What is decentralised finance (DeFi) and how does it work?

What is decentralised finance (DeFi)?

Decentralised finance (DeFi) is a financial system based on blockchain technology. It generally lacks centralised governance and can operate through protocols and decentralised governance mechanisms, although regulatory attention and oversight are increasing in many markets.

DeFi relies on smart contracts. These are self-executing code on blockchains like Ethereum that facilitate transactions without requiring a trusted intermediary. Early projects include Ethereum itself and protocols like MakerDAO, enabling decentralised stablecoins and lending.

The defining characteristics of DeFi are the reduced reliance on intermediaries, peer-to-peer transactions and broad accessibility of participation, although regulation and compliance expectations vary by jurisdiction and are evolving. Other distinguishing characteristics include rapid innovation, personal responsibility and the use of digital currencies and tokens for transactions and protocol governance.

DeFi operates separately from traditional centralised financial systems. As DeFi develops, opportunities for collaboration and integration between the two systems are beginning to emerge. For example, some financial institutions within the centralised financial system are exploring DeFi integrations.

The most obvious benefits of DeFi are accessibility, the speed of transaction and the rapid innovation of products and services. Risks include hacks and scams and technology issues associated with interoperability between protocols.

When did DeFi start? 

The term ‘DeFi’ was coined in August 2018 during an Ethereum online developer chat. But decentralised finance had existed for some years previously. Arguably the first truly decentralised form of finance was Bitcoin, which was launched in 2009.

Around six years after Bitcoin, the Ethereum blockchain was launched, which provided a foundational layer upon which new and innovative financial infrastructure could be built. Early examples of DeFi infrastructure include MakerDAO. By 2020, new platforms including Compound, Aave and Uniswap had launched and gained widespread use.

How does decentralised finance (DeFi) work?

DeFi relies on layered infrastructure that supports smart contracts and decentralised apps (dApps).

What are smart contracts?

These are self-executing digital agreements. The terms of the agreement are written into code that runs on the blockchain. They are based on a concept called ‘conditional logic’. If a pre-agreed condition is met, a pre-agreed thing happens. For example, ‘if the value of X = Y, you pay me Z’.

A smart contract has four elements; coding, writing the agreement into code; deployment, where the contract code is published to the blockchain; triggering, where the pre-agreed conditions of the agreement are met; and execution, where the action, such as a payment, happens automatically.

What are decentralised apps (dApps)?

These are software-based apps that run on a peer-to-peer network, for example blockchain, instead of a central server. Because they’re decentralised networks, they tend to be more resilient to single points of failure, but security and regulation can vary.

Combined together, smart contracts and dApps provide the bulk of DeFi infrastructure. The architecture has three layers; blockchain (the foundation), protocols (things that happen) and interfaces (what the user sees).

The infrastructure supports lending, borrowing and swapping via decentralised exchanges (DEXs), automated market makers (AMMs) and liquidity pools. Real world data comes from something called ‘oracles’.

The decentralised element allows for different types of financial services that are hard to access in centralised systems. For example, ‘flash loans’ allow users to access instant crypto assets without putting down collateral.

What is yield-farming?

In DeFi, people who own cryptocurrency can lend or ‘stake’ their assets to liquidity pools in return for rewards. Users typically lend in pairs to facilitate trades. The more assets lent, the more rewards earned. By moving assets between platforms, crypto owners are able to collect these rewards in high volumes.

What is liquidity provision?

Liquidity provision is any process where a person or organisation increases the volume of liquidity in a given market by allocating their own assets. In DeFi it specifically describes the process of lending digital assets like crypto or tokens to a pool to facilitate exchanges and trades. Users receive fees for increasing the liquidity of a pool. This rewards the risk of lending the asset.

The key distinction between DeFi liquidity provision and traditional liquidity provision is that in DeFi, the liquidity pools require trading pairs to be deposited. For example, equal values of two different cryptocurrencies. This facilitates trading.

DeFi key characteristics

1. Permissionless and open access

There’s no eligibility criteria for accessing DeFi. If you have an Internet connection, you can participate in the DeFi system, although access to certain services, platforms and assets can depend on local rules and provider requirements. 

2. Non‑custodial execution via smart contracts

You may be able to remain in control of your assets, distinguishing DeFi from centralised finance in an important way. In non-custodial setups, users control their private keys and can transact directly through smart contracts, but this also increases responsibility for security and key management.

3. Transparency and auditability

Because of the public and open-source nature of many blockchains, transactions can be viewable on-chain. This increases transparency and auditability across the network, although what is visible depends on the blockchain and the tools used.

4. Composability and modularity (‘money legos’)

One possibility that DeFi enables is the ability for users and developers to create new financial products and services by combining protocols. Interoperability can allow protocols to be pieced together to work in unison, and because many projects are open-source, new protocol combinations can emerge quickly.

5. Governance via tokens/DAOs

Some DeFi protocols use governance tokens that can give holders voting rights over protocol changes. Digital autonomous organisations (DAOs) are groups that form to vote and provide governance within the system. A DAO is a member-owned community with a decentralised structure and typically no single leader.

6. Interoperability across protocols

Many DeFi protocols, such as lending, borrowing or generating interest on a deposit, are designed to be interoperable. This can create new ways to combine services, but also introduces dependencies between protocols.

Decentralised finance (DeFi) strengths

The defining characteristic of DeFi is the reduced reliance on a centralised authority. It can operate through distributed protocols and governance, and with that, there are certain potential benefits. Let’s explore some of the major advantages.

1. Financial inclusion and global accessibility

Not everyone has access to developed banking systems and not all banking systems are stable or free from corruption. DeFi can make financial tools accessible to people who are otherwise excluded, although access to specific services and assets can still depend on local restrictions and platform requirements.

2. Lower costs and faster settlement

The reduced role of intermediaries can remove friction from the system and make transactions quicker. This can also create different operational cost structures, so in many scenarios DeFi can offer an alternative to centralised finance, though fees may still apply (for example, network fees).

3. High yield opportunities 

Participants can sometimes be rewarded for providing liquidity or participating in protocols. However, yields can vary materially and may reflect additional risks, including smart contract risk, market risk and token risk.

4. Transparency and user sovereignty

No single organisation is in charge of DeFi. Many systems are open-source, and users may be able to remain in direct control of their assets in non-custodial setups, depending on the protocol and the tools they use.

5. Programmable money innovation

Smart contracts can be used to create custom financial products and instruments. This can lead to rapid experimentation and new protocol designs.

Decentralised finance (DeFi) risks

No financial system is free of risk. Users make financial decisions based on their tolerance for the degree and type of risk on offer. Let’s explore some of the risks of participating in the DeFi system.

1. Smart-contract vulnerabilities and hacks

Smart contracts are often open-source, which means code flaws can lead to hacks and exploits where users may lose their assets. And because protections and recourse can be limited, losses may be significant and sometimes unrecoverable.

Financial systems are only as strong as their security protocols. And while DeFi is designed to be resilient, it isn’t completely impenetrable.

2. Market volatility and impermanent loss

Crypto assets are significantly more volatile than many traditional assets. This means they can increase and decrease in value significantly and quickly. This volatility can create uncertainty, including risks such as impermanent loss for liquidity providers.

3. Regulatory uncertainty and legal exposure

While much of DeFi operates through decentralised protocols, regulation and enforcement can still apply and may change over time. Policies and laws may evolve, introducing costs, restrictions and compliance requirements.

4. User responsibility 

DeFi is still vulnerable to human failure. People can lose their private keys and become victims of scams, fraud and phishing. Many safeguards focus on loss prevention rather than loss recovery, and recovery options can be limited.

5. Composability risk and systemic interdependence

Composability is a double-edged sword. Interoperability can enable novel financial products, but it also means failures in one component can affect others. As more code is introduced into the system, the probability of failure can increase.

Most users see this as a challenge that calls for trade offs, with constant improvements in code security and vigilance to new risks.

DeFi use cases and examples 

Here we’ll explore some examples of how people use DeFi as a financial system.

Lending and borrowing 

Aave is a protocol for lending and borrowing cryptocurrencies through a liquidity pool. It has an associated token for governance.

Compound is a similar protocol but it facilitates direct lending and borrowing of crypto between asset holders.

MakerDAO (now Sky/USDS) is a type of decentralised autonomous organisation. It governs the creation and management of a stablecoin, which is a form of crypto that is pegged to the value of a fiat currency.

Decentralised exchanges 

Uniswap is a decentralised exchange (DEX) on the Ethereum blockchain that uses liquidity pools. Users can swap cryptocurrency tokens directly from their digital wallets without using an intermediary.

Stablecoins

Stablecoins are backed by, or ‘pegged’ to a fiat currency, which gives their value more predictability. They offer some of the benefits of other cryptocurrency types, such as open-source oversight.

Stablecoins maintain their pegged value through the requirement of collateral for lending, algorithms that adjust supply, or a combination of both.

Yield farming and liquidity mining

Asset holders can earn rewards by moving their crypto between protocols. Yield farming is more complex and can expose asset holders to additional risks. Liquidity mining is generally less complex but may offer more modest rewards compared to yield farming.

Emerging areas

As a decentralised system, innovation and progress can be less constrained by centralised gatekeeping; people are free to build things on their own. Let’s look at some of the emerging applications of the DeFi system.

Decentralised insurance

Traditional insurance is based on a collective pooling of risk. This makes it suitable for use in the DeFi system. Instead of demonstrating a loss in order to claim, the insurance pool sets parameters which if triggered automatically issue the claim.

This can remove the need for certain manual claims processes, potentially making some designs less costly and more efficient, though outcomes depend on the protocol and its rules.

Tokenised real-world assets

By using the protocols and infrastructure of DeFi, users can sell, hold and trade digital versions of real world assets like property, art and financial instruments. This approach allows people to take a fractional share of an asset. NFTs are a form of tokenisation.

Derivatives

DeFi allows users to speculate on the value of crypto assets within the system. It works in a similar way to centralised derivatives trading, in that the speculator often doesn’t actually own the asset. But there are no intermediaries like brokers. The trades are placed and executed using smart contracts which are automatically enforced when certain thresholds are reached.

DeFi vs traditional finance: What’s the difference?

The main difference between DeFi and traditional finance is the reduced reliance on a centralised authority and associated intermediaries. DeFi is a peer-to-peer system where participants can trade directly with one another. It can therefore be quicker to complete transactions, generate value and create new products and services, though speed and cost depend on network conditions and protocol design.

While not governed by a central entity, it isn’t automatically a ‘wild west’ environment. Governance can happen through a distributed system of tokens, smart contracts and protocols, and regulation can still apply depending on the activity and jurisdiction.

Centralised finance is familiar and tends to be well regulated. DeFi is relatively novel, but can be accessible to people who may be excluded from mainstream financial systems.

What are DeFi dApps?

DeFi dApps are decentralised applications that run on smart contracts, rather than being operated by a financial institution that’s part of a centralised system. They provide similar levels of functionality, allowing users to trade, lend and swap assets. Users may need wallet integrations to secure access.

These decentralised apps are used in decentralised financial systems, gaming and digital asset ownership to give users the means to interact with the system.

DeFi ecosystem metrics and growth

Total value locked (TVL) is DeFi’s key metric. It describes the value of assets locked in the system. This amount will fluctuate as users move wealth between asset classes. TVL includes assets allocated into a variety of decentralised financial systems, including blockchains and dApps.

The value locked in a system is a gauge of use and participation. The more people that use a system and allocate assets into it, the more likely it is to reflect the confidence of its users.

Analysts predict that the total TVL of DeFi will increase in 2025. Factors influencing growth include economic fundamentals like the performance of fiat currencies, the stock market and whether interest rates are going up or down.

When the mainstream economy is underperforming, crypto assets can become a more interesting investment by comparison.

For example, if interest rates are increasing, investors may prefer the safe harbour of cash and fixed price investments. If interest rates are coming down, investors earn less on their savings and may look at alternative asset classes like crypto.

Regulatory and legal outlook

The regulatory and legal outlook for DeFi is uncertain. That’s mainly because it’s hard to regulate a decentralised system. However, governments and regulators are looking at ways to gain a degree of control. For example, the European Union has two regulations; the Markets in Crypto-Assets Regulation (MiCA) and the Digital Operational Resilience Act (DORA).

Across the world, regulators and policy-makers are examining how financial crime and anti-money laundering rules apply to decentralised systems, and how frameworks may address areas like consumer protection, operational resilience and market integrity.

Decentralised finance (DeFi) outlook

DeFi is still in its infancy compared to mainstream financial systems. One of the most interesting developments is the growing adoption of DeFi concepts by mainstream financial institutions.

This may lead to greater integration between DeFi and traditional finance (TradFi), as institutions identify areas where the systems can converge.

As DeFi capacity for governance, interoperability and tokenisation of real-world assets increases, the scope for participation will increase. Platforms like Crypto.com can be used as a gateway for users to explore crypto assets and related tools, subject to local availability and eligibility.

Ready to get started?

1. You can discover DeFi assets and tools on the Crypto.com App.
2. Sign up – secure and accessible on mobile or web.
3. Explore lending, stablecoins and DeFi gateways.
4. Get Started with Crypto.com.

FAQs about decentralised finance (DeFi)

What is decentralised finance in simple terms?

It’s a financial system built on blockchain technology that can operate without centralised control. DeFi uses smart contracts which automatically create and execute agreements and transactions. The system can facilitate rapid innovation and community-driven oversight and governance.

Is decentralised finance (DeFi) safe?

DeFi has security protocols that are subject to governance and ongoing development. It also promotes personal accountability and security. That said, no financial system is 100% safe, and DeFi can involve significant risks.

Is decentralised finance (DeFi) legal?

DeFi itself isn’t inherently illegal, but there are certain uses that may be illegal, depending on the jurisdiction. Regulation and enforcement can apply to activities involving crypto assets, depending on how and where those activities take place.

How can you invest in DeFi?

The best place for new users to get started is to find a platform that provides access to crypto assets while also delivering education and guidance on common risks. The Crypto.com App may be a useful starting point for someone looking at buying or trading cryptocurrency, subject to eligibility and availability.

What is the difference between DeFi and crypto?

DeFi is the system that people use for buying, selling and using different digital assets through blockchain-based protocols. Crypto is a type of digital asset that can be used within DeFi systems. Types of crypto include Bitcoin, Tether and Solana.

What is an example of DeFi?

Uniswap is a good example of DeFi. It’s a decentralised exchange where participants swap tokens directly from their wallets, without the need for intermediaries.

Is Bitcoin a DeFi?

No, Bitcoin is a digital currency. But its creation was a pivotal milestone in the progression of DeFi as a system.

How are DeFi protocols governed?

Token holders can vote on changes to protocols. One token is normally equivalent to one vote. Changes are governed through a decentralised autonomous organisation (DAO), which supports community-owned development and progress.

How do I start using DeFi via Crypto.com?

Get started by downloading the Crypto.com App. Then:

1. Credit your account using existing crypto or fiat currency.
2. Lock CRO and join Level Up*
3. Spend globally with competitive exchange rates
4. Earn rewards on travel spending

Disclaimer: This is informational content sponsored by Crypto.com and should not be considered as an investment recommendation or advice. Staking rewards, fee reduction, and other benefits and rewards referenced in this article may be subject to change. Eligibility requirements, token holdings, and other terms and conditions apply and may change at the discretion of Crypto.com.