crypto
Decentralized finance essentials
Explains the protocols, stablecoins, governance, and risks that defined DeFi in late 2021, and why DeFi changes trust rather than removing it.
Decentralized finance (DeFi) combines public ledgers, smart contracts, tokens, and market mechanisms into financial applications.
Public blockchains created another way to build financial services: programs and shared state could run on a network rather than one institution's database.
These systems let users trade, lend, borrow, and issue assets through shared software, along with technical, market, and governance risks.
Bitcoin launched in 2009. Ethereum's 2015 launch later made general-purpose smart contracts widely available and supported the first large DeFi market.
Figures in this essay are a snapshot from late 2021, when it was originally published. A few later edits are marked in place.
DeFi summer
The early DeFi experiments started with projects like MakerDAO (2014) and Compound (2018), but the ecosystem remained relatively small until 2020.
The catalyst came during the "DeFi Summer" of 2020, when commonly cited industry dashboards estimated that total value locked (TVL) grew from roughly $1 billion to more than $15 billion. TVL measures assets deposited in tracked protocols; it is not revenue and can count related assets more than once.
This period drove rapid adoption of automated market makers such as Uniswap, along with yield farming and liquidity mining. Uniswap itself launched in 2018.
Most of this early activity ran on Ethereum, whose Turing-complete virtual machine (the EVM) executes smart contracts: programs that implement token and application rules. Experiments on other chains existed, but Ethereum was where the core protocols took shape.
By 2021, DeFi had spread to multiple blockchains, each offering its own variations, and several recurring protocol categories had emerged.
Core DeFi components
Foundational
| Technology | Description |
|---|---|
| Layer 1 | The underlying blockchain architecture that supports transaction settlement and application development. Some L1s use Layer 2s to scale. |
| Coins | Native tokens used to pay transaction fees on Layer 1. Bitcoin was the first cryptocurrency. |
| Smart contracts | Programs stored on blockchains whose functions run when transactions call them. They support tokens, DeFi applications, NFTs, and governance systems. |
| Tokens | Assets recorded in smart-contract state under interfaces such as ERC-20 or ERC-721. They can be fungible or non-fungible. |
| Stablecoins | Specialized tokens designed to maintain parity with another asset, typically USD. |
| NFTs | Non-fungible tokens with distinct identifiers. Multiple tokens may still belong to the same edition or collection. |
| Liquidity pools | Smart contracts where users deposit assets to support swaps, lending, or other protocol functions in exchange for fees or incentives. |
| DEXes | Decentralized exchanges where users trade tokens through liquidity pools, order books, or other on-chain mechanisms. |
| Blockchain explorers | Tools that index and display transactions and state on public blockchains. |
| Lending and borrowing | Protocols enabling users to lend assets or borrow against collateral. |
| Leveraged Derivatives | Platforms for trading leveraged positions, e.g., futures or options, using coins or tokens as collateral. |
| Staking | Committing assets to proof-of-stake validation. Some products reuse the term for unrelated token lockups that pay incentives. |
| Analytics | Data platforms providing insights into DeFi activity. |
Advanced
Teams combined the foundational components into more complex protocols and mechanisms, some of which are listed below.
| Technology | Description |
|---|---|
| Liquid Staking | Tradable tokens representing claims associated with staked assets. They can be used elsewhere, but add issuer, smart-contract, liquidity, and depegging risk. |
| DEX Aggregators | Contracts or interfaces that compare routes across liquidity sources and seek a better execution price after fees and gas. |
| Yield Aggregators | Protocols that move or compound deposits under programmed strategies. Higher quoted yield can add contract, liquidity, and strategy risk. |
| Launchpads | Platforms for launching new tokens and NFT projects. |
| Bridges | Infrastructure connecting different blockchains to enable cross-chain asset transfers. |
| GameFi | Gaming platforms incorporating DeFi mechanics and blockchain-based economies. |
| Portfolio Management | Protocols that give a manager or strategy defined trading permissions over deposited assets. Users retain a withdrawal claim subject to the contract's rules, not unrestricted control at every moment. |
| DeFi Insurance | Protocols providing coverage and backstops against smart contract risks and failures. |
| Synthetics | Assets that track the price of other assets using oracle data, bringing off-chain asset markets on-chain. |
| Flash Loans | Uncollateralized loans that must be borrowed and repaid within a single transaction. |
Stablecoins
Stablecoins became a major regulatory and market-structure issue. They are intended to retain a peg to another asset, such as the USD. The biggest stablecoins in the world are USDT and USDC, which amounted to roughly $100 billion in combined value as of late 2021.
One useful, simplified taxonomy has three groups.
| Type | Description | Examples | Principal risks |
|---|---|---|---|
| Asset-backed | The issuer reports holding cash or other reserve assets against tokens in circulation | USDT, USDC | Issuer, reserve, banking, redemption, and regulatory risk |
| Over-collateralized | Users deposit excess collateral, such as $200 of crypto for $100 of DAI, to mint stablecoins | MakerDAO's DAI | Smart-contract, oracle, liquidation, governance, and collateral risk |
| Algorithmic | Smart contracts and market incentives attempt to maintain the peg without full direct reserves | Terra Classic (a later edit: it collapsed in May 2022) | Reflexivity, liquidity, governance, and death-spiral risk |
Other stablecoins are out there, but many combine features from more than one category. Most large stablecoins target one US dollar. While it's possible to peg stablecoins to other values (like 2 USD or even $3.1415926535), most stablecoins focus on maintaining a 1:1 peg with USD.
There are also stablecoins pegged to currencies like EUR and AUD, but USD-based stablecoins dominate in volume and use cases.
DeFi changes rather than removes trust
It may sound counterintuitive, but reducing reliance on a single institution can be valuable.
Public blockchains can make transaction rules and state easier to verify. Cryptography proves signatures and data integrity; it does not guarantee asset value, correct code, honest governance, or legal enforceability.
In developed economies, trust in financial institutions is often taken for granted, and recent history has shown that no financial system is immune to crisis:
Risks in less stable financial systems
- Hyperinflation and currency collapse (Venezuela, Zimbabwe)
- Sudden bank nationalizations by governments
- Financial corruption and fraud
- Asset seizures and capital controls
- Limited access to essential banking services
Risks in developed economies
- Bank runs, failures, and bailouts
- Payment censorship, freezing, and seizures
- Delayed settlement times and opaque processes
- Trading halts during market volatility
- Negative interest rates on savings accounts
Brokerages compared with DEXes
Brokerages and Decentralized Exchanges (DEXes) are two different ways of trading assets.
Brokerages generally custody client assets and apply account, identity, and regional requirements. DEX protocols can allow wallet-based access, but their interfaces, token issuers, governance, and infrastructure may still impose restrictions.
For a comparison, see the table below (reconstructed from the original's damaged formatting):
| Feature | Brokerage | DEX |
|---|---|---|
| Account Setup | Application and identity verification | Connect a wallet |
| Trading Timeline | Often market hours with later legal settlement | Often 24/7; blockchain finality and off-chain claims vary |
| Availability | Restricted by region and asset class | Protocol-dependent; interfaces and assets may still be restricted |
| Custody | Broker or its custodian holds client assets | Wallets authorize deposits into contracts; control depends on contract and asset rules |
| Market Making | Usually restricted to approved participants | Some pools accept public deposits; other venues or interfaces restrict access |
Risk and due diligence
DeFi was young when this essay appeared, and its later failures reinforced the need to examine each system rather than reason from the label.
Many experiments remain poorly documented. Users should examine contract audits, upgrade keys, oracle dependencies, liquidity, governance concentration, and loss scenarios before depositing assets.
For the broader access, NFT, and decentralized-organization context around these financial protocols, read Permissionless Systems.