You may have heard the term “DeFi” flying around. What is DeFi?
An abbreviation of Decentralized Finance, DeFi is an umbrella term for financial transactions that disrupt the traditional, centralized banking approach of most major financial institutions.
Today, these disruptive transactions happen most commonly in the worlds of blockchain and cryptocurrency.
DeFi financial products and applications are made available on a public blockchain network to anyone. This allows them to sidestep the need for financial institutions such as banks or brokerages that serve as “middlemen” for traditional transactions.
Whether you are buying, selling, or lending, DeFi allows you to engage in a peer-to-peer transaction without the need for a centralized institution.
This article will offer a deep dive on the topic of DeFi and cover:
- how DeFi works
- the DeFi tech stack
- real-world use cases of DeFi and
- how centralized institutions can take advantage of this momentum and use blockchain without losing control over financial transactions.
What is Defi
What is DeFi? DeFi (or Decentralized Finance) is an ecosystem that helps you make financial transactions without the mediation of banks, brokerages, or other financial institutions.
Most of us know the pain of transferring funds from one bank to another. The process can be so slow, and we often find ourselves slapped with additional service fees. This is where decentralized finance steps in, providing faster solutions for P2P financial transactions, with no middlemen and gatekeepers and no more annoying fees.
DeFi layers run on blockchain and cryptocurrency technologies, where all the transactions are recorded and stored in encrypted code rather than by some third-party financial institution. Thanks to cryptographic algorithms, this makes transactions more reliable and transparent. Customers gain more control over their financial operations without the need for intermediaries.
DeFi software has different use cases and can substitute most of the services provided by banks: payment transactions, P2P borrowing, derivatives, and trading. There are different types of DeFi software exist, such as decentralized exchanges, lending and borrowing platforms, stablecoins, yield farming, and decentralized identity platforms.
In summary, fintech and DeFi give customers unprecedented control over their financial assets. With no accounts or gatekeepers, users can directly interact with their digital wallets through smart contracts. These contracts execute transactions as soon as the conditions pre-defined by the buyer and seller are met, putting the power of financial decision-making in the hands of the users.
Understanding DeFi Layers: A Structural Overview
DeFi Layers consist of components that make up the whole structure of the decentralized finance ecosystem. Let’s review the main DeFi layers and their meaning.
- The base or settlement layer
The base layer is the pillar of the DeFi software ecosystem - a blockchain infrastructure on which other DeFi components are based. Settlement layers include the public blockchain and its cryptocurrency. Without this layer, there would be nothing to develop applications on.
- Protocol layer
The protocol layer is responsible for defining rules and standards for financial transactions. This layer includes different protocols, such as decentralized exchanges, asset management tools, and borrowing platforms. These protocols set rules for various financial operations using smart contracts.
- Application layer
This layer takes the rules and protocols from the base and protocol layers and turns them into a product people can interact with. It’s all about the user's interaction with financial applications. This layer allows users to access and manage DeFi services with the help of web and mobile applications, software, digital wallets, and other tools.
- Aggregation layer
Aggregators combine different applications into a single dashboard so users can manage and access their financial operations from one place. The main advantage of the aggregation layer is that it allows users to choose what decentralized applications they want to include in their dashboard and quickly switch between different decentralized applications.
In short, layers compose a framework for structuring and organizing fintech and DeFi applications. This system is also called a stack, as all the layers are built on one another.
How DeFi Works
What is DeFi technology and how does it work? Decentralized finance is created through several different types of protocols and technologies in addition to blockchain, including open-source technologies and proprietary software.
The majority of DeFi solutions currently run through the Ethereum blockchain, which uses smart contract functionality.
Smart contracts are an automated way to define the contractual terms between the buyer and seller on both ends of the transaction. These contracts contain a specific code that defines all terms and conditions; if the terms or conditions are not met by either party, the collateral involved can liquidate automatically.
In traditional financing, a financial institution such as a bank would perform this type of ‘oversight’ on the transaction.
While smart contracts have increased the volume of trading in the space, DeFi remains a growing industry with limited regulation and oversight. It does, however, function like more traditional, financial ecosystems, relying on stabilized currencies and various use cases.
The DeFi Software Stack
As with any software solution, DeFi is executed via a stack of components.
What comprises the DeFi software stack? The four layers of the DeFi stack are as follows:
1. Settlement Layer
Also known as Layer 0, the settlement layer provides the base on which all DeFi transactions are built. The settlement layer is formed by a public blockchain and its cryptocurrency or else a tokenized version of IRL assets.
These IRL assets replicated in the virtual world as tokens can be anything from USD to real estate land parcels.
2. Protocol Layer
At the protocol layer, all standards and rules for transactions are defined.
Think of the federal or regional rules governing financial transactions that banks must adhere to. Similar rules are defined here at the protocol layer for DeFi transactions.
All protocols defined at this layer are interoperable, meaning they can be leveraged by any app or service building in the DeFi stack. The protocol layer also creates liquidity within this virtual, financial ecosystem, giving apps the ability to convert virtual assets into real-world assets.
3. Application Layer
At the application layer, vendors create the apps and services that users will engage with.
These apps take the protocols of the bottom two layers and turn them into a product that consumers can leverage. Lending services, cryptocurrency exchanges, and other common DeFi apps all exist at this layer.
4. Aggregation Layer
Finally, at the aggregation layer, third-party vendors take the existing applications from the application layer and combine them to make appealing products for investors.
In the real world, any financial trading that takes place still requires a detailed paper trail for each transaction.
Given the complete virtuality of the investment trades at the aggregation layer, investors can enjoy a faster and more seamless process.
DeFi Use Cases
Historically, of course, banks have controlled the vast majority of financial transactions in the world.
As such, they have been slow to adopt DeFi, since it would force them to give up control of the centralized financial system.
Given the momentum DeFi has, banks are taking a middle ground for now, however. They are gradually moving towards a decentralized system while still retaining control over the majority of transactions.
DeFi had one of its most compelling applications in the real world recently in Venezuela.
With the Venezuelan economy seriously destabilized by sanctions from the U.S. and hyperinflation, many in the country have turned to cryptocurrency as a way to execute transactions they can’t initiate in the real world.
DeFi Lending
What is DeFi in the crypto world? What are its implications and applications? One of the most popular use cases for DeFi these days is lending. Folded into this is DeFi yield farming. What is DeFi yield farming? Yield farming is a process by which investors can lock up their funds and lend out cryptos via DeFi protocols to earn interest.
DeFi lenders lend out cryptocurrency just as a traditional, centralized bank would lend out fiat currency, and earn interest on that transaction. As DeFi applications continue to evolve, the space is generating more complex scenarios, too. This includes the option of becoming a provider of liquid assets to a decentralized exchange in the space.
DeFi lending is appealing to borrowers for several reasons, not the least of which are lower interest rates and lower barriers to entry.
While centralized banks have strict requirements for taking out a loan, including higher credit scores, DeFi lenders typically require only crypto assets or even NFTs as collateral.
The Big Banks and DeFi
The main question facing banks in the face of all this momentum in DeFi is how these institutions can engage successfully with a decentralized system. After avoiding the conversation for a few years, banks now are considering how to build a decentralized system using blockchain without losing control over financial transactions. To that end, banks with footprints as large as ING are exploring ways to enter the DeFi space.
In recent months, ING made an industry-wide impact by conducting a case study on how a large, centralized institution could test an entry point into DeFi.
ING did this by partnering with Aave, an open-source, non-custodial protocol that allows one to borrow and earn interest on deposits.
ING has pioneered this exploration into DeFi, in many ways; likewise, Aave has been forward-thinking by exploring how they could integrate their DeFi approach into the institutional space.
Both centralized and decentralized banking entities could potentially benefit from a partnership, according to the ING case study. Banks could benefit from transaction protocols that allow them to sidestep burdensome regulations, while crypto entities such as Aave could benefit from a bank’s extensive experience with AML and KYC protocols.
In Conclusion
Whatever scenarios occur, it is clear at this point that DeFi’s momentum is not slowing down.
While the uninitiated might not be blamed for having anxiety about the crypto space, it can potentially provide a more stable and fraud-free financial ecosystem free of human error or interference.
Time will tell as the transition to a decentralized system continues.
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