What is DeFi, and how does decentralised finance actually work?

What is DeFi?

DeFi stands for decentralised finance. The International Organization of Securities Commissions (IOSCO), the global body for securities regulators, describes it as financial products, services and arrangements that use blockchain technology, including self-executing code known as smart contracts³. The U.S. Treasury uses similar words, adding that these services purport to allow automated peer-to-peer transactions².

The community that builds DeFi on Ethereum describes it as financial services open to anyone with an internet connection who can use Ethereum¹. Instead of opening an account with a bank, you connect a self-custody wallet to an app and interact directly with contracts that hold pooled funds and follow fixed rules.

The tokens moving through this stack mostly follow shared formats such as ERC-20, a standard interface that lets any compliant token be reused by wallets and decentralised exchanges⁵. Our guide to token standards explains why that matters.

What can you do with DeFi?

IOSCO's central finding is that most DeFi products mimic or resemble services from traditional finance³. The table maps the main ones, drawing on IOSCO's descriptions³ and Ethereum's own overview¹.

Flash loans are the most unusual item. A borrower can take funds without collateral as long as the loan is repaid within the same blockchain transaction; if it is not, the whole transaction is reversed as if it never happened¹. Our explainer on stablecoins covers the dollar-pegged tokens that much DeFi activity runs on.

How does a decentralised exchange work?

A traditional exchange matches buyers with sellers in an order book. Many decentralised exchanges work differently, using an automated market maker (AMM). Developers deploy a set of smart contracts where participants deposit two or more tokens into a liquidity pool, and other users swap one token for another against that pool³.

Swapping against a pool rather than a queue of orders is the key difference from a traditional venue. How much a large trade costs still depends on how much sits in the pool, the theme of our page on liquidity and slippage.

How does borrowing work without a bank?

In a DeFi lending protocol, holders deposit tokens into a lending pool to earn a return, and other users borrow from the same pool³. Because the protocols are pseudonymous, there are no credit checks, so loans are generally required to be over-collateralised: you must lock up tokens worth more than you borrow³.

Protocols set parameters such as loan-to-value ratios, liquidation ratios and liquidation penalties that vary with the collateral used³. The contract learns what your collateral is worth from a price feed supplied by a blockchain oracle⁶. If that value falls past the liquidation ratio, the collateral can be liquidated to cover the loan, so a sharp price drop or a faulty feed can cost borrowers their deposit.

Is DeFi really decentralised?

Often less than the name suggests. IOSCO calls it a common misperception that DeFi products run fully automatically with no human involvement³. Whatever the governance structure, it says there is usually a responsible person or group that controls, or sufficiently influences, the service³. Many projects are run as DAOs (decentralised autonomous organisations), governed by holders of governance tokens who vote on changes³, and IOSCO describes these structures as often opaque, experimental and easy to manipulate³.

Regulators look at what a service does, not what it calls itself. The Treasury states that a DeFi service that functions as a financial institution must meet anti-money-laundering obligations, and that claiming to be fully decentralised does not change that status². In December 2023 IOSCO published nine policy recommendations aimed at investor protection and market integrity in DeFi⁴.

What are the main risks of DeFi?

IOSCO lists weak points across blockchains, smart contracts, governance, oracles and cross-chain bridges³. The Treasury groups attacks into three types: breaches using phishing or social engineering, exploits of bugs in smart contract code, and flash loan attacks that manipulate asset prices². On top of that, DeFi offers leveraged strategies, and shocks elsewhere in crypto tend to spill into it³. Moving tokens between chains adds the risks covered in our page on cross-chain bridges.