What is DeFi: Understanding Decentralized Finance

What is DeFi: Understanding Decentralized Finance

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.

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.

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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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