What is DeFi?

What is DeFi?

DeFi stands for decentralised finance: services such as trading and lending carried out through programs on a public blockchain. A user connects a wallet and authorises transactions; smart contracts then apply the service's rules to the crypto-assets involved. DeFi is a category of financial applications, rather than a single asset with a single price.

For example, someone can exchange one token for another through a trading pool, or borrow tokens after locking other crypto-assets as collateral. The program handles parts of the transaction that a financial intermediary would otherwise administer. The assets, developers and services around that program still matter.

Ethereum is one network used for DeFi. Its native asset, Ether (ETH), pays transaction fees even when a service moves other tokens. Applications can also run on networks such as Arbitrum, which operates as a layer above Ethereum. The underlying blockchain and the DeFi application are separate parts of the arrangement.

Trading through a pool

A liquidity pool holds crypto-assets made available by participants. When a trader exchanges one asset for another, a smart contract calculates and executes the swap using the pool's rules and balances. The trader is interacting with a pool rather than waiting for another person's matching order.

The amount received depends on the pool and the size of the trade. A pool with little available liquidity can produce a substantially different exchange price for a larger transaction. Token standards such as ERC-20 let Ethereum applications recognise and transfer compatible tokens; they do not establish a token's value or the reliability of the service using it.

Borrowing against crypto-assets

In collateral-based DeFi lending, a borrower locks assets in a protocol and borrows against them. If the collateral falls too far in value relative to the debt, the protocol can allow part of it to be sold or transferred to repay borrowing. This is liquidation.

For example, Aave uses a measure called the health factor to compare the collateral with the borrowing. The assets involved and the protocol's parameters determine when a position becomes eligible for liquidation. A borrower can therefore lose collateral without deciding to sell it.

Stablecoins can provide a currency reference for trading or borrowing, but their own backing and redemption arrangements remain relevant. Leaving a protocol means carrying out the transaction its rules allow: repaying debt, releasing collateral or withdrawing available assets. An interface's withdrawal button does not itself ensure that assets are available.

Where do the prices and permissions come from?

A lending contract needs a price to measure collateral. A blockchain program cannot independently observe an outside market, so an oracle supplies that information. Incorrect or delayed oracle data can affect how the lending rules are applied. Chainlink is one example of infrastructure used to deliver data to contracts.

A wallet also does more than identify a visitor. A signature can authorise a transfer or give a contract permission to spend specified tokens. Some spending permissions remain after the website is closed. The distinction matters because revisiting or leaving a page does not undo an authorisation already recorded on the chain. The smart-contract guide explains how those instructions run, and the wallet comparison explains control of the keys.

How decentralised is the service?

Different parts of a service can have different operators. A website may be hosted by a company, contracts may have administrators, and an oracle may supply essential information. Some administrators can pause or upgrade contracts. Those access controls affect who can change what the service does.

Code errors can lock assets or allow unintended transfers. A contract may also depend on other contracts, so a failure can reach a service whose own interface appears to work normally. These dependencies are part of the wider Web3 architecture.

The European Securities and Markets Authority (ESMA) identified operational and security vulnerabilities as investor-protection concerns in its October 2023 assessment.

In the EU, services provided in a fully decentralised manner without an intermediary fall outside the Markets in Crypto-Assets Regulation, or MiCA. A service calling itself DeFi does not, by that label alone, establish that the exclusion applies. The parties operating the service and the activities they perform still matter.

An Ethereum ETP does not create a DeFi account

Virtune Staked Ethereum ETP provides ETH price exposure through a security. Its holder does not receive a wallet, a DeFi lending position or entitlement to income from applications on Ethereum. The staked Ethereum ETP page sets out the product's own terms and costs; the ETP explainer explains this form of ownership.