Intro to DeFi: How Decentralised Finance Works

DeFi, short for decentralised finance, refers to financial applications built on public blockchains that let people trade, lend, borrow, and earn yield without a bank, broker, or centralised exchange sitting in the middle. Instead of a company managing an order book or a loan, code called a smart contract automatically enforces the rules. This guide walks through the core building blocks and the risks that come with each.

What Makes DeFi Different

In traditional finance, and even on a centralised crypto exchange, a company sits between you and the other side of a trade or loan: it holds funds, matches orders, and can freeze or reverse activity. In DeFi, that role is replaced by open-source smart contracts running on a public blockchain. Anyone can interact with them directly from a wallet they control, and anyone can, in principle, read the code that governs them. This removes a layer of intermediary trust, but it replaces it with a different kind of trust: trust that the code itself is correct and was not written maliciously.

Decentralised Exchanges (DEXs)

A decentralised exchange, or DEX, lets users trade tokens directly from their own wallets, without an intermediary holding custody of the funds during the trade. Rather than matching buyers and sellers on an order book the way a centralised exchange does, many DEXs use liquidity pools and automated pricing formulas to fill trades instantly. Uniswap is one of the most widely used DEX protocols and helped popularise this pooled-liquidity model. Trading on a DEX generally means you keep control of your funds until the moment a trade executes, but it also means you are fully responsible for using the interface correctly, since there is no customer support desk to reverse a mistake.

Lending and Borrowing Protocols

DeFi lending protocols let users deposit crypto to earn interest, or borrow against crypto they already hold as collateral, all handled automatically by smart contracts rather than a bank's credit department. Aave is a well-known example of this category. Because there is no credit check, borrowing is typically overcollateralised — you must deposit more value than you borrow — and if the value of your collateral falls too far relative to your loan, the protocol can automatically liquidate part of it to protect the system. Understanding a protocol's specific liquidation rules before borrowing matters enormously, because liquidations happen automatically and can occur quickly during volatile markets.

Liquidity Pools and Yield

Many DeFi protocols rely on ordinary users supplying funds into shared pools, which the protocol then uses to facilitate trading or lending. In exchange, the protocol usually pays the supplier a share of fees or rewards, commonly referred to as yield. This can sound like a straightforward way to earn a return on idle crypto, but the mechanics carry real risks, including impermanent loss (where supplying two assets to a pool can leave you worse off than simply holding them, depending on how their prices move) and the risk of the underlying smart contract itself. Yield that looks unusually high relative to comparable pools is worth treating as a prompt to investigate further, not as straightforward good fortune, since higher advertised yield generally reflects higher underlying risk of some kind. Our companion guide on yield farming and its real risks covers this in much more depth before you consider supplying any funds.

Gas Fees and Network Costs

Every action in DeFi, from swapping a token to supplying a liquidity pool, requires a network transaction, and most public blockchains charge a fee for processing it, often called gas. Gas costs vary considerably depending on network congestion and which blockchain a protocol runs on, and they are generally paid regardless of whether a transaction ultimately succeeds. For newcomers, this means testing a strategy with a very small amount first is doubly useful: it confirms the mechanics work as expected and gives a realistic sense of the network cost involved before committing more.

Connecting a Wallet

Using DeFi almost always starts with connecting a self-custody wallet, one where you, not a company, hold the private keys, to a protocol's website. Our guide on how wallets work explains the mechanics in full, but the key point for DeFi specifically is that "connecting" a wallet is not the same as depositing funds; it simply lets the site see your public address and propose transactions, which you must still separately review and approve each time. Never approve a transaction you do not understand, and be especially cautious of "unlimited approval" requests that grant a protocol ongoing access to move tokens on your behalf beyond a single transaction.

Smart Contract and Scam Risk

DeFi's biggest structural risk is that code, however well-intentioned, can contain bugs, and bugs in a smart contract that controls real funds can be exploited. Reputable protocols commission independent security audits and often run bug bounty programmes, but an audit reduces risk rather than eliminating it entirely. Beyond genuine bugs, DeFi also attracts deliberately malicious projects: unaudited "fork" protocols promising unusually high yield, fake token approval pop-ups designed to drain a wallet, and copycat websites impersonating well-known protocols. Before interacting with any DeFi protocol, verify you are on its genuine website, check whether it has been audited, and be sceptical of yield figures that look far higher than comparable, established protocols.

Reading a Protocol Before You Use It

Before supplying funds to any DeFi protocol, spend time on the basics: how long has it operated, is its code open source and independently audited, how is the protocol governed, and what happens to user funds in a worst-case scenario. Established protocols typically publish this information directly, along with documentation explaining exactly how their smart contracts work. A protocol that is vague about its own mechanics, or that relies heavily on urgency and marketing rather than technical documentation, deserves particular caution. This research step is simply DYOR applied specifically to DeFi, and it matters more here than almost anywhere else in crypto, given how directly and irreversibly smart contracts can move funds.

Self-Custody Is the Foundation

Because DeFi has no central company to appeal to if something goes wrong, self-custody discipline matters even more here than elsewhere in crypto. Keep your wallet's seed phrase offline, double-check every contract address and transaction before approving it, and consider using a separate wallet with only small amounts for experimenting with newer protocols, keeping the bulk of your holdings in cold storage. This is not financial advice, and nothing here is a recommendation to use any specific protocol — DeFi yields and risks vary enormously, and every protocol deserves its own research before you commit funds.

Where to Go From Here

DeFi rewards patience far more than speed. Start by exploring a well-established DEX or lending protocol with a small, low-stakes amount, focusing on understanding each confirmation screen rather than the potential return. As your comfort grows, gradually expand into other areas, always weighing the yield on offer against the smart contract and market risk that comes with it.