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What is Decentralized Finance (DeFi)

In its most simple form, decentralized finance is a concept where financial products are available on a public decentralized blockchain network making them open to anyone to use rather than going through a middleman like banks or brokerages.

(Investopedia) Unlike a bank or brokerage account, a government-issued ID, social security number, or proof of address are not necessary to use DeFi. More specifically, DeFi refers to a system where software written on blockchains makes it possible for buyers and sellers and lenders and borrowers to interact peer to peer or with a strictly software-based middleman 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 mix of open-source technologies, blockchain, and proprietary software. Smart contracts that automate agreement terms 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 intermediaries between transacting parties.

While the volume of trading tokens and money locked in smart contracts in its ecosystem has been growing steadily, DeFi is an incipient industry whose infrastructure is still being built out. Regulation and oversight of DeFi is minimal or absent. In the future, however, DeFi is expected to take over and replace the rails of modern finance.

What is DeFi?

The use of technology in financial services is not new. Most transactions at banks or other financial services companies are accomplished with the help of technology nowadays. However, the role of technology is restricted to being a facilitator of such transactions. Companies still have to contend with navigating the legalese of jurisdictions, competing financial markets, and different standards to make a transaction possible. With its stack of common software protocols and public blockchains to build them on, DeFi places technology at the front and center of transactions in the financial services industry.

DeFi is commonly placed in the domain 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 finance ecosystem.

Modern financial infrastructure is built on a “hub and spoke” model. Key economic centers of activity, such as New York and London, function as operational hubs for the financial services industry and influence economic activity at spokes – regional centers or financial powerhouses like Mumbai or Milan that may not be as important globally as hubs but, nevertheless, function as nerve centers for their respective economies.

Economic prosperity or hardship radiate outwards from hubs to spokes and towards the rest of the global economy. This model of interdependency is repeated in the functioning of global financial services corporations. They have headquarters in hubs and local branches, partnerships, or investments across the world. The sprawl of their operations means that the organization itself is subject to a phalanx of laws and regulations in each of its financial jurisdictions. Their reach has made such institutions systemically important to maintain the global economy’s balance and necessary to maintain or create new financial services infrastructure.

While this model worked well in the last century, the financial crisis and, subsequently, the Great Recession revealed the flaw in this architecture. The balance sheet problems for a couple of large financial institutions produced a domino effect of tumbling economies and, subsequently, the onset of the global recession.

Decentralized finance uses technology to disintermediate centralized models and enable the provisioning of financial services anywhere for anyone regardless of ethnicity, age, or cultural identity. DeFi services and apps 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 custom-designed for the DeFi ecosystem. At the same time, DeFi applications provide users more control over their money through personal wallets and trading services explicitly catering to individual users instead of institutions.

What Are the Components of DeFi?

At a broad level, the components of DeFi are the same as those for existing financial ecosystems, meaning 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 functioning of DeFi apps because they encode the terms and activities necessary for the functioning of these services. For example, a smart contract code have specific code that establishes the exact terms and conditions of a loan between individuals. If certain terms or conditions are not met collateral could be liquidated. All of this is done through specific code rather than a bank or other institution manually doing this process.

All components of a decentralized finance system belong to a software stack. Each layer’s components are meant to perform a specific function in the building of a DeFi system. Composability is a defining characteristic of the stack because the components belonging to each layer can be composed together to fashion a DeFi app.

Outlined below are the four layers that comprise the DeFi stack.

  • 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 occurring on DeFi apps are settled using this currency, which may or may not be traded in public markets. An example of settlement layer is Ethereum and its native token ether (ETH) that is traded at crypto exchanges. The settlement layer can also have tokenized versions of assets, such as the US dollar, or tokens that are digital representations of real-world assets. For example, a real estate token might represent ownership of a parcel of land.

  • Protocol Layer: Software protocols are standards and rules written to govern specific tasks or activities. In a parallel to real-world institutions, this would be a set of principles and rules that all participants pertaining to a given industry have agreed to follow as a pre-requisite to operating in the industry. DeFi protocols are interoperable, meaning they can be used by multiple entities at the same time to build a service or an app. The protocol layer provides liquidity to the DeFi ecosystem. An example of a DeFi protocol is Synthetix, a derivatives trading protocol on Ethereum. It is used to create synthetic versions of real-world assets.

  • Application Layer: As the name indicates, the application layer is where consumer-facing applications reside. These applications abstract underlying protocols into simple consumer-focused services. Most common applications in the cryptocurrency ecosystem, such as decentralized cryptocurrency exchanges and lending services, reside on this layer.

  • Aggregation Layer: The aggregation layer consists of aggregators who connect various applications from the previous layer to provide a service to investors. For example, they might enable seamless transfer money between different financial instruments to maximize returns. In a physical setup, such trading actions would entail considerable paperwork and coordination. But a technology-based framework should smoothen the investing rails, allowing traders to switch between different services quickly. Lending and borrowing is an example of a service that exists on the aggregation layer. Banking services and crypto wallets are other examples.

The Current State of DeFi

Decentralized finance is still at the beginning stage of its evolution. The total value locked in DeFi contracts is over $41 billion, as of March 20211. The total value locked is calculated by multiplying the number of tokens in the protocol and their value in USD. While the total figure for DeFi may sound substantial, it is important to remember that it is notional since many DeFi tokens lack sufficient liquidity and volume to trade in crypto markets.

The DeFi ecosystem is still riddled with infrastructural mishaps and hacks. Scams also abound in the rapidly-evolving DeFi infrastructure. DeFi “Rug Pulls,” in which hackers drain a protocol of funds and investors are unable to trade, are common, though there are well-established protocols that can be used to reduce this risk significantly.

The open and relatively distributed nature of the decentralized finance ecosystem might also pose problems to existing financial regulation. Current laws were crafted based on the idea of separate financial jurisdictions, each with its own set of laws and rules. DeFi’s borderless transaction span presents important questions for this type of regulation. For example, who is culpable in a financial crime that occurs across borders, protocols, and DeFi apps?

Smart contracts are another area of concern for DeFi regulation. Aside from Bitcoin's success, DeFi is the clearest example of the “code is law” thesis, where law represents a set of rules and they are written and enforced through immutable code. The smart contract’s algorithm is encoded with the necessary constructs and terms of use to conduct transactions between two parties. However, software systems can malfunction due to a wide variety of factors.

For example, what if an incorrect input causes a system to crash? Or, if a compiler (which is responsible for compiling and running code) errs. Who is liable for these changes? These and many other questions need to be worked out before DeFi becomes a mainstream system used by the masses.

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