DeFi, short for decentralized finance, is a category of financial applications built on blockchain networks that operate without traditional intermediaries like banks, brokerages, or exchanges. Instead of relying on centralized institutions to facilitate transactions, DeFi protocols use smart contracts””self-executing code on blockchains like Ethereum””to automate lending, borrowing, trading, and other financial activities. When someone deposits cryptocurrency into a DeFi lending protocol like Aave, for example, the smart contract automatically matches them with borrowers and distributes interest payments without any bank employee ever touching the transaction. The practical significance for entrepreneurs and startups goes beyond the technology itself. DeFi represents both an investment landscape and a potential business model, with the total value locked in DeFi protocols fluctuating between $40 billion and $180 billion over recent years.
Some founders are building DeFi protocols directly, while others are exploring DeFi mechanisms for treasury management, fundraising, or payment infrastructure. This article covers how DeFi actually works, the major protocol categories, real risks and regulatory considerations, and what founders should understand before engaging with this space””whether as builders or users. Understanding DeFi requires separating the genuine technological innovation from the considerable hype that surrounds it. The core premise is sound: programmable money can eliminate certain inefficiencies and access barriers in traditional finance. But the execution remains uneven, with some protocols proving remarkably resilient while others have collapsed spectacularly, taking billions in user funds with them.
Table of Contents
- How Does DeFi Work Without Banks or Intermediaries?
- The Major Categories of DeFi Protocols
- Why Entrepreneurs Are Watching DeFi Closely
- Getting Started With DeFi: Practical Considerations
- The Risks That Have Destroyed DeFi Projects and User Funds
- How DeFi Compares to Traditional Startup Financing
- The Future of DeFi for Founders and Startups
- Conclusion
How Does DeFi Work Without Banks or Intermediaries?
Traditional financial systems rely on trusted third parties to verify identities, hold assets, execute trades, and enforce agreements. Your bank confirms you have funds before processing a payment. A stock exchange matches buyers with sellers. A title company verifies property ownership. These intermediaries charge fees, set operating hours, and can deny service to anyone they choose. DeFi replaces these intermediaries with smart contracts””code deployed on a blockchain that executes automatically when predefined conditions are met.
When you interact with a DeFi protocol, you’re not asking permission from a company; you’re triggering code that runs exactly as written. If the smart contract says borrowers must maintain 150% collateral or face liquidation, that liquidation happens automatically when prices drop, whether it’s Tuesday afternoon or Sunday at 3 AM. The blockchain serves as a shared ledger that everyone can verify, eliminating the need to trust any single institution. However, “trustless” doesn’t mean “risk-free.” While you don’t need to trust a bank, you’re instead trusting that the smart contract code has no exploitable bugs, that the blockchain itself remains secure, and that the economic incentives built into the protocol won’t break down under stress. Several major DeFi protocols have lost hundreds of millions of dollars to code exploits. The Wormhole bridge lost $320 million in 2022 when hackers exploited a vulnerability in its smart contracts. Removing traditional intermediaries eliminates some risks while introducing entirely new ones.
The Major Categories of DeFi Protocols
DeFi encompasses several distinct protocol types, each replicating””and sometimes improving upon””traditional financial services. Decentralized exchanges (DEXs) like Uniswap and Curve allow users to swap tokens without a centralized order book. Instead of matching buyers with sellers, they use liquidity pools and automated market makers to determine prices algorithmically. Users who provide liquidity to these pools earn a share of trading fees. Lending protocols like Aave and Compound allow users to deposit cryptocurrency as collateral and borrow other assets against it.
Interest rates adjust automatically based on supply and demand within each pool. If a borrower’s collateral value drops too close to their loan value, the protocol liquidates their position automatically. These protocols have processed billions in loans without credit checks””because they’re overcollateralized, the protocol doesn’t care about the borrower’s creditworthiness. Stablecoins represent another crucial DeFi category, providing price-stable assets that can be used within DeFi without exposure to cryptocurrency volatility. Some stablecoins like USDC are backed by dollars held in bank accounts, while algorithmic stablecoins like DAI are backed by cryptocurrency collateral and maintained through smart contract mechanisms. The distinction matters: algorithmic stablecoins can depeg catastrophically, as demonstrated when TerraUSD collapsed from $18 billion to essentially zero in May 2022.
Why Entrepreneurs Are Watching DeFi Closely
For founders, DeFi presents opportunities on multiple fronts. Some startups are building infrastructure for the DeFi ecosystem””wallet providers, analytics platforms, security auditing firms, and bridges connecting different blockchains. Companies like Chainalysis and Fireblocks have raised hundreds of millions in venture funding to serve this market. The picks-and-shovels approach lets founders benefit from DeFi growth without building protocols themselves. Other entrepreneurs are exploring DeFi mechanisms for their own operations.
A startup holding cryptocurrency on its balance sheet might use DeFi lending protocols to earn yield on idle assets, or borrow stablecoins against crypto holdings to fund operations without triggering taxable sales. Some DAOs (decentralized autonomous organizations) have used DeFi rails to manage treasuries collectively, with token holders voting on fund allocation. If you’re considering DeFi for treasury management, understand that smart contract risk doesn’t appear on any balance sheet. A yield of 5% means nothing if the protocol gets exploited and you lose your principal. The safest DeFi positions””established protocols, blue-chip collateral, conservative leverage””offer yields often not dramatically higher than traditional alternatives once you factor in the risk. Founders should question whether the additional complexity and risk are justified by the returns.
Getting Started With DeFi: Practical Considerations
Interacting with DeFi requires a self-custody cryptocurrency wallet like MetaMask, a hardware wallet like Ledger, or increasingly, smart contract wallets like Safe that add features like multi-signature requirements. Unlike traditional finance, there’s no customer service to call if you send funds to the wrong address or approve a malicious transaction. You’re responsible for your own security, which means understanding phishing attacks, verifying contract addresses, and maintaining secure backups of wallet recovery phrases. The onramp from traditional finance to DeFi typically runs through centralized exchanges like Coinbase or Kraken, where you convert dollars to cryptocurrency before transferring to your wallet. This creates a regulatory touchpoint and paper trail””centralized exchanges comply with know-your-customer requirements and report to tax authorities.
Once funds are in DeFi, transactions are pseudonymous but not anonymous; every interaction is recorded on a public blockchain. Comparing DeFi options requires evaluating factors that don’t exist in traditional finance. Protocol governance matters””who can change the smart contracts, and under what conditions? Audit history reveals whether security researchers have examined the code. Total value locked indicates user confidence but doesn’t guarantee safety. Newer protocols often offer higher yields to attract users, but those yields frequently reflect higher risk rather than superior efficiency. The comparison isn’t just yield versus yield; it’s risk-adjusted return accounting for factors that are genuinely difficult to quantify.
The Risks That Have Destroyed DeFi Projects and User Funds
Smart contract exploits represent the most dramatic DeFi risk. Hackers have stolen billions by finding vulnerabilities that developers missed. Some exploits target logical errors in how protocols calculate prices or handle edge cases. Others exploit the composability of DeFi””the way protocols interact with each other””to create conditions the original developers never anticipated. Even audited protocols have been exploited; audits reduce risk but don’t eliminate it. Economic design failures can collapse protocols even without code exploits. When the Terra/Luna ecosystem imploded in May 2022, the smart contracts worked exactly as designed””the design itself was flawed.
The algorithmic stablecoin lost its dollar peg, triggering a death spiral that erased roughly $45 billion in value. Founders considering stablecoin holdings should understand the difference between fully-backed stablecoins (like USDC, where each token is backed by dollars in a bank account) and algorithmic or partially-backed alternatives. Regulatory risk looms over the entire sector. The SEC has taken enforcement actions against several DeFi projects, and the legal status of many activities remains unclear. A protocol that’s legal today might face enforcement tomorrow. For entrepreneurs, this uncertainty affects both building DeFi projects (potential regulatory liability) and using them (potential for accounts to be frozen or protocols to be forced offline). The November 2023 enforcement action against Kraken for its staking services demonstrated that regulatory risk extends beyond obvious securities law violations.
How DeFi Compares to Traditional Startup Financing
Traditional startup financing runs through established channels with well-understood rules. You pitch VCs, negotiate term sheets, issue equity, and comply with securities regulations. The process is slow, gatekept, and expensive””but it’s legally clear and provides founders with experienced investors who add value beyond capital. Some crypto-native startups have raised funds through token sales, selling governance or utility tokens rather than equity. This approach offers speed and access to a global investor base, but it operates in a regulatory gray zone.
Many token sales have later been deemed unregistered securities offerings by the SEC, resulting in fines and forced refunds. The legal landscape varies by jurisdiction, with some countries establishing clearer frameworks than others. For most traditional startups, DeFi financing is not a viable alternative to conventional fundraising. The regulatory risk is too high, the investor base is different (crypto speculators rather than strategic partners), and the legal structures don’t map cleanly onto corporate governance. Where DeFi becomes relevant is in specific use cases: crypto-native startups raising from crypto-native investors, or established companies exploring DeFi mechanisms for specific treasury or payment functions.
The Future of DeFi for Founders and Startups
Institutional adoption is gradually increasing, with traditional financial firms building DeFi products or acquiring crypto-native companies. JPMorgan has experimented with on-chain tokenized deposits. BlackRock launched a tokenized money market fund on Ethereum. This institutional interest legitimizes DeFi but also pressures the decentralization that made it distinctive.
As regulated entities enter the space, they bring compliance requirements that may reshape what DeFi looks like. For founders, the pragmatic path is to monitor developments without betting the company on any particular outcome. The startups best positioned for DeFi’s future are those building infrastructure that serves both decentralized and institutional use cases””security, compliance, analytics, and interoperability tools. The pure DeFi plays from 2020-2021 have largely consolidated or failed, while infrastructure providers continue raising funds and signing enterprise customers.
Conclusion
DeFi represents a genuine technological innovation””programmable, permissionless financial infrastructure””wrapped in considerable speculation and regulatory uncertainty. For entrepreneurs, it offers opportunities as both a building space and a set of tools, but those opportunities come with risks that don’t exist in traditional finance: smart contract exploits, economic design failures, and regulatory crackdowns that can appear without warning.
The founders who navigate DeFi successfully tend to approach it with clear-eyed pragmatism rather than ideological commitment. They understand the technology well enough to evaluate risks, maintain security practices appropriate for self-custody assets, and treat DeFi yields as compensation for real risks rather than free money. Whether DeFi becomes a foundational layer of future finance or remains a niche experiment, the underlying skills””understanding smart contracts, evaluating protocol economics, managing cryptographic security””are increasingly relevant for any founder operating in adjacent spaces.