Decentralised Finance (DeFi)

How DeFi uses smart contracts on blockchains to offer lending, trading and other financial services without banks, and the risks involved.

Decentralised finance, or DeFi, refers to financial services built on blockchains, mainly Ethereum, that operate without traditional intermediaries like banks or brokers.

Smart contracts

DeFi relies on smart contracts: computer programs stored on a blockchain that automatically carry out actions when certain conditions are met. For example, a smart contract can hold deposits and automatically pay interest or release collateral when a loan is repaid.

What DeFi offers

Decentralised exchanges: users trade cryptocurrencies directly from their digital wallets, using automated pools of funds rather than order books run by a company.
Lending and borrowing: users deposit crypto to earn interest or borrow against their holdings, usually by providing more collateral than they borrow.
Stablecoins for transactions.
Derivatives and other products.

Claimed benefits

Open access: anyone with an internet connection and a crypto wallet can use DeFi, without identity checks in many cases.
Transparency: transactions and code are visible on the blockchain.
Programmability: services can be combined like building blocks.

Risks

Hacks and bugs: flaws in smart contract code have been exploited many times, with billions of dollars stolen over the years.
Over-collateralisation: borrowers must lock up more value than they borrow, limiting usefulness for people without assets.
Volatility: sharp price falls can trigger automatic liquidations.
No deposit insurance or consumer protection.
Illicit finance: lack of identity checks can enable money laundering.
Regulatory uncertainty.

Economists at the Bank for International Settlements have noted that DeFi mainly serves trading and speculation within the crypto world, rather than financing the real economy.

Borrowing against crypto

A user deposits 1,500 dollars of Ethereum into a DeFi lending protocol and borrows 1,000 dollars of a stablecoin. If Ethereum's price falls so that the collateral is worth less than a set threshold, the smart contract automatically sells it to repay the loan. No bank is involved, but the user can lose the collateral quickly in a market fall.

Thinking DeFi removes all risks of traditional finance

DeFi removes intermediaries but adds new risks, such as code bugs and hacks, and lacks protections like deposit insurance. It has not escaped the risks of leverage and panic.

Key takeaways

DeFi offers financial services on blockchains using smart contracts.
It includes decentralised exchanges and crypto lending and borrowing.
It offers open access and transparency but faces hacks, volatility and no consumer protection.
It mainly serves crypto trading rather than the real economy.