Key Points

  • DeFi, short for decentralised finance, means financial services such as trading, lending and borrowing that run on smart contracts instead of through a bank or broker.
  • Anyone with a wallet can use DeFi, at any hour, without an account application. You keep custody of your own assets until you deposit them into a protocol.
  • The main building blocks are decentralised exchanges, lending markets, stablecoins and staking services, which can be combined with each other.
  • The trade-off is protection. There is usually no deposit insurance, no customer service that can reverse a mistake, and a real risk of losing funds to bugs or exploits.
  • Using DeFi can create tax events. In both the UK and the US, swaps and some lending or staking activity can be taxable.

Quick Answer

DeFi, or decentralised finance, is a set of financial services built on public blockchains, mainly Ethereum and its Layer 2s, Solana and similar networks. Instead of a bank holding your money and approving each action, smart contracts handle trading, lending and borrowing automatically, and anyone with a wallet can use them. Read DeFi as open and programmable, but unprotected. The common misread is that the high yields some protocols advertise are like interest from a bank. They are paid for by risk: borrower demand, token rewards, or exposure to losses.

What is DeFi?

DeFi is finance without the middleman. The rules for each service are written into smart contracts, programs on a blockchain that run exactly as coded and that anyone can inspect.

In traditional finance, a bank, broker or exchange holds your money, checks who you are and decides whether a transaction goes ahead. In DeFi, you connect a self-custody wallet to a protocol, approve a transaction and the contract carries it out. There is no account to open and no opening hours.

How is DeFi different from traditional finance?

  • Access. Banks and brokers check identity and can refuse customers. Most DeFi protocols are open to anyone with a wallet, although many websites now block users in some countries.
  • Custody. A bank holds your money. In DeFi, you hold your assets in your own wallet and only hand them to a smart contract when you use it.
  • Transparency. Bank balance sheets are published occasionally. DeFi protocols record every deposit, loan and trade on a public blockchain.
  • Hours and speed. DeFi runs every day around the clock, and transactions settle in seconds or minutes.
  • Protection. Bank deposits are covered by schemes such as the FSCS in the UK or FDIC insurance in the US. DeFi has no equivalent, and mistakes or hacks are often permanent.

What can you do with DeFi?

  • Trade on decentralised exchanges. Exchanges such as Uniswap let you swap one token for another from your wallet, priced by pools of tokens that other users supply. Our guide to slippage explains why the price you get can differ from the price you see.
  • Lend and borrow. Lending markets such as Aave let you deposit tokens to earn interest, or borrow against your deposits. Loans must be over-collateralised, and if your collateral falls in value it can be sold automatically.
  • Use stablecoins. Tokens pegged to the dollar, such as USDC, are the cash of DeFi and are used for trading, lending and payments.
  • Stake. Liquid staking services let you stake ETH or other proof-of-stake coins and receive a token that represents your stake. Our guide to crypto staking covers how this works.
  • Provide liquidity. You can supply tokens to an exchange pool and earn a share of trading fees, at the risk of ending up with a different mix of tokens than you put in.

These services connect to each other. A token earned in one protocol can be used as collateral in another, which is why DeFi is sometimes called money legos. That flexibility also means a failure in one protocol can spread to others.

What are the risks of DeFi?

  • Smart contract bugs and exploits. Code can contain flaws, and attackers have drained large sums from protocols, including audited ones. Our guide to smart contract audits explains what an audit does and does not cover.
  • Liquidation. If you borrow and your collateral falls in value, the protocol can sell it, often with a penalty.
  • Stablecoin and oracle failures. Protocols depend on stablecoins holding their peg and on price feeds, called oracles, being accurate. When either fails, losses can spread quickly.
  • Token approvals and phishing. Using DeFi means approving contracts to move your tokens. Fake sites and malicious approvals are a common way people lose funds. Our guide to token approvals explains how to check and revoke them.
  • Admin keys and governance. Many protocols can still be upgraded or paused by a small group, so you are trusting people as well as code.
  • Unsustainable yields. Very high advertised returns are often paid in a protocol's own token, whose value can fall faster than the rewards accumulate.

Is DeFi regulated, and is it taxed?

Regulation is still developing in both the UK and the US. Most DeFi protocols are not registered with a financial regulator, and they offer none of the protections of a bank or a registered broker. Some websites that front DeFi protocols block users from certain countries.

Tax rules do apply. In the US, the IRS treats crypto as property, so swapping one token for another is a taxable disposal, and rewards are generally taxed as income when received. In the UK, HMRC treats token swaps as disposals for Capital Gains Tax and publishes specific guidance on DeFi lending and staking. Keep records of every transaction, and check your tax authority's guidance or speak to an adviser.

Source: IRS digital assets guidance; HMRC Cryptoassets Manual, DeFi lending and staking.

How do you start using DeFi safely?

  1. Set up a self-custody wallet and store its recovery phrase offline. Our crypto wallets hub covers the options.
  2. Use a Layer 2 or low-fee network while you learn, so mistakes cost less. Our guide to Layer 1 and Layer 2 blockchains explains the difference.
  3. Use well-established protocols with a long track record, and reach them through bookmarks rather than search adverts.
  4. Start with a small amount you can afford to lose while you learn how approvals, fees and withdrawals work.
  5. Check and revoke approvals you no longer need.

Frequently Asked Questions

Is DeFi safe?

It carries more risk than a bank account. Established protocols have run for years, but hacks, bugs and user mistakes still cause regular losses, and there is usually no one to reverse them.

Do I need to verify my identity to use DeFi?

Most protocols do not ask for identity checks, but the exchange you use to buy crypto in the first place will, and some DeFi websites block certain countries.

Where does DeFi yield come from?

Mostly from borrowers paying interest, traders paying fees, and token rewards handed out by the protocol. If the source of a yield is unclear, treat that as a warning.

What is TVL?

Total value locked is the value of assets deposited in a protocol or across DeFi. It shows how much is at stake, not how safe or profitable a protocol is.

Every call, scored

We publish each market call with its date and the condition that would prove it wrong, then score it when it resolves, misses included. Anyone can check.

See the record

Further Reading

Sources

  • Internal Revenue Service, digital assets guidance: irs.gov
  • HM Revenue and Customs, Cryptoassets Manual, DeFi lending and staking: gov.uk

This article is for education only and is not financial, investment, tax or legal advice. Crypto assets are volatile and you can lose some or all of the money you put in. DeFi protocols carry smart contract, liquidation and counterparty risks and are generally not covered by deposit protection. Do your own research and consider independent advice before making any financial decision.