What is DeFi? Decentralized finance in plain words

DeFi, short for decentralized finance, is financial services such as lending, borrowing and trading that run as programs on a blockchain instead of through a bank or broker. The programs, called smart contracts, hold the money and apply the rules automatically: what you can borrow, what interest you pay, and when your collateral is sold. What that removes is the institution in the middle; what it adds is the risk that the code, or the people around it, fail.

In short

• DeFi apps are smart contracts that hold deposits and follow fixed rules, so anyone with a crypto wallet can lend, borrow or trade without asking permission.
• Loans are overcollateralized: you lock up more crypto than you borrow, and if its price falls far enough, the contract sells it automatically.
• The main risks are code bugs and hacks, sudden liquidations, and scams, with no deposit insurance or bank to call.

How is DeFi different from a bank?

A bank holds your money on its own books, decides who gets a loan, and answers to regulators. A DeFi app is code deployed to a blockchain, most often Ethereum, that anyone can read and use from a wallet. There is no account to open and no credit check; the contract doesn't know who you are. It only knows what collateral you have deposited, because that is recorded on the chain.

The Ethereum Foundation describes DeFi as open to anyone with an internet connection, running around the clock, with transactions that are public and settled in minutes. The same openness means there is no one to reverse a mistaken payment, and no regulator who checked the code before it went live.

The money moving through DeFi is mostly crypto, and much of it is stablecoins, tokens meant to stay at $1, because people want to borrow and save in something that doesn't swing in price.

How does a DeFi lending pool work?

A lending pool is a smart contract that collects deposits from many lenders and lets borrowers take loans out of the same pot. Lenders earn interest; borrowers pay it. The rate isn't set by a loan officer but by a formula: the more of the pool is borrowed, the higher the rate climbs, which draws in more deposits and discourages more borrowing, a market version of what interest rates do everywhere.

Because the contract can't chase anyone who doesn't repay, every loan is overcollateralized. You must lock up crypto worth more than you borrow. The key number is the health factor, which the lending app Aave defines as your collateral's value times its liquidation threshold, divided by what you owe. Above 1, the loan is safe. Below 1, anyone can repay part of your debt and take some of your collateral at a discount.

A worked example

Suppose you deposit 5 ether when ether is worth $2,000, so your collateral is worth $10,000. The pool sets ether's liquidation threshold at 80%. You borrow 6,000 dollar stablecoins.

1. The starting health factor is $10,000 × 0.80 ÷ $6,000 = 1.33. You are safe.
2. Where the line is. The health factor reaches 1 when your collateral times 0.80 equals $6,000, so when the collateral is worth $7,500. That is ether at $1,500, a fall of 25%.
3. The price drops to $1,450. Your collateral is now worth $7,250, and the health factor is $7,250 × 0.80 ÷ $6,000 = 0.97. The position can be liquidated.
4. A liquidator steps in. This is anyone running a bot that watches for unhealthy loans. Say it repays half your debt, $3,000, and the pool pays it a 5% bonus out of your collateral: $3,150 worth of ether, or about 2.17 ether at $1,450.
5. What you are left with. About 2.83 ether, worth $4,100, against $3,000 of debt. Your health factor is back to about 1.09. You still have the $6,000 you borrowed, but you have lost $150 to the bonus on top of the fall in ether's price.

No one decided to sell your collateral; the formula did, the moment the price crossed a line. In a fast crash, many loans cross that line at once, liquidators sell the seized collateral, prices fall further, and more loans tip over. Real pools set their own thresholds and bonuses for each asset, but the mechanism is the same.

What else can you do in DeFi?

The other large use is trading on decentralized exchanges. Instead of matching buyers and sellers, many use an automated market maker: a pool holding two tokens, with a formula that sets the price from the ratio between them. In Uniswap's design, the product of the two balances must stay constant, so buying one token out of the pool makes it scarcer there and pushes its price up (Uniswap docs). People who deposit both tokens earn a share of the trading fees.

These pieces can be stacked. A token received for a deposit in one app can be used as collateral in another, which is why DeFi is sometimes called "money legos". Stacking also stacks risks: a failure in one contract can spread to every app built on top of it.

What are the risks?

• Code bugs and hacks. A smart contract holds the money, so a flaw in it can be drained in one transaction. In 2022, according to Chainalysis, $3.1 billion was stolen from DeFi protocols, 82.1% of all crypto stolen by hackers that year, much of it from bridges that move tokens between blockchains, and an estimated $1.1 billion of it by hackers linked to North Korea.
• Liquidations. As in the example above, a sharp price fall can sell your collateral at the worst moment, automatically.
• Price feeds. Contracts learn prices from outside data services called oracles. If an attacker can distort a price briefly, they can borrow against inflated collateral or trigger false liquidations.
• Scams. Anyone can launch a token or an app. Some are built to vanish with the deposits, known as a "rug pull".
• No safety net. There is no deposit insurance, and a payment sent to the wrong place usually can't be recovered.

Still argued

Supporters say DeFi shows finance can run on open, auditable code that anyone can use, without gatekeepers. Researchers at the Bank for International Settlements argued in a 2021 review that "full decentralisation in DeFi is illusory": someone has to decide upgrades and parameters, usually holders of governance tokens, and those holdings tend to be concentrated. Whether DeFi should be regulated like banks, or can be, is open. This note explains how DeFi works; it isn't financial advice and endorses no app.

DeFi is the most developed part of the wider Web3 idea, and it runs on the same building blocks as other cryptocurrencies. It grew up on Ethereum rather than Bitcoin because Bitcoin's scripting language was kept deliberately limited, too simple to run programs like these.

Check yourself

• Without looking back, explain why DeFi loans have to be worth less than the collateral behind them.
• In the worked example, at what ether price would the loan first become eligible for liquidation, and why?
• What does a liquidator gain, and who pays for it?

Sources

• Decentralized finance (DeFi) — Ethereum Foundation, ethereum.org
• Liquidations — Aave
• How Uniswap works — Uniswap Labs
• 2022 biggest year ever for crypto hacking — Chainalysis, 2023
• DeFi risks and the decentralisation illusion — Bank for International Settlements, BIS Quarterly Review, 2021