DeFi Decentralized Finance

Decentralised Finance (DeFi) refers to a set of financial services and products built on public blockchains, primarily Ethereum, that operate without traditional financial intermediaries like banks, brokers, or exchanges. Users interact with DeFi protocols directly through smart contracts.

What Is DeFi?

Traditional finance requires intermediaries: you deposit money in a bank, borrow from a lender, trade through a broker. DeFi replicates these services on blockchains where code (smart contracts) automates the process, removing the need for middlemen.

Core DeFi services include:

– **Lending and borrowing**: deposit crypto as collateral and borrow other assets (Aave, Compound)
– **Decentralised exchanges (DEX)**: trade tokens directly without a centralised exchange (Uniswap, SushiSwap)
– **Yield farming**: earn returns by providing liquidity to DeFi pools
– **Stablecoins**: algorithmic and crypto-collateralised stablecoins (DAI by MakerDAO)
– **Insurance**: decentralised insurance against smart contract failures

How DeFi Works

1. Users connect a crypto wallet (MetaMask, Phantom) to a DeFi protocol
2. Smart contracts execute transactions automatically based on coded rules
3. No KYC, no account approval, no human intermediary
4. Transactions are transparent and verifiable on the blockchain

Risks of DeFi

– **Smart contract risk**: bugs in code can be exploited, leading to fund losses
– **Liquidation risk**: collateralised loans can be liquidated if collateral value drops
– **Impermanent loss**: providing liquidity in DEX pools can result in lower returns than holding
– **Regulatory uncertainty**: DeFi operates in an unclear regulatory space in most countries

Practical Example

Suresh deposits ETH worth Rs 10 lakh into an Aave lending pool and borrows USDC worth Rs 5 lakh (50% LTV). He uses the borrowed USDC to buy more ETH. This is a leveraged strategy. If ETH price rises 20%, his ETH gains increase. But if ETH falls 40%, his collateral may be liquidated automatically.

Key Takeaways

– DeFi provides lending, trading, and savings services on blockchain without banks or brokers
– Smart contracts automate all processes; no human intermediary is needed
– Major risks include smart contract bugs, liquidation, and impermanent loss
– DeFi protocols are open source and permissionless; anyone with a crypto wallet can participate
– In India, DeFi income (interest, trading gains) is taxable under the Virtual Digital Assets framework