Decentralized finance, or DeFi, is a system by which financial products become available on a decentralized public blockchain network. This makes them accessible to everyone, rather than going through intermediaries like banks or brokerage houses. Unlike a bank or brokerage account, a government issued ID, Social Security number, or proof of address is not required to use DeFi. More specifically, DeFi refers to a system whereby software written on blockchains allows buyers, sellers, lenders and borrowers to interact with peers or with a strictly software intermediary rather than a company or institution facilitating a transaction.
Multiple 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 that automate the terms of agreements between buyers and sellers or lenders and borrowers make these financial products possible. Regardless of the technology or platform used, DeFi systems are designed to remove the middleman between the parties to the transaction.
Although the volume of trade tokens and money stuck in smart contracts in its ecosystem has grown steadily, DeFi is a fledgling industry whose infrastructure is still being built. Regulation and oversight of DeFi is minimal or absent.
Key points to remember
- Decentralized finance, or DeFi, aims to use technology to remove intermediaries between parties in a financial transaction.
- The components of DeFi are stable parts, use cases, and a software stack that enables application development.
- DeFi’s infrastructure and use cases are still in development.
What is DeFi?
The use of technology in financial services is not new. Nowadays, most transactions in banks or other financial services companies are done using technology. However, the role of technology is limited to facilitating such transactions. Businesses always have to contend with the legal jargon of jurisdictions, competing financial markets, and different standards to make a transaction possible. With its stack of common software protocols and public blockchains on which to build them, DeFi puts technology at the forefront and at the center of transactions in the financial services industry.
DeFi is generally placed in the area of blockchain and cryptocurrencies. But its scope is much wider. To understand the thought processes that led to the development of decentralized finance, it is important to understand the current state of the financial ecosystem.
Modern financial infrastructure is built on a “hub and spoke” model. The main centers of economic activity, such as New York and London, function as operational centers for the financial services industry and influence economic activity at the shelf level – regional centers or financial powers like Mumbai or Milan that can not be as important as the centers but which still function as the nerve centers of their respective economies.
Economic prosperity or hardship radiates out of the centers to the shelves and to the rest of the world economy. This pattern of interdependence is repeated in the operation of global financial services companies. They have head offices in local hubs and branches, partnerships or investments around the world. The spread of their operations means that the organization itself is subject to a set of laws and regulations in each of its financial jurisdictions. Their reach has made these institutions systemically important to maintain the balance of the world economy and necessary to maintain or create new financial services infrastructures.
Although this model worked well in the last century, the financial crisis and, subsequently, the Great Recession, exposed the flaw in this architecture. The balance sheet problems of a few large financial institutions produced a domino effect of collapsing economies and the onset of the global recession.
Decentralized finance uses technology to disintermediate centralized models and enable the provision of financial services anywhere for anyone, regardless of ethnicity, age or cultural identity. DeFi services and applications are mostly built on public blockchains, and they either replicate existing offerings built on the rails of common technology standards, or they offer innovative services tailored to the DeFi ecosystem. At the same time, DeFi apps give users more control over their money through personal wallets and trading services that explicitly cater to individual users rather than institutions.
What are the components of DeFi?
On a general level, the components of DeFi are the same as those of existing financial ecosystems, which means they require stable currencies and a wide variety of use cases. DeFi components take the form of stablecoins and services like crypto exchanges and lending services. Smart contracts provide the framework for the operation of DeFi applications as they encode the terms and activities necessary for the operation of these services. For example, a smart contract code has a specific code that establishes the exact terms of a peer-to-peer loan. If certain terms or conditions are not met, the guarantee could be canceled. All of this is done via a specific code rather than manually by a bank or other institution.
All the components of a decentralized financial system belong to a software stack. The components of each layer are intended to perform a specific function in building a DeFi system. Composability is a defining characteristic of the stack because the components belonging to each layer can be composed together to shape a DeFi application.
The four layers that make up the DeFi stack are described below:
- Settlement Layer: The settlement layer is also referred to as Layer 0 because it is the base layer upon which other DeFi transactions are built. It consists of a public blockchain and its native digital currency or cryptocurrency. Transactions made on DeFi applications are settled using this currency, which may or may not be traded on public markets. An example of the stand layer is Ethereum and its Native Token Ether (ETH), which is traded in crypto exchanges. The settlement layer can also have tokenized versions of assets, such as US dollars, or tokens which are digital representations of real world assets. For example, a real estate token can represent ownership of a parcel of land.
- Protocol Layer: Software protocols are standards and rules written to govern specific tasks or activities. Along with real-world institutions, this would be a set of principles and rules that all participants in a given industry have agreed to follow as a prerequisite for operating 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 an application. The protocol layer provides liquidity to the DeFi ecosystem. An example of a DeFi protocol is Synthetix, a protocol for trading derivatives on Ethereum. It is used to create synthetic versions of real world assets.
- Application Layer: As the name suggests, the Application Layer is where consumer-facing applications reside. These applications summarize the underlying protocols into simple consumer-centric services. The most common applications of the cryptocurrency ecosystem, such as decentralized cryptocurrency exchanges and lending services, reside on this layer.
- Aggregation layer: The aggregation layer consists of aggregators that connect various applications from the previous layer to provide a service to investors. For example, they can allow the transparent transfer of money between different financial instruments in order to maximize returns. In a physical setup, such business actions would involve considerable paperwork and coordination. But a technology-based framework should smooth the investment rails, allowing traders to quickly switch between different services. Lending and borrowing is an example of a service that exists on the aggregation layer. Other examples are banking services and crypto wallets.
The current state of DeFi
Decentralized finance is still in the early stages of its evolution. Total value locked in DeFi contracts is over $ 41 billion, as of March 2021. The total locked value is calculated by multiplying the number of tokens in the protocol and their value in USD. While the total DeFi figure may seem substantial, it is important to remember that it is theoretical as many DeFi tokens lack sufficient liquidity and volume to trade in the crypto markets.
The DeFi ecosystem is still riddled with infrastructure issues and hackers. Scams abound in the rapidly evolving DeFi infrastructure as well. DeFi “carpet draws”, in which hackers drain a protocol of funds and investors are unable to negotiate, are common, although there are well-established protocols that can significantly reduce this risk.
The open and relatively distributed nature of the decentralized finance ecosystem could also pose challenges for existing financial regulation. Current laws have been developed based on the idea of separate financial jurisdictions, each with its own set of laws and rules. The extent of DeFi’s borderless transactions raises important questions for this type of regulation. For example, who is guilty of a financial crime that occurs across borders, protocols and DeFi applications?
For example, what if an incorrect entry causes a system to crash? Or, if a compiler (which is responsible for compiling and running the code) gets it wrong. Who is responsible for these changes? These questions and more must be resolved before DeFi becomes a mainstream system used by the masses.