DeFi: Decentralized Finance

The short answer to what is DeFi: financial operations without banks and brokers - swapping, lending and holding assets all run through programs on the blockchain. They are managed not by a company's employees but by smart contracts whose code is open for anyone to inspect.

How DeFi Works

To put the setup in simple terms: a familiar service leans on an intermediary - a bank keeps the accounts, checks the customers and executes payments. Here that role is performed by a program deployed on the blockchain. The user connects a wallet, signs a transaction, and the terms of the deal are executed automatically.

Three Pillars of the Design

Such a design rests on three pillars. The first is a public ledger where every operation is visible. The second is smart contracts, which set the rules with no way to change them retroactively. The third is tokens, which represent assets and rights inside the system.

Smart contracts here should be understood literally: a program deployed at a specific address. It accepts funds, evaluates the conditions and sends the result back. The logic cannot be changed after publication - you can only release a new version and migrate users to it. Hence the demand for audits: a mistake in published code cannot be fixed after the fact.

From this follows the main property: access does not depend on citizenship, credit history or a manager's approval. A wallet and a few coins to pay the network fee are enough.

Every action takes the form of a transaction. It goes into the blockchain, gets confirmed and becomes part of the shared history - it cannot be reversed. The cost of an operation depends on how loaded the particular network is: on one blockchain a transfer costs a fraction of a cent, on another several dollars. That is exactly why the same protocol runs on several networks at once.

In essence the user manages their finances directly, with no applications and no approvals. The flip side is just as direct: there is nobody to help if you make a mistake. A transfer to the wrong address is irreversible, and a forgotten recovery phrase means losing access forever.

What the Ecosystem Consists Of

The set of services repeats familiar banking products, but is assembled from independent protocols.

• Decentralized exchanges. Tokens are swapped directly between wallets, and liquidity is supplied by liquidity pools, where participants deposit pairs of assets. The price is calculated by smart contracts using a formula rather than from an order book.

• Lending protocols. The user posts collateral and borrows another asset; the rate is set algorithmically by the balance of supply and demand.

• Staking and derivatives. Coins are locked to support a network or used as collateral for more complex instruments.

• Yield aggregators. Programs automatically move funds between protocols, following current conditions.

• Bridges and wrapped tokens. They let value move between different networks.

Lending protocols deserve a separate note: a loan is issued only against excess collateral. If the value of the collateral falls below the threshold, the position is liquidated automatically - the mechanism is written into the code and works without human involvement.

How Swapping Works Without an Order Book

Decentralized exchanges do without an order book and market makers. Instead they use liquidity pools: participants deposit a pair of assets into a contract, and the exchange rate is calculated automatically from the ratio of the balances. The larger a trade relative to the size of the pool, the more it moves the price - this effect is called slippage.

Liquidity providers receive a share of the fee from every operation. In return they take on market risk: if the price of one asset in the pair moves noticeably, the outcome will be worse than simply holding the coins. Smart contracts execute the swap with no operator involved and no way to cancel the transaction.

A separate direction is the tokenization of assets: bonds, real estate, shares in funds. Such projects work at the junction of the classic market and the blockchain, so they are regulated more strictly than the rest.

How Staking Works

The word refers to locking coins to support the work of a network or a protocol. In blockchains using the Proof of Stake algorithm, the locked funds serve as security for a validator's honest behaviour, and in return the participant receives a share of the issuance.

There are several formats. Classic staking requires delegating coins to a validator and involves an unlocking period - funds cannot be withdrawn instantly. Liquid staking solves the timing problem: smart contracts issue a derivative token in exchange for the locked coins, and that token can be used in other protocols.

The mechanism has risks of its own. If a validator misbehaves, part of the security is written off; the derivative token may trade below the base asset; and the income is not guaranteed and changes along with network parameters. Staking is not a deposit: there is no insurance of funds here.

It is also worth telling apart staking in the network itself and platform offers with fixed terms. In the second case you entrust funds to a service, and the risk of the intermediary is added to the risk of the protocol: staking through a platform is more convenient, but you give up control over the coins.

How DeFi Differs From Banking Services

The difference also shows in the speed of change: the set of financial services here updates constantly, while banking products change slowly and through regulations. The key difference, though, is responsibility. Classic infrastructure compensates part of a client's losses; decentralized finance provides no such option: any mistake falls on the owner of the keys.

Risks and Limitations

Code vulnerabilities are the main threat. Even smart contracts checked by auditors sometimes contain an error that attackers exploit: stories of funds being drained from protocols repeat regularly.

A separate category is integration risk. Protocols are connected to each other, and a failure in one link shows up in the others: incorrect data from a price oracle, for example, makes smart contracts liquidate positions at the wrong price.

The second risk is market risk. The value of collateral can fall faster than liquidation triggers, and participants who put funds into liquidity pools face impermanent loss when the prices in a pair diverge. The wider the divergence, the more noticeable the difference compared with simply holding the coins in a wallet.

The third is tied to the position of regulators. The legal status of such protocols is undefined in most countries, and in Russia operations with digital currency have their own restrictions - when funds are withdrawn into fiat money, tax rules apply. The details are collected in the article on taxes on cryptocurrency and mining.

The fourth risk is fraudulent projects. Open code lets anyone deploy a contract on the blockchain and wrap it in a polished interface, while working out its logic is left to the user. What people usually check is whether an audit exists, how old the protocol is and how much value is locked in it.

One more thing worth remembering: returns in this field are guaranteed by nobody and are not interest on a deposit. High promised numbers usually mean a proportionally high risk of loss.

DeFi and AI: What Is Changing

A separate trend of recent years is the use of artificial intelligence to analyse operations on the blockchain. Algorithms track suspicious transactions, assess how reliable protocols are and help users find their way around interfaces.

Autonomous agents have appeared too, managing positions according to set rules. An AI model does not remove the risks: it works with the same smart contracts and is just as vulnerable to errors in code and to market moves.

What You Need to Get Started

Technically three things are enough: a wallet that supports the network you need, a small reserve of coins to pay fees, and an understanding of how the specific protocol works. People usually start with small amounts to get used to the interface.

A useful habit is checking an application's address against official sources: phishing copies of popular sites appear regularly and look convincing. A second habit is revoking granted approvals once a protocol is no longer in use: they stay active until the wallet owner cancels them.

It is also worth looking into how funds move between the two worlds in advance: how money gets onto the blockchain from a ruble account and back is explained in the article on how to exchange cryptocurrency for rubles. The nature of rubles and other state-issued units is described in the glossary entry on fiat currency.

In Brief: Frequently Asked Questions

What do people usually start with?

With the simplest operation - swapping one token for another in a trusted application. That way it is easier to see what signing a transaction looks like, how much the fee costs and how long confirmation takes.

How is DeFi different from a crypto exchange?

A centralized platform holds clients' funds itself and acts as an intermediary. In a decentralized service the assets stay in the user's wallet, and a program executes the deal.

Is verification required?

As a rule, no: the connection goes through a wallet. But services linked to real-world assets increasingly request documents.

Which network do most protocols run on?

Historically the main venue is Ethereum, but a noticeable share of applications is deployed on other blockchains with cheaper operations.

Do I need to understand code?

Not necessarily, but it helps to understand what exactly you are signing. The wallet shows which contract on the blockchain you are granting an approval to, and unlimited rights are better left ungranted.

Can I lose everything?

Yes, and that is the key difference from a bank deposit. There is no insurance and no compensation; responsibility lies entirely with the user.

What happens if a protocol fails?

Developers can pause a contract if the code allows for it, but they have no obligation to compensate losses. Practice shows that part of stolen funds is sometimes returned by agreement with the attacker, though counting on that is unwise.