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What Is DeFi?
Decentralised finance explained simply: how DeFi lending, trading and liquidity pools work without banks, why people use them and the risks behind the yields.
Key takeaways
- DeFi uses smart contracts to offer financial services such as lending and trading without a traditional intermediary.
- Anyone with a wallet can use it, but there’s no customer service, deposit protection or undo button.
- Smart-contract bugs, hacks, liquidations and scams have cost users billions.
On this page
Decentralised finance, or DeFi, is the idea of rebuilding financial services, such as lending, borrowing and trading, as programs on a blockchain instead of inside banks and brokers. It’s one of crypto’s most inventive corners, and one of its riskiest.
How DeFi works
DeFi apps are built from smart contracts, programs that run on blockchains such as Ethereum. You connect a self-custody wallet, approve a transaction and the contract does the rest: swapping tokens, lending them out or taking collateral for a loan. No account application and no bank opening hours, but also no one to call if something goes wrong.
Common DeFi services
| DeFi service | Traditional equivalent | Key risk |
|---|---|---|
| Decentralised exchange (DEX) | Stock exchange or currency desk | Fake tokens, price slippage |
| Lending and borrowing | Bank loans and savings | Liquidation if collateral falls |
| Liquidity pools | Market making | Impermanent loss, bugs |
| Stablecoins | Bank dollars | Losing the peg |
| Yield farming | High-interest savings | Unsustainable rewards, rug pulls |
Decentralised exchanges
Instead of matching buyers and sellers, many DEXs use liquidity pools: reserves of two tokens supplied by users. A formula sets the price as people trade. Liquidity providers earn a share of fees, but can suffer impermanent loss when prices move sharply.
Lending and borrowing
You can deposit crypto to earn interest, or borrow against collateral. Loans are usually over-collateralised: you might lock $150 of crypto to borrow $100 of a stablecoin. If your collateral’s value falls too far, it’s automatically sold, or liquidated.
Why people use DeFi
- Access for anyone with a wallet and internet connection
- Transparent rules written in public code
- Services that run around the clock
- The ability to combine apps, sometimes called “money legos”
The risks
- Smart-contract bugs and hacks. Exploits have drained billions of dollars from DeFi protocols over the years.
- Scams and rug pulls. Anyone can launch a token or protocol. Read how rug pulls work.
- Wallet approvals. Approving a malicious contract can let it drain your tokens later.
- Liquidations during sudden price drops.
- “Decentralised” in name only. Some protocols are controlled by a few people who can change the rules.
- No protection. There’s no deposit insurance, and transactions can’t be reversed.
- Unclear regulation, which varies by country and is still developing.
Frequently asked questions
Is DeFi legal?
Using DeFi is legal in many countries, but rules vary and are changing. Tax rules usually still apply to trades and income.
Do I need to be technical to use DeFi?
Not very, which is part of the risk. It’s easy to approve a transaction you don’t fully understand.
Is DeFi safer than an exchange?
It removes the risk of a company holding your coins, but adds smart-contract and user-error risks. Neither is risk-free.
Sources
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