DeFi Protocols Explained

Understanding DeFi Protocols

DeFi Protocols are decentralised financial services implemented as programs governed by predefined rules written in code (smart contracts). These protocols operate autonomously based on predefined smart contract logic, with limited external influence through governance mechanisms and oracles.

What Are DeFi Protocols?

The DeFi Protocol definition refers to a financial service implemented in the form of a program that contains predefined rules written in code (also known as smart contracts).

These rules regulate transactions autonomously and without outside influence.

Definition and Key Features of DeFi Protocols

A distinctive feature of DeFi Protocols is their decentralisation, meaning that they generally do not have a single centralized authority, although protocol rules may be modified through governance mechanisms or privileged roles. This decentralised nature significantly affects usability, as most DeFi Protocols do not require registration or KYC procedures — users typically only need a third-party crypto wallet to interact with the protocol.

Differences Between DeFi and Traditional Finance

While in traditional financial institutions, such as banks, issues related to exchange, lending, or the transfer of funds are handled by employees, i.e. real people, DeFi Protocols allow these operations to be carried out completely independently, without the need to involve any individuals in the process. In addition, since the information and rules for conducting transactions are embedded in the code itself, direct human involvement in transaction execution is minimized, although governance and protocol upgrades may involve human decision-making, which can have a positive impact on the reliability, speed, and efficiency of transactions performed via DeFi Protocols.

Moreover, in traditional banks, a client’s money is under the control of the bank, which may freeze or restrict the use of funds in accordance with a regulator’s decision. DeFi protocols do not hold funds in the traditional custodial sense; instead, funds are locked within smart contracts.

Additionally, in traditional finance, access to the services of a particular institution may be limited depending on credit history, national legislation, or documentation requirements.

DeFi is generally more accessible, although access may be restricted by technical, regulatory, or front-end limitations.

Types and Examples of DeFi Protocols

In general, there are a large number of types of DeFi Protocols, but the main types include:

• Decentralised exchanges (DEX) — allow tokens to be exchanged directly between users without the need for an intermediary; all operations are performed automatically in accordance with the protocol code.

• Lending protocols — designed for users who want to lend or borrow crypto assets. The entire mechanism operates on the basis of collateral provided by the user, against which a loan is issued.

• Stablecoin protocols — aim to create a token with a stable price. As a rule, such tokens are pegged to the exchange rate of a specific fiat currency, such as USD or EUR.

Most Popular DeFi Protocols in 2025

Among the most popular DeFi Protocols in 2025 are Uniswap, Curve, and Compound, each of which can be considered a DeFi protocol example with its own characteristics and usage mechanics, allowing users to choose the protocol that is the best option for their situation.

• Uniswap is suitable for fast token exchanges when users need to swap tokens without relying on a centralised exchange.

• Curve is also used for exchanges, but it is specifically optimised for stablecoins and assets with similar prices; as a result, it often offers more favourable rates for stablecoin pairs.

• Compound is designed for lending and deposits. For example, users can supply assets to earn interest or borrow assets against collateral.

How DeFi Protocols Work

As with any other program, DeFi’s core functionality is based on written code, often referred to as a smart contract. This code defines the conditions for executing transactions and establishes the applicable rules. DeFi code is designed to operate autonomously, which means direct intervention in transaction execution is limited, though transaction ordering, oracle data, and governance decisions may affect outcomes.

To get started, a user must connect their crypto wallet to a DeFi Protocol and approve an action (such as an exchange or deposit). DeFi Protocol then performs the action independently, by following the written code.

Core Mechanisms: Lending, Borrowing, and Liquidity Pools

The main mechanisms most commonly used in DeFi Protocols are lending, borrowing, and liquidity pools.

Lending works as follows: the user enters into a smart contract under which their cryptocurrency is transferred to a DeFi protocol. These funds are then combined with the assets of other users to form a common pool. Users who wish to borrow funds can access assets from this pool, while those who supply and maintain it receive interest. In many respects, this mechanism is similar to a deposit in a traditional bank; however, in DeFi, all operations are performed automatically in accordance with the code. Key risks include smart contract vulnerabilities, oracle failures, liquidation risks, and market volatility, which may result in an irretrievable loss of funds.

Borrowing allows users to access other users’ assets for their own purposes. As with lending, all actions are executed automatically based on the program code. A key drawback of this mechanism is the frequent requirement for overcollateralisation: for example, to borrow USD 100, a user may need to provide collateral worth USD 100–150. In addition, a sharp decline in the value of the collateral may trigger its automatic liquidation in accordance with the smart contract terms.

A liquidity pool is a shared pool of funds contributed by users to ensure the proper functioning of the protocol and to earn returns. For stable operation, such pools must be continuously maintained by users. In practice, liquidity pools form the financial foundation of DeFi protocols, as the protocols themselves do not hold funds independently. As with other mechanisms, there is a risk of smart contract errors leading to the loss of funds. Additionally, by locking assets in a pool, users are exposed to the risk of significant token price fluctuations.

How to Create a DeFi Protocol

First, determine what function the protocol performs. Next, select the blockchain on which it will operate. Then, define the protocol rules in code, such as commission fees and interest calculation mechanisms. After that, design and test the smart contract architecture to ensure it works correctly. Finally, integrate wallets, conduct security audits, deploy the contracts, and establish governance and risk controls before launch.

FAQ on DeFi Protocols

What are the best DeFi protocols?

There is no universal best DeFi protocol, it's all individual and depends on the specific purpose for which a DeFi protocol is used. However, in general, it is possible to highlight several well-established protocols with proven models, significant scale, and strong reputations, such as Uniswap, Curve, and Compound.

How do DeFi protocols work?

Their operation is based on the complete automation of processes in accordance with the conditions specified in the smart contract.

Are DeFi protocols safe for businesses?

DeFi protocols are not entirely secure. Regardless of the specific protocol used, technical risks and, to some extent, regulatory risks will always remain.