What is decentralized finance?

Decentralized finance works by replacing the intermediary of a financial service with a smart contract. In traditional finance a bank, exchange or fund manager keeps private records and carries out the contract. In DeFi a protocol, a set of smart contracts on a public blockchain, does both, and the records sit on the chain.

In simple terms, DeFi does the work of banks and exchanges with code that anyone can inspect on the chain. The Bank for International Settlements (BIS) groups the services into trading, lending and investment. Stablecoins connect them: they let users move funds between platforms without converting to and from fiat money at every step.

Decentralized finance applications are the protocols that offer one service each, such as an exchange or a lending pool. Decentralized finance examples are decentralized exchanges, lending protocols and stablecoins. The BIS compares them with their counterparts in traditional finance.

Outside data such as market prices reach these protocols through a blockchain oracle.

DeFi lending works with collateral worth more than the loan. The BIS gives the reason: lenders cannot trust anonymous borrowers, and crypto collateral is volatile. When the ratio of collateral to loan falls below a threshold, the protocol sells the collateral automatically. The need for crypto collateral "stands in the way of lending to households and businesses", for example for house purchases.

DeFi also offers flash loans. A flash loan has zero duration: the borrower takes the loan, trades and repays principal and interest in the same block. The protocol grants it only if the trade ensures that repayment.

Decentralized finance is less decentralized than its name suggests. The BIS speaks of a "decentralisation illusion" because "the need for governance makes some level of centralisation inevitable". Every DeFi platform has a governance framework. Holders of governance tokens, often the developers, vote on proposals much like shareholders.

The BIS adds that these governance structures give authorities natural reference points for questions of financial stability, investor protection and illicit activity.

Decentralized finance carries the risks of traditional finance plus risks of its own. The Financial Stability Board (FSB) concludes that DeFi "does not differ substantially from traditional finance in the functions it performs or the vulnerabilities to which it is exposed". It names operational fragilities, liquidity and maturity mismatches, leverage and interconnectedness. Crypto-assets "lack inherent value and are highly volatile", and the FSB says this magnifies the impact of these weaknesses (FSB, February 16, 2023).

The European Securities and Markets Authority (ESMA) sees "serious risks to investor protection", among them "the lack of a clearly identified responsible party". It also lists new forms of market manipulation such as maximal extractable value and flash loan attacks (ESMA, October 11, 2023).

DeFi regulation in the EU starts with MiCA, which applies directly in Germany and Austria. Its recital 22 draws the line: MiCA applies to crypto-asset services "including when part of such activities or services is performed in a decentralised manner", but "where crypto-asset services are provided in a fully decentralised manner without any intermediary, they should not fall within the scope of this Regulation". Whether a DeFi service has an intermediary is a question for the single case. A firm that provides crypto-asset services needs an authorization under Article 59. BaFin supervises in Germany, the FMA in Austria.

The Deutsche Bundesbank, whose head office is in Frankfurt am Main, described DeFi in its Monthly Report of July 2021 as applications that replace "intermediaries such as banks, exchanges or insurers". It also found that DeFi applications used in practice "employ centrally managed governance processes", for example to fix code bugs (Bundesbank, July 2021).

Article 142 of MiCA asked the European Commission for a report by December 30, 2024 with "an assessment of the necessity and feasibility of regulating decentralised finance".

Switzerland is outside the EU, so MiCA does not apply there. FINMA judges tokens by their "economic function and purpose", as set out in its ICO guidelines of February 16, 2018. This page gives no legal advice.