DeFi (Decentralized Finance) is a category of financial services built on public blockchains that uses smart contracts to provide products like trading, lending, borrowing, payments, derivatives, and yield strategies without relying on traditional intermediaries such as banks or brokers.
Instead of accounts managed by institutions, users interact with on-chain protocols using wallets and transaction signing.
How DeFi Works
DeFi applications are typically composed of smart contracts that hold funds and execute rules automatically. Users connect a wallet, approve a transaction, and the protocol performs the action on-chain, such as swapping tokens, depositing collateral, or minting a synthetic asset.
DeFi systems generally rely on:
- Smart contracts to enforce rules and automate execution
- Liquidity pools or order books to enable trading
- Collateralization to secure loans and synthetic positions
- Oracles to provide external data like prices and interest rates
- Governance mechanisms to update protocol parameters
What DeFi Is Used For
DeFi can be used to:
- Swap assets via decentralized exchanges (DEXs)
- Lend and borrow using overcollateralized positions
- Earn yield through lending markets, liquidity provision, or staking-related products
- Issue stablecoins and synthetic assets backed by collateral
- Move value globally with on-chain settlement and programmable payments
- Manage portfolios via automated strategies and vaults
Core DeFi Building Blocks
1. Decentralized Exchanges (DEXs)
Protocols that allow users to trade tokens directly from their wallets, often using liquidity pools and automated market maker (AMM) pricing.
2. Lending and Borrowing Protocols
Markets where users supply assets to earn interest and borrowers post collateral to access liquidity. Terms and rates are set algorithmically.
3. Stablecoins and Collateral
Stablecoins are commonly used as settlement and quote assets in DeFi. Some are issued by protocols using on-chain collateral and rules-based liquidation.
4. Oracles
Services that feed external data (especially asset prices) into smart contracts. Oracle reliability is critical for lending, liquidation, and derivatives.
5. Liquidations
Automated processes that sell or seize collateral when a borrower’s position falls below required thresholds, designed to keep lending markets solvent.
Examples of DeFi in Practice
DeFi use cases commonly include:
- Swapping USDC to ETH through a DEX liquidity pool
- Depositing ETH as collateral to borrow a stablecoin
- Providing stablecoins to a lending market to earn variable interest
- Adding tokens to a pool to provide liquidity and earn fees
- Using a vault product that automatically rebalances positions based on strategy rules
Risks and Considerations
DeFi introduces trade-offs and risk vectors that users must evaluate:
- Smart contract risk: bugs, exploits, or faulty upgrades
- Oracle risk: incorrect price data can trigger bad liquidations or insolvency
- Liquidity risk: thin liquidity can cause slippage and poor execution
- Market risk: collateral volatility can liquidate positions quickly
- Governance risk: parameter changes or captured governance can harm users
- Composability risk: failures can cascade across integrated protocols
- Operational risk: wallet security, approvals, phishing, and user error
Summary
DeFi (Decentralized Finance) is an on-chain financial system where smart contracts deliver services like trading, lending, borrowing, and yield without traditional intermediaries. It offers programmable, global settlement and open access, but it also requires careful risk management due to smart contract, oracle, liquidity, and market risks.
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