An ecosystem of blockchain-based financial protocols that replicate lending, trading, and yield-generating services without banks or intermediaries.
DeFi protocols run as smart contracts on blockchains (primarily Ethereum and its competitors), allowing users to lend, borrow, trade, and earn yield directly from their wallets with no account registration, credit checks, or geographic restrictions. The total value locked (TVL) in DeFi protocols peaked above USD 180 billion in late 2021 before contracting sharply - a measure of the sector's scale and volatility.
Core DeFi primitives include decentralised exchanges (AMMs), lending protocols (Aave, Compound - where users earn interest by depositing assets or pay variable rates to borrow), liquid staking (converting locked staking positions into tradeable tokens), and yield aggregators (Yearn Finance) that automatically route capital to the highest-yielding strategies.
DeFi introduces risks distinct from traditional markets. Smart contract vulnerabilities can be exploited by hackers - billions of dollars have been lost to protocol exploits. Liquidation risk in lending protocols works similarly to margin calls: if the value of collateral falls below a threshold, the position is automatically liquidated. Impermanent loss affects liquidity providers whose pool positions underperform simply holding both assets. These risks, combined with the complexity of gas fees, wallet management, and on-chain transaction hygiene, mean DeFi suits technically proficient users comfortable with self-custody.
Worked Example
A user deposits USD 10,000 worth of ETH into Aave as collateral and borrows USDC at a variable 3% annual rate. They deploy the USDC into a yield farming strategy generating 8% APY - capturing the 5% net spread. If ETH price drops 30%, their collateral value falls and Aave may liquidate the position to recover the USDC loan.