Decentralised Finance (DeFi)

Why DeFi exists

Traditional finance requires permission. To open a bank account, send money internationally, or access a loan, you need a bank to approve you, a government to recognise you, and a company somewhere to decide you are worth serving. Billions of people — mostly in the developing world, including much of India — are either unbanked or underserved by these systems. Even for those who are served, financial intermediaries charge fees, move slowly, and operate behind closed hours.

DeFi is a bet that financial services can be rebuilt as open, permissionless software. Instead of a bank holding your money and deciding whom to lend it to, a smart contract on a public blockchain holds the funds and executes the rules automatically, transparently, and without discretion. Anyone with a crypto wallet and an internet connection can participate — no account, no ID check, no approval required.

The building blocks: smart contracts and protocols

The foundation of DeFi is the smart contract — a program stored on a blockchain that executes automatically when certain conditions are met. Think of it as a vending machine rather than a cashier: you put in the right input, the machine dispenses the right output, and no human needs to be involved or trusted. A DeFi "protocol" is a collection of smart contracts that together deliver a financial service.

These protocols are "composable" — they can be combined like Lego bricks. A user can take tokens from a lending protocol, use them as collateral in a trading protocol, and deposit the proceeds into a yield protocol, all in a single transaction. This composability has enabled financial products and strategies that would be impossible in traditional finance's siloed system, and it is part of what makes DeFi both powerful and complex.

The main categories of DeFi

Decentralised exchanges (DEXes) let you swap one token for another without a central company. They use "automated market makers" (AMMs) — communal pools of tokens where a mathematical formula sets prices automatically. You trade against the pool, not against another person. Uniswap (Ethereum), Raydium (Solana), and PancakeSwap (BNB Chain) are the largest. Anyone can provide liquidity to these pools and earn trading fees.

Lending and borrowing protocols let people deposit crypto to earn interest, or borrow against their crypto holdings. There are no credit checks — borrowers must deposit more collateral than they borrow (overcollateralisation). If the collateral's value falls too close to the loan, it is automatically sold to repay the debt. Aave and Compound are the foundational protocols; Kamino and marginfi dominate on Solana.

Stablecoins are the backbone of DeFi — tokens that track $1 (or another stable value), making them essential for pricing, trading, and holding value without crypto volatility. Some (like USDC) are backed by real dollars. Others (like DAI) are backed by crypto collateral in smart contracts. Ethena's USDe uses a delta-neutral hedging strategy. Each approach involves different tradeoffs between stability, decentralisation, and risk.

Yield and liquidity strategies let people earn returns on idle crypto beyond simple lending rates. Yield farming involves moving assets between protocols to earn the highest available returns, often including protocol tokens as rewards. Liquid staking (via Lido or Jito) lets people earn Ethereum or Solana staking rewards while keeping their assets liquid and usable.

Derivatives allow traders to bet on price movements without owning the underlying asset, using leverage. Perpetual futures (perps) are the dominant instrument — offered by Hyperliquid, dYdX, GMX, and Drift, among others. These are high-risk instruments that amplify both gains and losses.

DeFi in India: what to know

DeFi is legal to use in India. All tokens and yields from DeFi activities are treated as Virtual Digital Assets (VDAs) under Indian law. Gains are taxed at a flat 30%, and 1% TDS applies on transfers. Importantly, losses from one DeFi activity cannot be offset against gains from another — each event is taxed independently. DeFi interactions often create many taxable events (each swap, each yield harvest, each liquidity withdrawal), so careful record-keeping is essential. See our India crypto tax guide.

The risks every DeFi user must understand

Smart contract risk: DeFi protocols are code, and code can have bugs. Several protocols have been hacked for hundreds of millions of dollars. Even audited, battle-tested protocols carry this risk. Newer protocols carry more.

Liquidation risk: If you borrow against collateral and the collateral falls in value, your position can be automatically liquidated (your collateral sold to repay the loan) before you can react.

Impermanent loss: Providing liquidity to a trading pool carries a specific risk: if the prices of the two tokens in the pool diverge, you can end up with less value than if you had simply held them. The trading fees you earn must outweigh this loss for liquidity provision to be profitable.

Oracle risk: Most DeFi protocols rely on "oracles" (external price feeds) to know what assets are worth. If an oracle is manipulated or goes wrong, the protocol can be exploited.

Scam and rug-pull risk: DeFi is permissionless, which means anyone can launch a protocol. Many are fraudulent, launching tokens only to drain the liquidity pool and disappear ("rug pull"). Stick to audited, established protocols.

DeFi protocols on the Codex