Decentralized Finance, or DeFi, aims to use technology to remove intermediaries between the parties in a financial transaction. In its simplest form, decentralized finance is a system in which financial products are made available on a public decentralized blockchain network so that they can be used by anyone instead of through middlemen like banks or brokers.
What makes DeFi different?
In contrast to a bank or brokerage account, a government ID, social security number, or proof of address is not required to use DeFi. More specifically, DeFi refers to a system where software written on blockchains enables buyers, sellers, lenders, and borrowers to interact peer-to-peer or with a purely software-based middleman rather than a company or one Institution that enables a transaction.
Several technologies and protocols are used to achieve the goal of decentralization. For example, a decentralized system can consist of a mixture of open-source technologies, blockchain, and proprietary software. Smart contracts, which automate the contractual terms between buyers and sellers or lenders and borrowers, make these financial products possible.
DeFi systems are designed to remove intermediaries between the transacting parties regardless of the technology or platform.
Although the volume of trade tokens and the money tied up in smart contracts in its ecosystem is growing steadily, DeFi is an emerging industry whose infrastructure is still being developed. Regulation and oversight of DeFi are minimal or nonexistent.
DeFi is expected to take over and replace the rails of modern finance in the future.
DeFi Explained
The use of technology in financial services is not new. Most transactions at banks or other financial service providers today are carried out with the help of technology. However, the role of technology is limited to facilitating such transactions. Companies still have to grapple with the legal gibberish of jurisdictions, competing for financial markets, and different standards to make a transaction possible.
With its stack of shared software protocols and public blockchains on which they are built, DeFi puts technology at the forefront of transactions in the financial services industry.
DeFi is commonly classified as part of the blockchain and cryptocurrencies. But its scope is much broader. To understand the lines of thought that led to the development of decentralized finance, it is essential to understand the current state of the financial ecosystem.
What makes DeFi different from the existing financial model
The modern financial infrastructure is built on a “hub” model. Major economic hubs like New York and London act as operational hubs for the financial services industry, influencing economic activity in the regional centers or financial powerhouses like Mumbai or Milan, which may not be as globally significant as the hubs but act as nerve centers for their markets.
This interdependence model is repeated in how global financial services groups work. They are headquartered in the hubs and have local offices, partnerships, or investments worldwide. Their reach has made such institutions essential to maintaining the equilibrium of the world economy.
Although this model has worked well over many centuries, the financial crisis and the subsequent global recession have revealed flaws in this architecture. The balance sheet problems of some large financial institutions created a domino effect that staggered the economy.
Decentralized finance uses technology to decouple centralized models and enable the delivery of financial services anywhere to anyone, regardless of race, age, or cultural identity.
DeFi services and apps are mostly built on public blockchains and either replicate existing offers built on the tracks of common technology standards or offer innovative services specially developed for the DeFi ecosystem.
At the same time, DeFi applications offer users more control over their money through personal wallets and trading services that are explicitly aimed at individual users and not at institutions.
What are the components of DeFi?
By and large, the components of DeFi are the same as those for existing financial ecosystems, meaning they require stable currencies and various use cases. Smart contracts form the framework for the functioning of DeFi apps, as they encode the conditions and activities necessary for the functioning of these services.
For example, a smart contract code has a specific code that sets out the exact terms of a loan between individuals. If certain conditions are not met, the collateral can be realized. All of this is done by a specific code and not manually by a bank or other institution.
All components of a decentralized financial system belong to a software stack. The components of each layer are designed to perform a specific function in building a DeFi system. Compatibility is a crucial feature of the stack, as the components of each layer can be put together to create a DeFi app.
The four layers of the DeFi stack
Settlement layer
The Settlement Layer is also known as Layer 0 because it is the base layer on which other DeFi transactions are built. It consists of a public blockchain and its native digital currency or cryptocurrency. Transactions that take place on DeFi apps are processed using this currency, which may or may not be traded in public markets.
An example of the settlement layer is Ethereum and its native token, Ether (ETH), which is traded on crypto exchanges. The settlement level can also have tokenized versions of assets, such as the US dollar, or tokens, which are digital representations of real-world assets. For example, a real estate token could represent ownership of a piece of land.
Protocol layer
Software protocols are standards and rules that are written to regulate specific tasks or activities. In parallel with real-world institutions, this would be a set of principles and rules that all participants in a particular industry have agreed upon as a prerequisite for working in the industry.
DeFi protocols are interoperable, which means that they can be used by multiple entities at the same time to create a service or app. The protocol layer ensures liquidity in the DeFi ecosystem.
Application layer
As the name suggests, consumer applications are located on the application layer. These applications abstract the underlying protocols into simple, consumer-oriented services. Most of the typical applications in the cryptocurrency ecosystem, such as decentralized cryptocurrency exchanges and lending services, reside at this level.
Aggregation layer
The aggregation layer consists of aggregators that combine different applications from the previous layer to offer a service to investors. For example, they can enable the seamless transfer of money between different financial instruments to maximize returns. In a physical setup, such trades would involve significant paperwork and coordination. But a technology-based framework should smooth the investment tracks and allow traders to switch between different services quickly. Lending and borrowing are examples of services on this layer.
The current status of DeFi
Decentralized finance is still in the early stages of its development. The total value tied in DeFi contracts is more than $ 48 billion as of May 2022.
The DeFi ecosystem is still riddled with infrastructural glitches and hacks. The rapidly evolving DeFi infrastructure is also teeming with scams. DeFi rug pulls, where hackers can steal a protocol and investors can no longer trade, are not uncommon, although there are well-established protocols that can significantly reduce this risk.
The decentralized financial ecosystem’s open and relatively distributed nature could also pose problems for existing financial regulation. The current laws are based on the idea of separate financial jurisdictions, each with its own set of laws and rules.
DeFi’s limitless transaction margin raises essential questions for this type of regulation. For example, who is guilty of a financial crime that occurs across borders, protocols, and DeFi apps?
Smart contracts are another area that is important for DeFi regulation. DeFi is the clearest example of the “code is law” thesis, in which the law is a set of rules written and enforced by immutable code. The smart contract algorithm is coded with the necessary constructs and conditions of use to carry out transactions between two parties.
Conclusion
As more and more people are drawn to DeFi apps, it’s hard to say where they will head to. Much depends on who finds it useful and why. Many believe that various DeFi projects have the potential to become the next Holy Grail by attracting hordes of new users. This, in turn, will make financial applications more inclusive and open to those who traditionally do not have access to such platforms.