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

Imagine trying to walk into a bank at 3 AM on a Sunday to apply for a loan. In the traditional world, the doors are locked. Even during opening hours, you usually need to complete forms, provide identification, pass a credit check, and wait for a decision.

Decentralised finance, or DeFi, tries to change this model completely. In DeFi, a computer programme, not a person, processes that loan. It can happen quickly, at any time of day, often without anyone asking for your name or credit score. The trade‑off is that many of the usual safety nets such as fraud protection, complaints procedures, and regulatory oversight are limited or missing altogether.

This guide explains what DeFi is, how it works in practice, how people use it today, and the critical risks you should understand before you even consider using it.

What is decentralised finance?

DeFi refers to a collection of financial applications built on public blockchains. Bitcoin introduced the idea of digital, decentralised money. DeFi goes further and tries to recreate services such as lending, borrowing, trading, and insurance using computer code instead of central intermediaries.

In the traditional financial system (often called "TradFi" or "CeFi"), a centralised company sits in the middle. When you deposit money, the bank takes custody of it and keeps the official record. You must trust that institution to safeguard your funds, follow the rules, and process your transactions correctly.

DeFi uses a non‑custodial model. Instead of handing your cryptoassets to a company, you keep them in a personal digital wallet that you control. You interact directly with a protocol, usually through a website or app, and your assets only move when you approve a specific transaction.

This gives you more direct control, but it also means you carry most of the responsibility and risk yourself.

How it works in practice

To understand DeFi, it helps to look at the two core mechanisms that replace the bank manager and the traditional exchange: smart contracts and liquidity pools.

Smart contracts

You can think of a smart contract like a digital vending machine. With a physical vending machine, the rules are built into the machine. If you insert the right amount of money and press button A1, it releases a drink. There is no shopkeeper checking every sale.

DeFi works in a similar way. A smart contract is a piece of code stored on a blockchain, such as Ethereum, Solana, or Arbitrum. It automatically carries out transactions when certain conditions are met. For example, a contract might say: "If User A deposits 1 ETH, send them 2,000 USDC." When the conditions are triggered, the blockchain processes the swap.

Smart contracts can reduce the need for intermediaries, but they are only as safe as the code and the people who wrote it. If there is a mistake, users can lose money and there may be no realistic way to recover it.

Liquidity pools and AMMs

Traditional stock markets use an "order book" where buyers and sellers place orders and a central venue matches them. If nobody is willing to sell at your price, you simply cannot trade.

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 large pot of tokens supplied by other users.

People who put their tokens into these pools are called liquidity providers (LPs). In return for allowing the protocol to use their assets to process trades, LPs earn a share of the trading fees. This means markets can function 24/7 without a central company managing every order.

However, LPs are not just passively collecting fees. They face several risks, such as:

• Impermanent loss" which is when the price ratio between your two tokens changes after you deposit them, you may end up with less total value than if you had simply held the tokens in your wallet. While you earn trading fees, these may not offset the loss from the price changes. The loss becomes permanent if you withdraw your tokens while prices are unfavourable.
• Smart contract failures that can wipe out the entire pool.
• Sudden drops in demand for a token, which can make it hard to exit a position without large losses.

Real‑life examples of DeFi

DeFi technology is still experimental and can be highly volatile. It is mainly used by experienced crypto users who are comfortable taking significant risk. Three common use cases are described below.

Decentralised exchanges (DEXs)

Decentralised exchanges such as Uniswap allow you to swap one cryptocurrency for another directly from your wallet. You usually do not create an account or go through a traditional identity check on the DEX itself. Instead, you connect your wallet, choose the tokens you want to trade, and the smart contract carries out the swap using a liquidity pool.

This removes the need to trust a central exchange to hold your funds, but it introduces other risks. For example:

• You might select the wrong token, including fake or malicious copies that scammers have created.
• If you approve a malicious contract, you may give it permission to spend all of your tokens.
• If a bug or hack affects the DEX smart contracts, you could lose your assets with no recourse.

Lending and borrowing

Lending and borrowing protocols such as Aave and Compound let users lend out tokens or borrow against them.

• Lenders: You can deposit your crypto into a lending pool and receive variable interest, paid by borrowers. Rates can change quickly as supply and demand move.
• Borrowers: You can borrow from the pool, but DeFi loans are usually over‑collateralised. For example, to borrow £1,000 worth of stablecoins, you might have to lock £1,500 worth of Bitcoin as collateral. If the value of your collateral falls below a set threshold, the protocol can automatically sell it to repay your loan.

This structure can be useful for some advanced strategies, but it carries serious risks. Sudden price moves can trigger automatic liquidations, leaving you with large losses even if the market later recovers. There is no negotiation, no payment holiday, and no one to appeal to.

Liquid staking

Liquid staking services such as Lido allow users to stake their Ethereum to help secure the network and, in return, receive a "receipt" token such as stETH. This token tracks the value of your staked ETH and can sometimes be used in other DeFi applications to earn extra yield. This mix‑and‑match approach is sometimes called "money legos" or composability.

While this can increase potential returns, it also layers risks on top of each other:

• You depend on the staking service to operate honestly and securely.
• You depend on the underlying blockchain network.
• You depend on any additional DeFi protocol where you use the receipt token.

If any one layer fails, your position may collapse, and you could lose your entire investment.

Key risks and red flags

DeFi is often compared to a "Wild West" version of finance. The code for many protocols is public and transparent, but that does not make it safe. If you make a mistake or are targeted by a scam, you are usually on your own.

In the UK, you are very unlikely to be covered by the Financial Services Compensation Scheme (FSCS) or have access to the Financial Ombudsman Service for DeFi‑related losses.

Smart contract vulnerabilities

Smart contracts are written by people, and people make errors. A single bug or poorly designed feature can allow attackers to drain all the assets from a protocol. This has happened many times, even to high‑profile projects that had passed security audits.

If a smart contract is hacked, losses are often instant and permanent. There is usually no central authority that can reverse transactions or refund users. Even if the team behind a project promises to make users "whole", they may not have the money or legal obligation to do so.

Rug pulls and scams

DeFi is often described as permissionless, which means almost anyone can launch a new token, platform, or yield‑farming scheme. This low barrier can encourage innovation, but it also makes it much easier for scammers to set up fake projects.

A common scam is the "rug pull". Developers attract users with marketing, eye‑catching returns, and sometimes anonymous online personalities. Once enough money has entered the protocol or liquidity pool, the scammers remove the funds and disappear.

Warning signs can include:

• Promises of extremely high or "risk‑free" yields.
• Anonymous or unverified teams with no track record.
• No independent code audits or unclear documentation.
• Pressure to act quickly or "not miss out".

Even if you do careful research, it can still be very hard to spot a sophisticated scam.

User error

In DeFi, you are effectively acting as your own bank. This brings control, but it also means that simple mistakes can be very costly.

Common issues include:

• Lost keys or seed phrase: Your seed phrase is the master backup for your wallet. If you lose it, or someone else gets hold of it, your funds can be lost or stolen and there is usually no way to recover them.
• Wrong address: If you send crypto to the wrong address or on the wrong network, you normally cannot reverse the transaction.
• Malicious links and approvals: If you connect your wallet to a phishing website or approve a malicious contract, scammers may be able to move your tokens without further permission.

Basic security practices can reduce these risks, but they cannot remove them entirely.

The future of DeFi

DeFi is evolving quickly and some projects are trying to connect it more closely with the traditional financial system. This does not mean it is becoming safe or low risk. It remains highly experimental and subject to sudden changes in regulation, technology, and market interest.

One trend is the tokenisation of real‑world assets (RWAs). This involves issuing blockchain tokens that represent things like government bonds, real estate, or corporate loans. These tokens can then be traded or used as collateral inside DeFi protocols.

Tokenisation might make some markets more efficient, but it also creates complex legal and operational questions. For example, who actually owns the underlying asset, what happens if a company defaults, and which courts or regulators have authority?

Alongside this, "institutional DeFi" is emerging. These are permissioned pools that use DeFi technology but only allow approved users who have passed Know Your Customer (KYC) and Anti‑Money Laundering (AML) checks. The aim is to combine some of the automation of smart contracts with the compliance standards expected by large financial firms.

For everyday users in the UK, DeFi remains a high‑risk, specialist area. It can offer new ways to move, trade, or use cryptoassets, but it also exposes you to the possibility of rapid and total loss. If you decide to explore it, you should only use money you can afford to lose, take time to understand how each protocol works, and be prepared for things to go wrong without warning.