What is DeFi? A Beginner’s Guide to Decentralised Finance

For centuries, the financial system has relied on central gatekeepers. If you want a loan, to trade shares, or to send money abroad, you normally go through a bank, broker or payments provider. These intermediaries help create trust, but they also introduce fees, delays and entry barriers.

Decentralised Finance, or DeFi, offers an alternative approach. It builds financial services on top of public blockchains and uses code to manage transactions. By reducing the role of traditional intermediaries, DeFi aims to create systems that are more open, transparent and available around the clock.

Defining Decentralised Finance

DeFi refers to a broad set of financial applications built on blockchain networks. Ethereum is the most widely used for DeFi today, although other networks such as Solana and Arbitrum are also significant.

In traditional finance, a centralised institution usually holds your money and controls your account. In DeFi, many applications are non-custodial. This means you keep control of your own digital wallet and private keys.

In a non-custodial DeFi set-up, no central company holds your assets, and your access to your wallet is not dependent on a single institution. You interact directly with smart contracts to trade, lend or borrow. However, you also take on the responsibility for securing your own wallet and understanding how the protocol works.

How DeFi works

Two main technologies underpin most DeFi services: smart contracts and liquidity pools.

Smart contracts

A smart contract is a computer program stored on a blockchain that runs exactly as it has been coded, once certain conditions are met.

You can think of it like a digital vending machine. In the traditional world, a lawyer or a banker might check that both sides follow the terms of an agreement. A smart contract automates this process.

For example, a simple contract might say: “If User A deposits 1 ETH, then send them 2,000 USDC.” Once the deposit is confirmed on the blockchain, the trade executes according to the code. There is no manual approval, but also usually no option to reverse the transaction.

Liquidity pools and AMMs

Most centralised exchanges use an order book to match buyers and sellers. Many DeFi platforms use a different model called an Automated Market Maker (AMM).

Instead of trading directly with another person, you trade against a liquidity pool. This is a shared pool of tokens that other users, known as Liquidity Providers (LPs), have deposited.

LPs earn a share of trading fees in return for providing liquidity. This system allows markets to remain open and available 24/7, without a central party managing every order. However, LPs can face specific risks, such as “impermanent loss,” where the value of their deposited tokens changes relative to simply holding them.

Key characteristics of the DeFi ecosystem

DeFi introduces several design principles that differ from traditional finance. These features can offer benefits, but also come with important trade-offs.

• Permissionless:
  Many base DeFi protocols allow anyone with a compatible wallet and internet connection to interact with them, without individual approval. However, access from certain interfaces or jurisdictions may still be restricted for regulatory reasons, and regulated service providers must comply with laws such as anti-money laundering (AML) and counter-terrorist financing (CTF) rules.

• Transparent:
  Most DeFi transactions and much of the underlying smart contract code are visible on public blockchains. Anyone can view balances, flows and, in many cases, audit how a protocol is intended to work. This is very different from traditional financial ledgers, which are usually private. Transparency does not guarantee safety, and reading complex code still requires specialist expertise.

• Composable:
  DeFi protocols can often be connected to each other like building blocks. For example, you might lend a token on one platform, receive a “receipt” or derivative token, then use that token as collateral on another application. While this composability increases flexibility, it can also spread risk between protocols and make it harder to predict how failures will cascade.

Real-life examples of DeFi in action

DeFi is already being used to create alternatives to many traditional financial services. The following examples are provided for illustration only and are not endorsements or recommendations.

Decentralised Exchanges (DEXs)

Decentralised exchanges such as Uniswap allow users to swap tokens directly from their own wallets. There is usually no need to create a central account or deposit funds onto the platform before trading.

You sign a transaction with your wallet, the smart contract processes the trade, and you receive the new token in the same wallet. Fees, supported assets and legal treatment can vary between platforms and jurisdictions.

Lending and borrowing

Lending protocols such as Aave and Compound allow users to lend their cryptoassets and potentially earn interest. Other users can borrow assets from the pool, usually by providing other cryptoassets as collateral.

This typically works through over-collateralisation. For example, to borrow the equivalent of 4,500 EUR in stablecoins (for instance, EUR or USD-pegged tokens), you might need to deposit 9,000 EUR worth of Bitcoin as security. If the value of your Bitcoin falls below a certain threshold, the protocol may automatically sell it to repay the loan.

This automated liquidation process helps keep the system solvent without debt collectors, but it can also lead to sudden losses for borrowers if markets move quickly.

Liquid staking

Liquid staking services, such as Lido, allow users to stake assets like Ethereum to help secure the network and potentially earn staking rewards. In exchange, users receive a derivative token, such as stETH, that represents their staked position.

This derivative token can often be used in other DeFi applications, for example as collateral or in liquidity pools. While this can increase capital efficiency, it also adds extra layers of risk, such as smart contract risk on multiple platforms and the possibility that the derivative token may not always trade at the same value as the underlying asset.

Risks and red flags

DeFi is still a young and fast-developing area. It combines financial risk with technology risk and, in some cases, legal and regulatory uncertainty. You should treat it as highly speculative.

Smart contract risk

DeFi protocols rely on smart contracts. These are written by humans and can contain coding errors or design flaws. If a vulnerability is discovered, attackers may exploit it and drain funds from the protocol.

Unlike deposits in many traditional banks, funds in DeFi protocols are usually not covered by government-backed deposit guarantee schemes. Once assets are lost through a contract exploit, it is often impossible to recover them.

Security audits and open-source code can help, but they do not remove risk entirely.

Governance and protocol risk

Many DeFi protocols are governed by token holders, who can vote on upgrades and changes. This can be more open than traditional corporate structures, but it also brings new risks.

A small group of large holders might control decisions. Governance processes can be complex or poorly understood. Changes to protocol parameters, such as collateral ratios or fee structures, can have a strong impact on users.

Rug pulls and scams

A “rug pull” happens when developers launch a token or project, attract funds, then remove the liquidity or exploit the code to take users’ assets.

Because creating new tokens and contracts is relatively simple, scam projects can appear convincing at first glance. Warning signs include anonymous teams with no track record, unrealistic return promises, unaudited code and unclear documentation.

User error and complexity

Managing your own wallet, private keys and seed phrases is a major responsibility. If you lose your seed phrase, or send funds to the wrong address, there is usually no way to reverse the transaction.

Many DeFi interfaces are designed for experienced users and can be confusing at first. Misunderstanding how a protocol works, or failing to read the terms carefully, can lead to unexpected losses.

Regulatory and legal risk

Regulation of cryptoassets and DeFi is evolving, especially in the European Union under MiCA and related frameworks. Some assets or services may be restricted, require authorisation, or be treated differently from one jurisdiction to another.

Future regulatory changes could affect how DeFi protocols operate, how they are accessed, or how gains and losses are taxed. Users are responsible for understanding and complying with the rules that apply to them.

The future of DeFi

DeFi is moving from early experiments to more structured services. The line between traditional finance (often called TradFi) and DeFi is slowly becoming less clear, as banks, fintechs and institutional investors explore blockchain-based settlement and custody.

There is growing interest in tokenised “real-world assets” (often referred to as RWAs), such as government bonds, money market instruments and real estate, being brought onto blockchains in compliant ways. In the European context, these efforts must comply with MiCA and other financial regulations, which aim to provide stronger consumer protection and regulatory oversight.

The first DeFi wave was largely driven by speculation and very high, often temporary, yields. The next phase is more likely to focus on efficiency, risk management and integration with the wider economy. If the technology and regulation continue to mature, DeFi-based infrastructure could help make some financial services faster, more transparent and more accessible. However, it remains experimental, and there is no guarantee that current projects or tokens will hold their value over time.

Keep in mind

The Irish Revenue Commissioners treat gains from cryptoasset transactions, including DeFi activities like trading, lending, and staking rewards, as potentially taxable events subject to Capital Gains Tax or Income Tax depending on the circumstances. You should keep detailed records of all transactions and consider consulting a tax advisor familiar with cryptoassets. It's also crucial to understand that funds held in DeFi protocols are not protected by deposit guarantee schemes like those that cover up to €100,000 in Irish and EU banks.

And of course, the regulatory landscape in Europe is actively evolving. MiCA is being implemented so keep checking regulations regularly. Rules around stablecoins, trading platforms, and service providers are becoming clearer, but this may affect which services you can access and how they operate.