Decentralised Finance (DeFi)DeFi
Decentralised finance (DeFi) is lending, trading and other financial services run by smart contracts on public blockchains instead of by banks or brokers.
In traditional finance, a bank or broker stands between you and every loan, trade or deposit. DeFi replaces that middleman with code. Anyone with a wallet can lend, borrow or trade around the clock — but there is no help desk, no deposit insurance and no one to reverse a mistake. Understanding how it works and where it breaks is essential before putting money in.
- Category
- Cryptocurrency and Blockchain
- Reading time
- 4 min
- Also called
- Decentralized finance, Open finance, On-chain finance
- Updated
DeFi in plain words
DeFi is an umbrella term for financial products and services that anyone with access to Ethereum can use.1
It uses crypto and smart contracts to offer services without a bank or broker in the middle.1 Users can lend, borrow, go long or short and earn interest.1
Stablecoins are increasingly important in DeFi.2 Trading often happens on automated market makers instead of an Order Book.3 See Stablecoin and Liquidation.
How a DeFi loan works, step by step
Connect a wallet
DeFi apps are used from a self-custody wallet; no account is opened.
Deposit collateral
You lock crypto in a lending smart contract — a service with no intermediary.1
Borrow
You borrow another asset, often a Stablecoin, up to a limit set by the protocol.
Pay interest
Interest rates are usually variable and set by supply and demand in the pool.
Watch the health of the loan
If collateral value falls too far, the protocol can liquidate it automatically.
Know the code risk
Attackers try to exploit vulnerabilities in smart contracts, and stolen assets are mostly irrecoverable.4
Worked examples
Example 1 — Borrowing against collateral
Liquidated after a 37.5% fallYou deposit ETH worth $10,000 and borrow $5,000 of a stablecoin. The hypothetical liquidation threshold is 80%.
| Liquidation when collateral < | $5,000 ÷ 0.80 = $6,250 |
| Fall needed | ($10,000 − $6,250) ÷ $10,000 = 37.5% |
The loan is run by smart contracts rather than an intermediary.1 Liquidation happens automatically, with no one to ask for more time.
Example 2 — Earning interest
+$80You lend $2,000 of a stablecoin at a hypothetical variable 5% APR, which falls to 3% after 6 months.
| First 6 months | $2,000 × 5% × 6/12 = $50 |
| Next 6 months | $2,000 × 3% × 6/12 = $30 |
| Year total | $50 + $30 = $80 |
Earning interest is one of the main DeFi uses, but the rate is not fixed.1
Example 3 — A contract exploit
−$3,000You deposited $3,000 in a protocol whose smart contract is hacked.
| Funds drained | $3,000 |
| Chance of recovery | Very low |
Deployed code usually cannot be patched, and stolen assets are mostly irrecoverable.4
DeFi vs. traditional finance
| Aspect | DeFi | Traditional finance |
|---|---|---|
| Run by | Smart contracts | Banks and brokers |
| Access | Anyone with a wallet | Account and identity checks |
| Opening hours | 24/7 | Business and market hours |
| Protection | Usually none | Deposit and investor protection schemes |
What people use DeFi for
Swapping tokens
Trading on decentralised exchanges.
Lending
Earning variable interest on deposited crypto.
Borrowing
Getting stablecoins against crypto collateral.
Leverage
Building leveraged positions on-chain.
Advantages and disadvantages
Advantages
- Open to anyone with an internet connection.
- Runs 24/7 without intermediaries.
- Transparent, public code and transactions.
- Services can be combined freely.
Disadvantages
- Smart contract bugs and hacks can drain funds.
- No deposit insurance or customer support.
- Automatic liquidations in fast markets.
- Rates and token prices are volatile.
Going deeper
Read as far as you need. Each level builds on the one before it.
Finance without middlemen
Beginner
DeFi provides financial services through smart contracts rather than intermediaries.1
The building blocks
Intermediate
Risk stacks up
Advanced
Each protocol adds code risk; attackers look to exploit vulnerabilities in smart contracts.4 Combining protocols stacks those risks, together with Liquidation, Volatility and stablecoin risk. Rules differ by country.
Common mistakes
Borrowing too close to the limit
Getting liquidated by a normal price swing.
Chasing the highest yield
Ignoring where the yield comes from.
Trusting unaudited code
Depositing in new protocols without checking.
Approving unknown contracts
Signing approvals that let a contract move your tokens.
Check your understanding
Test yourself before moving on. Each answer comes with an explanation.
Key points to remember
- DeFi is financial services run by smart contracts.
- Anyone with a wallet can use it, 24/7.
- Lending, borrowing and swapping are the main uses.
- Collateralised loans can be liquidated automatically.
- Code risk is real and losses are hard to recover.
Frequently asked questions
Is DeFi regulated?
Can I lose more than I deposit?
Is DeFi only on Ethereum?
Further learning
- Stablecoin
The main currency of DeFi.
- Liquidation
What happens when collateral falls.
- Leverage
How borrowing amplifies results.
- Liquidity
Why pool depth matters.
Sources
This article is written in our own words. The sources below support the specific facts, rules and figures marked with a number in the text. Links open the original publisher’s page.
- ethereum.org. Decentralized finance (DeFi) (opens in a new tab) Checked .
- Federal Reserve Board (FEDS Notes). Primary and Secondary Markets for Stablecoins (opens in a new tab) Checked .
- Uniswap Docs. How Uniswap works (opens in a new tab) Checked .
- ethereum.org. Smart contract security (opens in a new tab) Checked .
Educational content, not financial advice. Examples use hypothetical prices and simplified costs; actual fees, margin rules and regulations vary by broker, market and country. We are not affiliated with any publisher linked above. Last reviewed . Report an error or request a source credit.