provider may receive a fungible receipt token or another representation of its position and may earn a share of trading fees.
For a simplified example, Antoine deposits one ETH and 2,000 USDC when ETH is worth $2,000. His contribution is worth $4,000. The position's later value depends on trading, price movements, fees and the pool's rules.
Understanding impermanent loss
Impermanent loss compares a liquidity position with simply holding the deposited assets. It is not necessarily an absolute loss compared with the original investment.
In the original constant-product example, Antoine contributes one ETH and 100 USDC when ETH is worth $100. He owns 10% of a pool containing 10 ETH and 1,000 USDC. Ignoring fees, suppose ETH rises to $400 and the pool contains five ETH and 2,000 USDC.
His share is now 0.5 ETH plus 200 USDC, worth $400. Holding the original one ETH and 100 USDC would have been worth $500. His pool position has doubled in value, but it is $100 behind the holding alternative. The result depends on this simplified model and does not represent every pool design.
4. Lending and borrowing
Depositors may supply assets that borrowers use. Rates and withdrawal conditions depend on the protocol and utilisation. A quoted rate may change; available liquidity can limit an immediate withdrawal.
Borrowers often provide collateral and must maintain a required health or collateral ratio. Liquidation rules, price feeds and fees matter as much as the headline borrowing rate. A falling collateral price or rising debt can trigger a forced adjustment.
The historical article combined an ETH deposit, a USDC loan and liquidity provision. Such a strategy introduces several linked positions. Comparing the expected fee income with loan interest is insufficient unless price risk, liquidation and exit costs are also considered.
5. Yield farming
A protocol may distribute tokens to encourage deposits or activity. These incentives add another source of return whose value depends on the reward token and its market. They are not economically risk-free or necessarily sustainable.
A user might deposit a liquidity receipt into another contract to earn additional rewards. That creates another dependency and may make unwinding the position more complex. More protocol usage does not guarantee that the reward token's price will rise.
6. Synthetic exposure
A synthetic asset seeks to reproduce exposure to another asset or basket without necessarily transferring direct ownership of the underlying property. Designs may depend on collateral, price feeds, counterparties or liquidation mechanisms.
Tokenisation does not automatically confer a legally enforceable property right, and decentralisation does not eliminate all intermediary risk. The contract, redemption mechanism and legal rights must be understood.
7. Coverage and hedging
The original article mentioned Nexus Mutual as an example of protocol-related cover. Any coverage requires examination of eligibility, exclusions, limits and claim procedures. The discontinued document linked in the archive should not be treated as current terms.
Hedging products can change price exposure but introduce their own costs, collateral needs and basis risk. A product that moves inversely to another price is not a universal guarantee against loss.
Accounting for the combined position
For a company, retain the original asset movements, rights represented by receipt tokens, rewards, fees and outstanding borrowing. Reconcile the whole position across protocols rather than treating each export as an independent portfolio.
Our current DeFi guide and wallet-management guide explain how to organise the records for an accounting engagement.