Definition
Decentralized finance (DeFi) is a set of financial services, such as trading, lending and borrowing, that run on blockchain smart contracts instead of through a bank, broker or other central intermediary.
How it works
A smart contract is a program stored on a blockchain that runs exactly as written when users send it transactions. DeFi applications use smart contracts to swap tokens, lend and borrow, earn interest or trade derivatives. Users connect their own wallet, approve each transaction and keep custody of their assets until they deposit them into a contract. Most applications need no account or approval, only a wallet and some of the network's coin to pay gas fees.
Lending shows how the system enforces its rules. Borrowers lock collateral worth more than the loan. If the collateral value falls too far, the contract lets other users repay part of the debt and take collateral at a discount, which is called liquidation. Prices come from oracles, services that bring outside market data onto the blockchain. The size of DeFi is often measured by total value locked (TVL), the value of assets deposited in its contracts, which also rises and falls with token prices.
The risks are different from a bank's, not absent. Code bugs can be exploited, oracles can report wrong prices, and fake or copied applications can drain wallets that approve them. There is usually no deposit insurance and no help desk that can reverse a mistaken transaction.
Example (hypothetical numbers)
Suppose a lending app lets users borrow against Coin A and liquidates a loan when the debt reaches 80% of the collateral value.
You deposit Coin A worth $10,000 and borrow $5,000 of a stablecoin: loan-to-value = $5,000 ÷ $10,000 = 50%.
Liquidation starts when the collateral is worth $5,000 ÷ 0.80 = $6,250, a fall of ($10,000 − $6,250) ÷ $10,000 = 37.5%.
The example shows that a DeFi loan is enforced by code: if Coin A falls 37.5%, liquidation can happen automatically, with no warning call first.
Common mistakes
- Assuming that audited code cannot be hacked or contain bugs.
- Approving unlimited token spending for an unknown or copied application.
- Reading a high TVL as proof that an application is safe.
- Comparing advertised yields without asking where the yield comes from.
Related calculators
This glossary is for education only and is not investment advice. Examples use hypothetical numbers.