Feb 10, 2022

8 min read

DeFi: Defying the Normal

Understanding Decentralized Finance

Decentralized finance (DeFi) provides financial instruments without the use of intermediaries like brokerages, exchanges, or banks. Instead, it employs blockchain-based smart contracts. People can use DeFi platforms to lend or borrow money from others, speculate on asset price movements with derivatives, trade cryptocurrencies, insure against risks, and earn interest in savings accounts.

Before we look deeper into decentralised finance let us compare the differences between centralised finance

Centralised vs Decentralised Finance

Centralized Finance

Banks, corporations whose overarching goal is to make money, hold your money in centralised finance. Third parties who facilitate money movement between lending parties and borrowing parties abound in the financial system, each one of them charges a fee for their services.

For example, if you use your credit card to fill gas in your car, the charge is routed from the merchant to an acquiring bank, which then forwards the card information to the credit card network. The network clears the charge and asks your bank for payment. Your bank approves the charge and forwards it to the network, which then forwards it to the merchant via the acquiring bank. Each entity in the chain is compensated for its services, primarily because merchants must charge you for your ability to use credit and debit cards.

Similarly, most of the financial transactions have some or other charge attached to them in a centralised finance system

Decentralized Finance

Decentralized finance eliminates the need for intermediaries by allowing individuals, merchants, and businesses to conduct financial transactions using this emerging technology. This is accomplished through peer-to-peer financial networks that employ security protocols, connectivity, software and hardware advancements, and so on.

One can lend, trade, and borrow using DeFi Apps that records and verify financial transactions in distributed financial databases from anywhere you have an internet connection. A distributed database is accessible from multiple locations; it collects and aggregates data from all users and verifies it using a consensus mechanism.

Decentralized finance makes use of this technology to eliminate centralised finance models by allowing anyone, regardless of who or where they are, to use financial services anywhere.

Through personal wallets and trading services tailored to individuals, DeFi applications give users more control over their money.

Decentralized finance, while removing control from third parties, does not provide anonymity. Your transactions may not bear your name, but they can be traced by the entities who have access to them. These entities could be governments, law enforcement, or other organisations whose sole purpose is to protect people’s financial interests.

The architecture of DeFi Eco-system

DeFi employs a layered architecture and highly modular building blocks. The DeFi ecosystem consists of several layers, such as the underlying distributed ledger (a blockchain such as Ethereum), 2-layer DApps (Decentralized Apps) or even 3-layer DApps integrated offerings.

As shown in the graphic above essentially the DeFi stack consist of the following layers:

1. Settlement Layer

The settlement layer, also known as Layer 0, serves as the foundation for all DeFi transactions. A public blockchain and its cryptocurrency, or a tokenized version of IRL assets, form the settlement layer.

These IRL assets replicated as tokens in the virtual world can range from USD to real estate land parcels.

2. Protocol Layer

All transaction standards and rules are defined at the protocol layer.

Consider the Central/Federal or regional rules that govern financial transactions and must be followed by banks. For DeFi transactions, similar rules are defined at the protocol layer.

All protocols defined at this layer are interoperable, which means they can be used by any app or service built within the DeFi stack. The protocol layer also creates liquidity within this virtual, financial ecosystem, allowing apps to convert virtual assets into physical assets.

3. Application Layer

Vendors create the apps and services that users will interact with at the application layer.

These apps turn the protocols of the bottom two layers into a product that consumers can use. This layer contains lending services, cryptocurrency exchanges, and other common DeFi apps.

4. Aggregation Layer

Finally, third-party vendors combine the existing applications from the application layer to create appealing products for investors at the aggregation layer.

In the real world, any financial transaction still necessitates a detailed paper trail for each transaction.

Investors can benefit from a faster and more seamless process due to the complete virtuality of investment trades at the aggregation layer.

Decentralized finance (DeFi) is a new financial technology that is based on secure distributed ledgers, similar to those used by cryptocurrencies.

Key Attractions of DeFi Technology

It eliminates the fees that banks and other financial companies charge for using their services.
One can hold one’s money in a secure digital wallet instead of keeping it in a bank.
Anyone with an internet connection can use it without needing approval.
One can transfer funds in seconds and minutes.

“Two of DeFi’s goals are to reduce transaction times and increase access to financial services.”

Key Features of DeFi Technology

Decentralized finance, or DeFi, uses emerging technology to remove third parties in financial transactions.
The components of DeFi are stable coins, software, and hardware that enables the development of applications.
The infrastructure for DeFi and its regulation are still under development and debate.
DeFi’s operations are not managed by institutions or employees, rather, in the DeFi environment, their role is played by algorithms written in code or via smart contracts.
One of the prominent DeFi features that clearly distinguish DeFi from traditional banking apps is the latter’s power of code transparency. This allows anyone to audit, which builds trust among users because everyone has the opportunity to understand the contract’s functionality.
A fundamental element of the DeFi environment is DeFi Apps (dApps), which are designed to operate globally from the start.
Decentralized finance applications can be created by anyone and used by anyone. Unlike in traditional finance, there are no accounts or gatekeepers on this front, and users interact with smart contracts directly from crypto wallets
The new decentralized finance applications are built and composed by mixing other DeFi products such as Money Legos, Therefore decentralized exchanges, stablecoins, and the prediction markets can be mixed to develop new products.

DeFi Apps

DeFi apps (dApps) are financial instruments that allow you to buy, sell, and trade digital assets on a decentralised network, similar to the solutions we use today, such as PayPal or RobinHood. Because dApps operate on the blockchain, no single entity has control over the network.

The graphic below shows the environment in which dApps operate.

Benefits of DeFi

Permission-less

DeFi welcomes everyone to the financial system, regardless of pay, race, culture, wealth, or geographic location. All that is required of each user is a smartphone or computer with internet access.

There are many unbanked people all over the world, a current estimate shows that still, 20% of the world’s population lacks access to banking applications. One reason for such a large fraction of unbanked people is that they don’t possess necessary know-your-customer (KYC) documents such as state-issued identification cards.

Users can work without any of this in a few DeFi Apps.

Interoperability

Developers of DeFi Apps can freely build on top of existing protocols, customize interfaces, and integrate third-party apps with decentralised accounts. Cross-chain interoperability between various blockchains is required for DeFi interoperability, as various DeFi products such as stable coins, ‘Money Legos’, and underlying blockchains must cross-link.

Transparency

DeFi enables a higher level of openness and accessibility. Because most DeFi protocols are built on the blockchain, a public ledger, all exercises are open to the public. Transactions can be viewed by anyone, but they are not directly associated with any one, as is the case with traditional banks. Overall, the accounts are pseudo-anonymous, posting only numerical addresses. Because most DeFi products are open source, users with programming knowledge can also access the source code to review or build upon.

Finance control

With DeFi platforms, you retain control over your funds and finances. While you must store your assets in the platform, you have control over what happens to them. Rather than relying on human intermediaries to qualify you for a loan and manage your investments, a smart agreement does so.

Nobody can prevent you from using the DeFi protocol. The underlying smart contract is a law, and it operates indiscriminately.

Innovation opportunity

The DeFi environment offers viable opportunities for innovation and the development of DeFi services and products. DeFi is an open protocol that can be of great assistance in the development of a new era of financial solutions. The DeFi significance grows as it can use Ethereum and allows trailblazers to create new decentralised applications for the financial sector.

The Future of DeFi

Decentralized finance is still in its early stages of development. To begin with, it is unregulated, which means that the ecosystem is still riddled with infrastructure mishaps, hacks, and scams.

Current legislation is based on the concept of distinct financial jurisdictions, each with its own set of laws and rules. The ability of DeFi to conduct border-less transactions raises critical issues for DeFi ecosystem. In case of Financial crimes that may occur across borders, protocols, and DeFi apps, what rules will be applied and who will enforce them, is still a million dollar question.

The open and distributed nature of the decentralised finance ecosystem may also pose challenges to existing financial regulation.

System stability, energy requirements, carbon footprint, system upgrades, system maintenance, and hardware failures are also issues to consider.

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