What is DeFi?

How does DeFi work?

Traditional finance always has a middleman. Your bank holds your money, decides whether you get a loan and sets its own opening hours. In DeFi, software does all of this.

A smart contract is a program that runs on a blockchain and enforces its own rules automatically. It works a bit like a vending machine: you put in a coin, choose a product and the machine serves you according to fixed rules. Nobody can change the outcome afterwards, and usually anyone can read the code.

You don't need to open an account or prove who you are. Your crypto stays in Self-custodySelf-custodyHolding the private keys to your crypto in your own wallet, so nobody else controls it but all the responsibility for the keys is yours., either in your wallet or in a smart contract that no company controls.

The main building blocks

Decentralised exchanges

On a decentralised exchangeDecentralised exchange (DEX)An exchange run by smart contracts, where people swap crypto straight from their own wallets with no company in the middle. (DEX), you swap one token for another without a company taking your money. The best known is Uniswap, which launched on Ethereum on 2 November 2018.

Instead of an order bookOrder bookA list of all open buy and sell orders for an asset, sorted by price. A trade happens when a buy order and a sell order meet., Uniswap is an automated market makerAutomated market maker (AMM)A smart contract that prices tokens on a decentralised exchange with a fixed formula, based on how much of each token sits in the pool. (AMM). People pool two tokens in a shared fund, a liquidity poolLiquidity poolA shared pot of tokens held in a smart contract, which people trade against on decentralised exchanges. Those who fund it earn a share of the fees., and you trade directly with it. The price depends on the ratio between the two tokens and changes with every trade. Depositors earn a share of the trading fees.

Lending and borrowing

On a lending service such as Aave, you can deposit crypto to earn interest, or borrow against other crypto as CollateralCollateralAn asset pledged as security for a loan. In DeFi, the collateral usually has to be worth more than the loan.. Nobody checks your credit score. Instead, the collateral always has to be worth more than the loan, and if its price falls too far, it is sold automatically. This is called LiquidationLiquidationWhen a loan or leveraged position is closed automatically because the collateral or margin no longer covers the debt..

Stablecoins

StablecoinsStablecoinA cryptocurrency designed to keep a steady price, usually by tracking the US dollar or another currency. such as USDC are the dollars of DeFi. They are used for trading, as collateral and as the currency of loans, because their price is meant to stay close to one US dollar. Some, such as DAI and its successor USDS, are themselves created in DeFi with crypto as collateral. Read more about stablecoins.

Liquid staking

Staked ether is locked up for the time being. With liquid stakingLiquid stakingStaking where you receive a token as a receipt for your stake. The token can be sold or used while the crypto itself stays locked., you receive a token instead that represents the staked ETH and collects the rewards. The best-known example is Lido's stETH. The token can be used elsewhere in DeFi, for example as collateral for a loan. Read more about staking.

Derivatives

DeFi also has markets for DerivativesDerivativesContracts whose value comes from another asset, such as shares, a currency or a cryptocurrency., contracts that track the price of another asset. The most common are perpetual futuresPerpetual futures (perps)A derivative with no expiry date that tracks the price of a crypto. Regular payments keep it close to the market price, and it allows leverage., often traded with high LeverageLeverageTrading with borrowed money, which multiplies both gains and losses and can wipe out your whole stake in a short time.. Hyperliquid is a well-known example of a decentralised derivatives exchange. Read more about Hyperliquid.

Bridges

Blockchains don't talk to each other on their own. A BridgeBridgeA service that moves crypto or tokens between two blockchain networks, usually by locking the asset on one network and issuing an equivalent on the other. moves tokens between them, usually by locking a token on one chain and issuing an equivalent on another. Bridges often hold huge sums, which makes them a favourite target for hackers.

How do people use DeFi?

You connect a crypto wallet, such as a browser extension or a phone app, to the service's website. The website is just an interface: the transactions happen in the smart contract, and you confirm each step in your wallet.

Two things are key:

• Approvals. A smart contract needs your permission, called an approval, before it can move a token out of your wallet. The approval can stay in place after the trade is done, and it is often unlimited.
• Network fees. Every action is a transaction on the blockchain and costs GasGasThe unit that measures the computing work a transaction or smart contract needs on Ethereum, which sets how high the network fee is., paid in the network's own coin, such as ether. The fee depends on how busy the network is and is usually much lower on a layer 2 than on Ethereum itself.

Total value locked (TVL)

The most common measure of DeFi's size is total value lockedTotal value locked (TVL)The total value of crypto that users have deposited in a DeFi service's smart contracts. A common yardstick for its size. (TVL), the total value of the assets held in its smart contracts. According to DefiLlama, TVL in DeFi was just under USD 89 billion in October 2026. In November 2021 it passed USD 177 billion.

TVL is a rough measure, though. It rises and falls with crypto prices, so it says more about prices than about how many people use DeFi.

Governance through DAOs and governance tokens

Many DeFi services are run by a DAODAOAn organisation run by rules in smart contracts, where token holders vote on decisions instead of a board or chief executive. (decentralised autonomous organisation). This is a group that makes decisions through votes on a blockchain. Voting rights come with a governance tokenGovernance tokenA token that gives voting rights over a DeFi service's rules and treasury. It is not a share and gives no ownership stake or right to dividends., and the more tokens you hold, the more weight your vote carries.

Holders of UNI, Uniswap's governance token since September 2020, vote on matters such as fees and the use of funds. Holders of AAVE vote on interest rates and new assets in Aave. Critics point out that votes are often concentrated in a few hands, so decentralisation is weaker than the name suggests.

Why do people use DeFi?

• Open to anyone. Anyone with an internet connection and a wallet can use DeFi, wherever they live and whatever their means. Nobody has to approve you as a customer.
• Transparency. The code is usually open, and every transaction is visible on the blockchain. You can see how much money sits in a pool and how much of it is lent out.
• Composability. Services plug into each other like Lego bricks. A liquid staking token can be collateral in a lending service, and the borrowed money can go straight into a decentralised exchange.
• Always open. DeFi doesn't close at weekends or on public holidays, and transactions settle in seconds or minutes.
• No company holds your assets. You trust open code that anyone can inspect instead.

What are the risks?

Without middlemen, nobody catches you if something goes wrong. These are the main risks:

• Bugs in code and hacks. If a smart contract or bridge has a weakness, a hacker can drain the money held in it. In March 2022 about USD 620 million was stolen from the Ronin bridge, which connects the game Axie Infinity to Ethereum. The FBI attributed the theft to the North Korean Lazarus Group.
• Contagion. Composability works both ways. On 18 April 2026 a bridge for the rsETH token accepted a forged message and released 116,500 rsETH with nothing behind them. The attacker used the tokens as collateral on Aave and borrowed ether worth about USD 190 million. Aave's code was not at fault, but its lenders were still affected. In May 2026 a joint effort by many parties restored full backing for rsETH.
• Rug pulls. In a rug pullRug pullA scam where the people behind a new token or crypto project collect money from buyers and then vanish with it, leaving the token worthless., a project's founders disappear with users' money.
• Oracle manipulation. Smart contracts get their price data from oraclesOracleA service that brings outside information, such as prices or weather data, into smart contracts on a blockchain.. If someone manages to distort a price, for example in a small market, they can take out more than they are entitled to.
• Impermanent loss. If you put two tokens into a liquidity pool and the price of one of them doubles, your share is worth about 5.7% less than if you had simply held the tokens. Trading fees offset this, but not always in full. This is called impermanent lossImpermanent lossThe loss that occurs when token prices in a liquidity pool move apart, leaving your share worth less than if you had simply held the tokens..
• Slippage. In small markets, large trades move the price. The difference between the price you expect and the price you actually get is called SlippageSlippageThe difference between the price you expected and the price your trade was actually carried out at..
• Approval scams. Fake websites trick people into granting unlimited approvals or signing messages that empty their wallet. This is a form of PhishingPhishingA scam where criminals pretend to be a trusted company or authority to get you to hand over passwords, card details or your seed phrase..
• No protection. No deposit guarantee covers money in DeFi, and transactions can't be reversed.

DeFi and MiCA

The EU's MiCAMiCAThe EU regulation on markets in crypto-assets, in force in Iceland since 1 January 2026, which sets the same rules for crypto services across the EEA. regulation has applied in Iceland since 1 January 2026, through Act No. 101/2025 on markets in crypto-assets. It doesn't cover all of DeFi, though. Recital 22 of the regulation states that crypto-asset services provided in a fully decentralised manner, without any intermediary, should not fall within its scope.

Where a person or company provides or controls a service, directly or indirectly, MiCA still applies, even if part of the service runs in a decentralised way. Recital 94 adds that MiCA does not address the lending and borrowing of crypto-assets. Article 142 asked the European Commission to assess whether both should be regulated.

So in fully decentralised DeFi, there is no licensed provider answerable to you, no supervisor and no complaints procedure. A licensed crypto-asset service providerCASP (crypto-asset service provider)A company licensed under MiCA to provide crypto-asset services, such as buying, selling, custody or transfers., on the other hand, must give information that is fair, clear and not misleading, safeguard clients' ownership rights and handle complaints. The Central Bank of Iceland or another supervisor oversees it. Here is how to check whether a provider is licensed.

Closing thoughts

DeFi is an attempt to build a financial system out of open code instead of institutions. Exchanges, loans, stablecoins and derivatives are open to anyone, around the clock, and anyone can check how the system works.

That freedom comes with responsibility. No supervisor, deposit guarantee or customer service team stands behind a fully decentralised service. If DeFi interests you, make sure you understand the risks well first.