What is DeFi? A DeFi analysis guide to decentralized finance

Decentralized finance, usually shortened to DeFi, is a group of financial services built on public blockchains. Instead of a bank, broker or exchange holding customer money and keeping the books, software called smart contracts carries out the terms of a trade, loan or deposit automatically. Users interact with these contracts directly from their own wallets.

The Financial Stability Board (FSB) describes DeFi as an umbrella term for crypto-asset services that aim to replicate some traditional financial functions while seemingly removing intermediaries and decentralizing governance. This guide is a starting point for DeFi analysis: it explains the main building blocks, how a typical loan or trade works, where the risks concentrate, and how to read claims about decentralization with care.

In brief

• DeFi applications run as code on a blockchain, so transactions settle on-chain and are visible to anyone.
• The main product types are decentralized exchanges, lending markets and stablecoins.
• Removing intermediaries also removes some protections that traditional finance provides.
• Public authorities have warned about leverage, liquidity mismatches, concentration and misleading claims of decentralization.

The layers of a DeFi system

The FSB describes DeFi as having four layers, which is a useful way to organize any DeFi analysis:

1. Settlement layer: a permissionless blockchain, such as Ethereum, that records transactions.
2. Smart contracts: self-executing code on that blockchain.
3. Protocols: sets of contracts that define the terms and standards for a service, such as lending or trading.
4. Applications: the websites and apps, called decentralized applications or DApps, that people use to reach the protocols.

The FSB notes that DeFi is largely self-referential, interacting with other DeFi products more than with traditional finance or the wider economy. The BIS makes a similar point, observing in 2021 that DeFi had few real-economy uses and mostly supported speculation and arbitrage. Both statements describe the state of the market when written, and readers should check whether later research updates them.

Smart contracts

A smart contract is code stored on a blockchain that runs when its conditions are met. If a borrower deposits enough collateral, the contract releases a loan. If the collateral falls too far in value, the contract sells it. No employee approves either step.

The FSB cautions that the name is a misnomer. The contracts execute predefined conditions rather than reacting to events with judgment, and their legal enforceability is unclear in many jurisdictions. A bug in the code is also a financial risk, because the contract does what it was written to do, not what its authors intended.

Decentralized exchanges

A decentralized exchange (DEX) lets users trade tokens directly from their wallets. The FSB explains that trades are settled atomically through smart contracts, meaning the swap either completes in full or fails, and users do not deposit funds with an operator. It identifies two main designs.

• Order-book exchanges match buyers and sellers at stated prices, as traditional exchanges do.
• Automated market makers (AMMs) hold pools of tokens supplied by users and set prices with a formula based on the pool’s balance. Traders swap against the pool instead of against another person. The suppliers, called liquidity providers, earn a share of trading fees.

The FSB adds that DEXs do not convert crypto-assets to government-issued currency. Users who want to cash out generally need a separate service.

Lending and borrowing

DeFi lending platforms pool deposits from lenders and let borrowers draw from the pool. The FSB explains that these platforms rely on collateral rather than on the borrower’s creditworthiness, since the borrower is usually anonymous. Loans are typically over-collateralized: a borrower must lock up more value than they borrow. If the collateral falls below a required ratio, the contract liquidates it automatically.

A simplified example

The numbers below are hypothetical and chosen only to show the mechanics.

A user deposits tokens worth 150 units of value into a lending contract and borrows 100 units of a stablecoin against them. The protocol requires collateral worth at least 120 percent of the loan, so the loan is currently safe with room to spare. If the collateral’s market price falls by 25 percent, its value drops to about 112.5 units. That is below the 120 percent threshold, so the contract sells enough collateral to restore the ratio, usually at a discount that rewards whoever triggers the sale.

The borrower never negotiates with anyone, and the sale happens on the contract’s schedule, not the borrower’s. In a fast decline, many borrowers can hit their thresholds at once, and the resulting sales can push prices lower. The FSB flags this dynamic as a source of contagion.

Stablecoins

Stablecoins are tokens designed to hold a steady value, usually against the US dollar. The BIS describes them as one of DeFi’s two core parts, alongside the trading, lending and investing protocols, because they move value around the system without the price swings of other tokens. The FSB notes that designs include reserve-backed models and algorithmic ones, and that centralized issuers play a major role.

Stablecoins can face runs if holders doubt the quality of the reserves behind them. The FSB cites the collapse of TerraUSD and Luna as an illustration of that risk. In the United States, the SEC’s March 2026 interpretive release says that payment stablecoins issued by a permitted issuer under the GENIUS Act are excluded from the definition of a security, and that other stablecoins may or may not be securities depending on their characteristics. Readers should consult the release itself, since the treatment turns on specific facts.

The main risks

Leverage

DeFi makes it easy to borrow against crypto assets and then use the borrowed funds as collateral elsewhere. The FSB says this reuse makes leverage hard to measure. Automatic liquidations can force sales into thin markets, and DeFi has no central counterparty to manage an orderly unwind and no market-wide circuit breakers.

Liquidity and maturity mismatches

The FSB calls these arguably the most concerning vulnerabilities. A platform may promise that depositors can withdraw at any time while its assets are locked in loans or other positions. If many depositors try to leave at once, the platform may not be able to pay them. The BIS adds that DeFi relies on private collateral and lacks the shock absorbers of the banking system, such as a central bank that can supply liquidity in stress.

Interconnectedness and concentration

Because protocols can be combined like building blocks, a failure in one can spread to others. The FSB reported that, as of October 2022, the top four DeFi applications held more than 75 percent of total value locked, and about 60 percent of DeFi value sat on Ethereum. Those figures are dated, but the point stands that activity can be more concentrated than the word decentralized suggests.

Operational and misconduct risk

The BIS article lists examples of code errors and exploits, including an erroneous reward distribution on one lending platform and a flash-loan exploit on another. A flash loan, as the FSB explains, is a loan with zero duration that needs no collateral because it must be borrowed and repaid within a single transaction.

Limited consumer protection

The SEC’s Office of Investor Education and Advocacy warns that crypto platforms often lack the safeguards that registered firms must follow, and that accounts at such platforms are not covered by SIPC, FDIC or NCUA insurance. It also says that pseudonymity makes recovering funds difficult after a fraud. Anyone considering these products should read the alert in full.

Is DeFi really decentralized?

The BIS article argues that full decentralization is unattainable, a view it labels the decentralization illusion. Strategic and operational decisions need some central governance, and code cannot anticipate every situation. Platforms often have governance tokens that let holders vote on proposals in a way that resembles corporate shareholders, and large holders, often developers and early investors, can hold a major share of the votes.

The FSB found something similar in its data. For five governance tokens it examined in June 2022, the top 100 addresses held roughly 86 to 95 percent of supply. It concluded that a protocol that appears decentralized may be controlled by a concentrated set of interests.

For an analyst, the practical questions are: who can change the code, who holds the keys to upgrade it, who controls the oracles that feed it prices, and how concentrated is token ownership? The answers say more about risk than the label does.

How regulators are approaching DeFi

The BIS authors recommend applying the principle of same risks, same rules to DeFi, so that identical activities face similar requirements regardless of the technology. They also point to governance structures as natural entry points for oversight.

In the United States, the SEC’s Division of Corporation Finance publishes staff FAQs on how the federal securities laws apply to certain crypto assets. The staff states that its answers are nonbinding views and not Commission rules. Whether a particular token or activity involves a security depends on the facts, and readers should check the SEC’s current guidance and consult counsel for any real decision.

Common misconceptions

DeFi does not eliminate risk by removing the middleman. It replaces institutional risk with code risk, market risk and governance risk.

Over-collateralization does not make a loan riskless. As the example above shows, falling prices can trigger forced sales, and a rapid decline can outrun the system.

A high advertised yield is not free money. It compensates for risks that may include contract bugs, token volatility and the chance that a platform fails.

A short checklist for DeFi analysis

• What does the protocol do, and how does it earn revenue?
• Who controls upgrades, and how concentrated are governance tokens?
• What is the collateral, how is it priced, and what happens in a rapid decline?
• Has the code been independently audited, and what does the audit not cover?
• What would a user lose if the platform failed, and is there any recourse?

This guide is educational and is not investment advice.

FAQ

What does DeFi stand for?

DeFi stands for decentralized finance. It refers to financial services delivered through smart contracts on public blockchains instead of through a bank or broker.

How is DeFi different from a crypto exchange app?

A centralized exchange holds customers’ assets and keeps its own records. In DeFi, the user keeps control of a wallet and signs transactions that smart contracts carry out. The trade-off is that the user bears more responsibility for security and has fewer avenues for recovery.

Do I need a bank account or ID to use DeFi?

Many protocols are permissionless, which means anyone with a wallet can use them. That openness is also why regulators are concerned about illicit finance, and some interfaces apply their own restrictions.

What is total value locked?

Total value locked is a common metric for the amount of assets deposited in DeFi protocols. It is useful for comparing size but can move sharply with token prices, so it is not the same as the number of users or the profitability of a protocol.

Are DeFi products insured?

The SEC investor alert states that crypto platform accounts are not covered by SIPC, FDIC or NCUA insurance. Some protocols offer their own cover products, whose terms and reliability vary widely.