What Is DeFi? Banking With Nobody Behind the Counter

Until May 2022, a lending protocol called Anchor paid close to 20% a year on deposits of UST, a token built to be worth one dollar, and banks at the time paid under 1%. Twenty times the bank rate, on something calling itself a dollar, with no queue, no forms, no branch. Then the bill arrived. Terra, the system underneath it, collapsed, and roughly $40 billion evaporated in about a week.

That 20% was never a return, it was a price tag, and the thing it priced was everything that could go wrong. Keep that idea nearby, because it is the most useful sentence in DeFi, the corner of crypto holding both the sector's most interesting machinery and its most expensive rubble. This is an explainer, not financial advice, and it nudges you towards nothing.

Banking with nobody behind the counter

DeFi stands for decentralised finance, the idea being to take the services a bank sells, lending, trading, holding something dollar-shaped, and rebuild each one as a smart contract, a program on a blockchain that holds funds and follows its own rules with nobody able to lean over and override them. No counter, no manager.

Vending machines, basically: a bank branch has a counter and someone who can say no, a vending machine just has a slot, and it serves anyone at 4am without asking who they are. Apps built this way are called dapps, and the financial ones are DeFi. Nearly all of the ones that matter run on ethereum, which launched in July 2015 precisely so that people could program money like this, something Bitcoin was never built for.

The machines that already run

The surprising part is how much of this genuinely works, and how long it has.

The oldest machine makes dollars: since December 2017, MakerDAO has issued DAI, a stablecoin that aims to sit at one dollar. Not because a company promises redemption: because every DAI is backed by a larger value of crypto locked in contracts anyone can inspect. It has wobbled, it has not broken.

Trading came next: Uniswap has been live since November 2018 and lets anyone swap one ethereum token for another at any hour, with no exchange operator on the other side, and no order book either. Prices come from a formula run over pooled funds: your trade tips the ratio of the pool, and the formula moves the price. Crude, and it works, with no front desk to phone.

Lending pools complete the set, Compound and Aave being the big names, Aave's main network arriving in January 2020. Depositors put coins in and earn interest paid by borrowers on the other side. Every cent of it is compensation for the risk that the contract, or the price feed it relies on, fails. None of it pays you for showing up, the rate exists because something real can break.

No credit check, because there is no credit

Here is how a machine lends to a stranger: it never learns your income, your history or your name, it only watches your deposit.

Say you want to borrow $100 of stablecoin against ether, the pool might demand $150 of ether locked up first. If ether's price slides and the cushion thins, the contract does not send a warning letter, it sells your collateral automatically, makes the loan whole and charges a penalty for the trouble. Liquidation, in the trade, and it runs at machine speed. On 12 March 2020, the day crypto roughly halved in the COVID panic, liquidation engines sold collateral into a market with almost no bidders. Some borrowers were sold out for next to nothing.

The design has a name, overcollateralised lending, and it inverts the bank model. A bank hands you money and hopes you are good for it. A DeFi pool hands you less than you have already handed over. The reason anyone borrows on those terms is usually to spend dollars without selling coins they expect to rise, a bet stacked on a bet, and worth naming as one.

DeFi summer and the numbers people wave at you

The sector's first mania has a start date. In June 2020, Compound launched a token called COMP and handed it to anyone lending or borrowing through the protocol. Within weeks, money was hopping between protocols to harvest whichever token was on offer that day. The sport got a name, yield farming, and the advertised rates got silly. Mostly they were paid in freshly minted tokens that could halve while you held them, and that half of the sentence never made the adverts.

Out of that summer came DeFi's favourite bragging metric: TVL, total value locked, the market price of everything deposited across these contracts. At cycle peaks it reads in the tens of billions of dollars. Impressive, and worth the scepticism you would give market cap, because it is a mark-to-market snapshot, not money in a vault. When token prices halve, TVL halves with nobody withdrawing a thing.

The wreckage, honestly

Anchor set the template, and the template was not exotic. Pay a rate the system cannot afford, attract billions, hold on until confidence blinks. The other patterns are blunter, starting with exploits: someone finds a flaw in a contract and drains the pool, and it keeps happening, sometimes for sums in the hundreds of millions. Poly Network lost roughly $600 million to one attacker in August 2021. Most of it came back, but only because the attacker chose to return it. That is not a recovery process, that is luck.

And rug pulls, the crude classic: a team launches a token or pool, waits for deposits, then leaves with them.

There is a quieter attack surface under all of it. A lending contract cannot see the market, it learns prices from an oracle, a feed pushing numbers on-chain. Bend the feed and you can walk the machine into mispricing collateral. The vending machine reads whatever label you show it.

When any of this goes wrong, notice what does not exist: no deposit insurance, no chargeback, no support desk with a queue and a reference number. A drained pool or a fat-fingered transaction is final in a way retail finance spent decades training you not to expect. Your money, your problem, and the sentence cuts both ways. The design that stops anyone freezing you out of the machine is the same design that sends nobody when it eats your deposit.

What it costs, and the one rule worth keeping

A practical wall first: every step in DeFi is a blockchain transaction, and on ethereum's main network each one pays gas. Enter a position, adjust it, exit it: three or four fees before anything has happened. On a small deposit those costs can outrun whatever the position does. Small experiments tend to live on layer 2 networks instead, the cheaper venues covered in their own guide. Tax treatment of any of this differs by country and sits outside this guide too.

Then the rule from the top: every yield in DeFi is a risk premium. The machine pays because something real can go wrong: the contract, the oracle, the peg, the token the rate arrives in. The bigger the number, the louder it is telling you so. Anchor said 20%, and 20% was the honest answer.

Most people meet all this from the shallow end anyway: they hold some ether, because the whole arcade runs on it and the fees are paid in it. If that is your route, the plumbing is the familiar bit. An on-ramp such as Banxa has moved money into crypto since 2014, with 100-plus payment methods across 100-plus countries where available. What happens after the coins land is the part no counter, and no machine, will ever do for you.