DeFi

The idea

Take the functions a bank or exchange performs, matching buyers and sellers, holding deposits, issuing loans against collateral, and write them as smart contracts instead.

Nobody takes custody. You interact from your own wallet, the contract holds funds under rules anyone can read, and the code runs the same for everyone.

Decentralised exchanges

Instead of an order book run by a company, most decentralised exchanges use a liquidity pool: a contract holding reserves of two assets. Traders swap against the pool, and the price moves along a formula as the balance shifts.

Anyone can supply assets to a pool and earn a share of trading fees. The trade-off is impermanent loss: if the two assets diverge in price, withdrawing can leave you worse off than simply having held them. It is a genuine cost, not a technicality, and it is routinely understated.

Lending

Lending protocols hold collateral and issue loans against it, with interest rates set by supply and demand rather than by a committee.

Loans are typically over-collateralised: borrowing 100 euros of value might require 150 deposited. Since there is no credit assessment and no way to pursue a defaulter, the collateral is the only protection, and it is liquidated automatically if its value falls too far.

That makes DeFi lending useful for leverage and for borrowing without selling a position. It does not extend credit to people who lack assets, which is worth stating plainly given how often financial inclusion is claimed for it.

Where the risk is

Smart contract risk. A bug is exploitable by anyone who finds it, and large sums have been lost this way. An audit reduces the risk; it does not remove it.

Oracle risk. Protocols need external prices. Manipulate the price feed and you can trigger liquidations or drain a pool.

Governance risk. Many protocols can be changed by token holders. If voting power is concentrated, the rules can change under you.

Regulatory risk. Much of this sits uneasily against EU financial law, and MiCA largely does not cover fully decentralised protocols, which leaves the position unsettled rather than settled favourably.

The honest summary

DeFi genuinely removes the need to trust an institution with your funds. It replaces that with trusting code, price feeds and governance, which are different risks, not smaller ones.

This page is general information, not investment advice.