What is DeFi (decentralized finance)?

Imagine swapping currencies or borrowing crypto without waiting for approval from a bank clerk. In DeFi, short for decentralized finance, the rules are executed by smart contracts: programs on the blockchain that carry out specific actions when their conditions are met.

For example, in a lending app you can lock up crypto as collateral and borrow other crypto. In typical apps of this kind, the collateral must be worth more than the loan. If its value falls below the threshold set by the app, it can be sold automatically to cover the debt. That’s liquidation, and there’s no phone call offering you an extension.

Other apps let you swap tokens through decentralized exchanges (DEXs). Instead of necessarily trading with a specific seller, you can use shared pools of tokens, known as liquidity pools. Those who supply funds there may earn a share of the fees, but they also take on risks.

Why it matters

You usually connect your wallet and approve the transactions you want to make. Many apps are open to anyone with a compatible wallet, although access restrictions may apply. Transactions and code can often be checked publicly, and different apps can work with each other.

We find this composability particularly interesting: one service can build on another, like LEGO bricks. The same connection, however, can carry problems from one app to the next. The absence of a bank intermediary doesn’t mean the absence of trust or risk.

What to watch out for

A bug in the code, a hack or a malicious approval giving access to your tokens can lead to losses. A security audit is not a guarantee. Displayed yields change, and network fees affect the final result.

Also, the “DeFi” label doesn’t prove that an app is fully decentralized. We check who can change the rules, freeze functions or control critical permissions. Funds in a DeFi protocol don’t automatically get the protection of a bank deposit.