The Elements of DeFi Explained

DeFi’s rapid rise in the past year has been credited to its vast space for innovation, from new token models to new governance structures to new platforms, with more to come. We revisit the basic elements that continue to fuel its growing influence.

Decentralized finance (DeFi), in its most basic form, is a framework through which fiscal products are made available on an open decentralized blockchain network. That way anybody who’d like to use them can access them instead of going through intermediaries such as brokerages or banks. Unlike a brokerage or bank account, DeFi does not require proof of residence, a social security number, or a government-issued identification.

In a system powered by DeFi, sellers, buyers, borrowers, and lenders engage peer-to-peer or with a solely software-based intermediary instead of a corporation or institution mediating a transaction using software built on the blockchain technology. 

To meet the objective of decentralization, a variety of protocols and technologies are employed. A decentralized system, for instance, could be made up of blockchain, open-source technology, and proprietary software. The fiscal products are made feasible by smart contracts, which automate the terms of an agreement between lenders and borrowers or buyers and sellers. DeFi solutions are meant to eliminate middlemen between parties involved, irrespective of the platform or technology employed.

Even as the amount of money and trading tokens held in smart contracts on its network have been on the rise, DeFi remains a young sector with a nascent infrastructure. It is subject to little or no regulation and monitoring. Some see in the coming years, the potential for DeFi to challenge, even supersede, the global financial system as we know it today.

What Exactly Is Decentralized Finance?

Technology’s usage in financial institutions is certainly not new; nowadays technology helps to complete the majority of operations at banks and other financial institutions. Nevertheless, its function is limited to that of a mediator. Companies must still navigate the legalese of many governments, competitive financial markets, and differing standards to complete a transaction. DeFi, with its public blockchains and network of standard software frameworks, places innovation at the forefront of financial transactions.

DeFi is frequently associated with cryptocurrency and blockchain technology, yet it has a far broader reach. It’s helpful to look at the current financial system to comprehend the thought patterns that contributed to the emergence of decentralized finance.

The “hub-and-spoke” concept has been central to the modern economic and financial systems. London and New York, for example, serve as financial centers, emanating economic growth in spokes. Global financial institutions operate from hubs around the world, directing their investments, partnerships, and local branches. Their size and scope make them critical to the world’s economic stability and the continued progress of its financial systems.

Although this model functioned effectively in the previous century, the economic meltdown and, as a result, the Great Recession exposed its weakness. A chain reaction of collapsing markets and the start of the financial crisis resulted from the balance sheet issues of a few major banking institutions.

DeFi utilizes technological systems to “democratize” finance and allow everyone to access financial products from anywhere around the globe. The majority of DeFi applications and services are developed on blockchain networks, either mimicking current products established based on common technological standards or producing unique services tailored to DeFi. DeFi apps, on the other hand, offer consumers greater autonomy over their funds via trading platforms and personal wallets that cater to individuals rather than organizations.

What Are the Elements of DeFi?

On a broad scale, the elements of DeFi are just like those for traditional financial systems – this means that they need stable legal tenders and a wide range of use cases. Crypto exchanges, lending services, and stablecoins are typical components of DeFi.

Smart contracts offer an essential platform for DeFi applications, encapsulating the conditions and actions required for the applications to function. A smart contract program, for example, contains a particular code that defines the precise details and circumstances of a financial obligation between parties. Collateral may be liquidated if specific terms or circumstances are not satisfied. Everything is done via a code instead of through a financial institution.

A software stack contains all of the elements of a DeFi system, and each tier’s constituents are designed to fulfill a particular role in the design. Composability is a distinguishing feature of the stack since the modules of each layer may be combined to create a DeFi application. The multiple layers that make up the DeFi stack are described below:

  • Settlement Layer

This layer, also known as Layer 0, serves as the foundation for all subsequent DeFi activities. It is made up of a cryptocurrency and a public blockchain. This coin, which may or may not be exchanged on public marketplaces, is used to complete payments on DeFi applications. Ethereum and Ether, which are exchanged on cryptocurrency trading platforms, are examples of the settlement layer. Tokenized forms of assets, like the USDT, or other digital assets that are a virtual depiction of real-world assets can be used at the settlement tier. A real estate token, for instance, may indicate the ownership of a piece of property.

  • Protocol Layer 

In DeFi, software protocols are defined norms and regulations that govern certain tasks or operations. It provides a set of rules and principles that all players in a specific industry have committed to obeying as a condition of functioning in the sector, similar to those in real-world scenarios. DeFi procedures are intended to be widely compatible, which means they may be utilized by various companies to create an app or service simultaneously. The protocol layer gives the DeFi network stability. An example is Synthetix, an Ethereum-based derivative trading system that is utilized to make digital replicas of real-world financial assets.

  • Application Layer

The application layer is the consumer-facing part of the DeFi application. The core protocols are abstracted into concise consumer-focused functions in these applications. This layer houses the majority of the crypto ecosystem’s key advantages, such as loan services and decentralized cryptocurrency exchanges.

  • Aggregation Layer

Aggregators integrate multiple apps from the preceding layer to give a service to shareholders in the aggregate layer. They may, for example, make it possible to move funds seamlessly across various financial products to optimize profits. Such trading operations would need a lot of documentation and organization in a physical setting. A technology-based structure, on the other hand, would streamline the investment rails, letting traders quickly switch between various services. On the aggregation level, borrowing and lending are two examples of services. Other examples include cryptocurrency wallets and banking services.

The Contemporary Position of Decentralized Finance  

Towards the end of the first quarter of 2021, the overall value of DeFi deals reached more than $41 billion. That number is calculated by multiplying the token amounts in the scheme and their dollar equivalent. While that overall amount for DeFi may appear large, it’s essential to realize that it’s only a theoretical number because several DeFi coins lack adequate volume and liquidity to trade on crypto exchanges.

Infrastructural failures and hackers continue to plague the DeFi ecosystem. Frauds also run deep in the fast-evolving DeFi ecosystem. Decentralized finance “rug pulls,” wherein attackers deplete a protocol of financial resources and shareholders are unable to transact, are prevalent. Although certain protocols can mitigate this risk.

The relatively distributed and open nature of the DeFi ecosystem could also spell trouble to existing economic and financial policy. Existing rules are founded on the concept of different market jurisdictions, each jurisdiction with its set of regulations and laws. The boundless transaction range of DeFi raises major challenges for those regulatory parameters. Who is responsible for a money laundering case that happens across countries, networks, and DeFi applications, for instance?

Another topic of interest for DeFi management is smart contracts. Besides Bitcoin’s bull run, DeFi is the best representation of the “code is law” theory, whereby law is defined as a collection of rules established and implemented by indelible code. The program of a smart contract is pre-programmed with the essential structures and terms of service to perform transactions between two people. Software systems, on the other hand, might fail for a variety of reasons.

What if a system crashes as a result of an erroneous input? Or if the app’s compiler (responsible for building and executing code) makes a mistake. Who is responsible for these modifications? Before De-Fi becomes a widely utilized technology, these issues, and other issues must be addressed.

What Are the Main Advantages of DeFi?

De-Fi is predicated on blockchain technology, which is often thought of as a generic protocol stack. DeFi is considered a collection of second-layer apps — thus, its built-in, essential characteristic of decentralization. It’s worth noting that this only applies if the blockchain is autonomous in the first place.

The main advantages of DeFi are associated with the key advantages of blockchain if these prerequisites are met:

  • Genuine decentralization eliminates the need for third parties, thus preventing financial crises attributed to the high concentration of economic power in the hands of few financial institutions. It also enables wider access to financial services participation irrespective of social standing. 
  • The use of blockchain as a financial network infrastructure creates space for relatively low-cost and efficient settlement, transactions, contract automation, and financial contract management. 
  • DeFi apps often enable the user to maintain control of the financial information. In the blockchain network, this is known as non-custodial. The operator is in full control of the fund without the interference of a reliable third-party. 
  • Market efficiency and price are improved as a result of greater ecosystem openness. Information asymmetry is absent, and individual interests are regulated by a clear procedure; therefore, principal-agent hazards are negligible.

One of the biggest current DeFi deals, for instance, locks in $10 million without a third-party or bank account, and the client retains ownership of the base crypto at all times.

In comparison, in the conventional financial world, huge resources are spent towards a process of trust formation, which comes at the expense of excessive centralization (like the too-large-to-fail financial institutions), openness (the 2008 economic collapse), and regulatory discrimination in some countries. 

DeFi might have prevented the 2008 financial crisis with the distributed ledger system ensuring access to financial details of the major institutions responsible and also with the decentralization of financial activities, thereby preventing trust issues. 

Furthermore, the current system has yet to catch up with the technological age in terms of cost and efficiency, and DeFi has the potential to push forward that progress. On average, an international transaction requires three business days and with fees running at around 6.8%. With DeFi, funds can be transferred from a person in China to someone in Argentina within minutes and with negligible transaction fees.

 

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