What are the basics of Decentralized Finance (DeFi)?

Decentralized Finance (DeFi) refers to an ecosystem of financial applications built on public blockchains. The term was used for the first time in 2018 by the Ethereum community.

Unlike traditional finance, DeFi protocols are open, permissionless, and non-custodial, meaning anyone with a crypto wallet can access services such as trading, lending and borrowing without relying on intermediaries. The rules are encoded in smart contracts, ensuring transparency and security.

A key innovation in DeFi is composability, often described as “money Legos”. Because DeFi protocols are open-source and interoperable, users and developers can combine different applications to create new financial products.

Within this ecosystem, decentralized exchanges (DEXs) like Uniswap enable users to trade tokens. At the same time, lending and borrowing protocols like Aave and Compound allow users to earn interest on deposits or access liquidity against their crypto collateral.

A Decentralized Exchange (DEX) is a type of cryptocurrency trading platform that enables users to trade digital assets directly on a blockchain, without relying on centralized intermediaries like traditional exchanges or brokers. Instead of custodying funds, DEXs use smart contracts to facilitate peer-to-pool or peer-to-peer transactions, giving users full control over their assets and private keys. Liquidity is provided by users rather than centralized entities.

In this article, we’ll focus in peer-to-pool DEXs. They are far more popular than P2P DEXs because they offer instant execution, easier access, and abundant liquidity, making them the go-to choice for most traders and DeFi users, peer-to-pool dominates DEX trading volume.

In a peer-to-pool DEX, users trade against a liquidity pool rather than directly with another person. Each pool contains reserves of two tokens. Traders swap one token for another by interacting with the pool. Prices are determined automatically based on the ratio of tokens in the pool, using a predefined mathematical formula. This mechanism is called AMM (Automated Market Maker).

When a trader swaps tokens, the pool adjusts balances so that k remains constant. This automatically changes the token price: buying more of token A increases its price, selling lowers it.

• Anyone can deposit Token A and Token B at the current ratio in the pool and become an LP
• LPs earn a share of trading fees from swaps proportional to their share of the pool.

1. Trader chooses the token pair and amount to swap.
2. Smart contract calculates the output amount using the pool formula and deducts a small fee (e.g., 0.3%).
3. Tokens are swapped instantly and the pool balances are updated.
4. Fees are accumulated for LPs.

• No need for a counterparty; trades are instant.
• Always available as long as the pool has liquidity.

Uniswap  is one of the most widely used DEXs, the protocol pioneered the AMM model on Ethereum, allowing anyone to swap tokens or provide liquidity to earn fees in a fully permissionless and transparent way.

It is governed by UNI token holders. The UNI token is primarily a governance and ecosystem coordination token. It lets holders influence Uniswap’s development, treasury spending, etc.

Then UNI token is available on SQX, Swissquote’s regulated crypto trading platform that allows clients to buy, sell and custody digital assets securely.

A decentralized, non-custodial lending and borrowing protocol is a blockchain-based financial platform where users can lend their digital assets to earn yield or borrow against collateral without relying on intermediaries. “Non-custodial” means that users always retain control of their funds through smart contracts, rather than depositing them with a central authority. These protocols use transparent, automated rules coded into smart contracts to manage lending, borrowing, interest rates and liquidations, creating an open and permissionless money market.

How It works

Lending (Supplying Liquidity)

• Users deposit tokens (e.g., ETH, USDC) into a protocol’s liquidity pool.
• In return, they receive interest-bearing tokens (like aTokens in Aave or cTokens in Compound).
• These tokens automatically accrue value, reflecting earned interest over time.
• Lenders can withdraw their funds at any time, subject to liquidity availability.

Borrowing

• To borrow, users must supply collateral to the protocol.
• Each asset has a Loan-to-Value (LTV) ratio that defines how much can be borrowed against it (e.g., 75%).
• If collateral value drops and the health factor falls below 1.0, the position can be liquidated by third parties.

Interest Rate Model

• Interest rates are normally variable and algorithmically determined by supply and demand.
  • High utilization (more borrowed relative to supplied) = higher rates.
  • Low utilization = lower rates.
• This dynamic model ensures pools remain balanced and attractive for both lenders and borrowers.

Liquidations

• If the value of a borrower’s collateral falls too much, the loan becomes undercollateralized.
• Liquidators can repay part of the borrower’s debt and receive a portion of the collateral at a discount.
• This keeps the protocol solvent and protects lenders.

Aave was founded in 2017, originally under the name ETHLend. ETHLend was one of the earliest attempts at decentralized lending, operating as a peer-to-peer matching marketplace where individual lenders and borrowers were directly paired. While innovative, this model faced liquidity and efficiency challenges.

In 2020, ETHLend was rebranded and relaunched as Aave (meaning “ghost” in Finnish). Instead of peer-to-peer lending, Aave shifted to a pool-based liquidity model, where users deposit assets into smart contract pools and borrowers draw from them — making lending more efficient and scalable.

AAVE token powers governance, enabling holders to vote on protocol upgrades and risk parameters, and can also be staked in the “Safety Module” to backstop the system in exchange for rewards.

AAVE token can be purchased in SQX, Swissquote’s crypto-exchange. 

Compound, launched in 2018, is one of the earliest decentralized money market protocols. The native COMP token is primarily a governance token, allowing holders to propose and vote on protocol changes, including the addition of new assets, parameter adjustments and system upgrades.

COMP token can be purchased in SQX, Swissquote’s crypto-exchange.

The content in this article is provided for educational purposes only. It does not constitute investment advice, financial recommendations, or promotional material. Investing in digital assets carries a high degree of risk.