Cryptocurrencies may seem like a mysterious puzzle to an average person, and especially in this decade, when we keep hearing about its different sagas. But most are still not aware of the potential this revolutionary technology possesses. We know it offers us much more than Bitcoins, but exactly what?! One of those gifts is Decentralized finance!
Decentralized Finance, or Defi, provides a way for the general public to interact with the financial instruments and products on a blockchain network, regardless of their geographical location, race, gender, or any other discriminatory factor. It usually eliminates the need for an intermediary, like a bank or a broker, to facilitate a transaction between two parties. Currently, almost 41 Billion US Dollars are in the form of DeFi contracts on different blockchain networks across the world. Although, due to low liquidity and volume, this figure might vary.
Since DeFi is still in its maturity phase, mishaps, scams, and cyber hacks are not uncommon. To prevent such scenarios, companies prefer to use long-established protocols to reduce risks and vulnerabilities in their systems. In addition to that, our current legislative system does not take a fully autonomous financial system into account, so dealing with these new sets of problems is relatively difficult.
What is DeFi?
DeFi is the technology that enables the transition from our current centralized financial infrastructure to a P2P (peer-to-peer) decentralized system built on top of mainly, but not exclusively, Ethereum blockchain. It represents a cumulation of several protocols and standards that enable the creation of DeFi Apps, which can range from a simple insurance application to complex financial instruments like derivatives and options. It covers a huge spectrum by just working with the contracts and applying a wide range of use cases for the institutions and various developers as well. Blockchain enables the users to have direct transactions. The whole system has its nodes and distributions. While this technology provides transparency, it provides us with duplicate copies of our transactions at the same time. With this, the security increases, and the chances of hacking decrease. Here, we work with two types of keys, the public key, and the private key. If the private key is lost, you cannot recover your data or your wallet systems.
This is what is DeFi in layman’s terms. Now, let’s move to its components to understand what is decentralized finance and its web app layered stack.
Components of DeFi
There are four layers in the DeFi stack. The whole framework is designed in a way that it structures and shapes the complete set of the system. Knowing the concept of the token is important to understand how the framework works into the layers. With components, there are protocols that we need to keep in our minds. Once we get hands-on to layer analysis we will progress towards the protocol system.
Settlement Layer
The settlement layer, also known as Layer 0 or the base layer, serves as the foundation for DeFi transactions on the blockchain network. This layer includes the network itself and its corresponding cryptocurrency. For example, Ethereum and its native token called Ether (or ETH), that make up the settlement layer using which all the trades and transactions take place. This layer may also have tokenied assets that are backed by physical real-world entities, like US dollar, real estate, or gold.
Asset Layer
The asset layer is known as Layer 2 of the whoe framework of our five-layered tech stack. Any asset that is above the main asset, which is known as our settlement layer, would add up to this layer. If any additional asset is taken on this, it will take care of that as well. Primarily it will focus on the native protocol asset and any token (issued blockchain) would be counted under this.
Protocol Layer
DeFi protocols are interoperable which means that multiple entities would have access to them. Protocol Layer is Layer 3 in this framework. The areas to be dealt with under this are – market derivatives, debt markets, other real-world institutions, and on-chain asset management. A standard set of smart contracts is used for the implementation. An example of the same is Synthetix, which is a derivative used for a real market situation for a trading protocol on Ethereum.
If you have any real-world assets, you will use this to create their corresponding synthetic versions.
Application Layer
As the name suggests, the abstraction of other layers is done over here, so real-world usable applications can be built using this. This is our layer 4 and it works upon the creation of user-oriented applications. It would then be connected to the individual user protocols. By using simple consumer-focused services, such as front-end web development, we can do abstraction over smart contracts. For example, lending services, cryptocurrencies, exchanges are built using this layer and we access them through a web app or mobile app.
Aggregation Layer
The aggregation layer has aggregators for connecting several applications using the application layer. This layer 5 is the extension of our application layer discussed above. Combining and performing complex tasks are done in this layer to get ourselves a concise and clear approach. We connect several protocols and applications that are completely user-oriented.
We usually see a seamless transfer happening between two investors, which are at the topmost layer, although several parts are involved under the hood. For any transaction to occur properly, the process involves a set of physical setups, coordination, and any digital or paperwork requirements. All the crypto wallets and other digital net banking services that we use today are possible because of this aggregation layer. They majorly provide us with maximum tools to carry out transactions between several protocols.
Benefits of DeFi
Now that we have understood what decentralized finance is and discussed its components, let’s see what are the properties which make DeFi apps beneficial in general. There are six major points that we will be exploring, which are as follows:
Interoperability
Transactional transparency and security is a pivot in any decentralized system that we use. When we wish to see some transactions, we tend to require an intermediary and this property enables us to access and view different blockchain networks. It creates an ecosystem with the ability of various networks to build communication within themselves. For example, the tech stack of Ethereum provides us with protocols and applications that will support and complement each other respectively. Execution of smart contracts becomes user-friendly.
“Everyone is dependent on physical goods’ ability to move across all participants in the global supply chain with minimal friction. We need the same ability to move a digital asset from one blockchain to another without creating redundant data or a new market for intermediaries. This is why blockchain interoperability is critical.” Rasmus Winther Mølbjerg, Director, Deloitte, Denmark.
Permissionless
Fiat money and our traditional transaction methods require a set of permissions to be fulfilled. But in the world of DeFi, there is the involvement of blockchain, which makes it a completely secure transaction without any restrictions. There are no funds or minimum funds required for us to carry forward with this transaction. You can access your crypto wallet globally anytime. Financial inclusion gets a leeway.
Easy accessibility and permissionless innovation are encouraged. Anyone can join as a validator and transact. The copies/duplicates are stored across the globe nodes, making it difficult to hack or tamper with.
Also, Utility tokens or monetary tokens are used within this for digital assets to have transparency and decentralization. No additional infrastructure is required for permissionless blockchains, but they are relatively more energy-consuming.
Immutability
Blockchain provides us with a completely decentralized architecture, which means, the data cannot be changed on it. It becomes tamper-proof or immutable, which makes transactions and financial procedures easy to carry out. No entity can manipulate or tamper with the data, may that be a government or a huge organization. In addition to that, the auditing process becomes quick and cost-effective.
“Immutability ensures integrity”, making it the best possible feature for the DeFi ecosystem.
Self-Custody
This property gives you absolute control over your wallets and personal data. That means you’re the sole responsible party to protect your private keys and other sensitive data. Using Web3 wallets like Metatask, you can achieve this. It has several advantages over traditional banking systems, primarily, no hacker or a person with access can view or modify your bank details due to decentralization. You require no cut, no financial intermediaries, for any investment you want to make.
Programmability
This property of DeFi allows you to create new financial instruments and digital assets in the form of smart contracts. All the smart contracts tend to be highly programmable using which, you can create automated processes. They came into existence with the advent of Ethereum Blockchain, in the form of smart contracts. Peer to peer value movement saw an increase in programmability. More smart contracts mean more programmability in the system.
Transparency
All the Ethereum addresses are termed as encrypted keys that lie in a phase of pseudo-anonymity. The codes of Ethereum are open source making it a tool of public accessibility. Anyone can view, save, fork, or edit the code. The requirement of blockchain came so that all the distributed ledgers could have a certain amount of transparency unlike the fiat ecosystem provides. Rich data analysis with amazing network connectivity becomes a profitable source of research for any end-user.
“The foundations of new economies start with borrowing and lending. In 2019, the blockchain industry enabled these necessary primitives in what has become DeFi.”– Collin Myers, Global DeFi Product Strategy Lead, Codefi
Applications and Advantages of DeFi
The use of blockchain technology in finance is not new. Most financial institutions use it to facilitate and manage transactions. However, its role is limited as a facilitator, nothing more. Companies still have to manage jurisdictions and competing markets. But DeFi, unlike traditional systems, lets technology lead the pack. It is now changing horizons with its magnanimous properties that are helping financial services to upscale and upskill. New technology frameworks are regularly added for developers to stay updated. Few glaring benefits of DeFi that are enabling the advancements in this field are:
- Permissionless
- Provides open-source workability
- Using blockchain and working over ‘Decentralized’ systems.
- Traditional systems are removed and there is zero involvement of any current ‘Central Entity’.
- Provides better leverage and High Liquidity
- Exceptionally Borderless
- Self-custody or full control over funds
- Saves Time
- Displays productivity with the cost and provides asset management.
- Data Security and no fraudulent activities or crimes.
We have curated a list of advantages of DeFi, that has majorly impacted this industry. It will help you better understand what DeFi is and specifically, what are the benefits of DeFi in those particular scenarios.
Tokenization
It is important to have a basic understanding of how tokens work. Recently, it has gained a notable interest and eyes of people around it. All the crypto tokens are our current digital assets. They have different features and use cases.
For example, we have real estate tokens and security tokens. Real estate tokens give us fractional ownership over physical properties, whereas security tokens help us effectively work within digital shares and the management of wallets. They are all crypto-synthetic assets that are collateralized by the Ethereum smart contracts backing something substantial.
Asset management
The latest DApps use protocols that enable you to remain the sole owner of your own funds. Crypto wallets such as Metamask, Agent, and Gnosis safe lets you securely interact with DApps and help you with buying, selling, and trading with no cost or low-cost management.
Your private keys are locally stored on your device so that only you have the access to them in the DeFi space. All your phrases, passwords, personal data are safe with you. This use case is profitable and makes this technology the crux of DeFi space.
Lending and Borrowing
Peer to Peer services is the pivot aim of the whole architecture. Lending and borrowing offer sustainable and profitable solutions to its end users. A maintained and well-integrated smart contract is introduced while we deal in the sector of lending and borrowing. The verification of intermediaries is completely blocked, unlike the traditional system. It ensures safeguards for any other counterparty. The compound has become a popular platform that allows lenders to exchange crypto assets in several pools. The interest rate depends on the contribution made by the lender during the process. The liquidity of crypto assets is crucial to determine the internet rates in the Defi space.
Saving Applications
As mentioned earlier, lending platforms are enabling users to generate revenue through interests, which subsequently opens up the doors of savings apps. For example, if you lock any asset in any lending protocol, like Compound, you would get interest benefits at a mushroomed rate. And this can further go into your savings.
“Yield farming” is currently the trending term that can be used over here. It means that users can move across various lending platforms to generate maximum interest through their investments or savings.
Compliance and KYT
In our traditional banking services, KYC (Know Your Customer) guidelines are extremely important. They provide a link to track or prevent any money laundering activities. The decentralized infrastructure offered by Ethereum enables us the next-generation compliance analysis. This Know Your Transaction (KYT) mechanism provides us an upper edge to judge any real-time risk or threat to our wallets.
Margin trading
Margin Trading means that you can use leverage to make trades by borrowing funds from a broker, who in turn takes funds from other investors, who have invested their money to gain interest. In the decentralized system, this intermediary step is eliminated where a broker is involved. It has non-custodian lending protocols in place which facilitate the transactions without the need of a middleman. These are implemented using smart contracts which automate the brokerage process, making it “autonomous money markets” in the DeFi ecosystem.
Stablecoins
To understand how coins or tokens work in a better way, you can term them or relate them to the synthetic asset. It is possible to peg crypto to another basket of assets like fiat money, gold, or any other commodity. Stablecoins were developed to reduce the volatility of the crypto rates so that we could use them as an apt option for payment. Now it is used widely across the DeFi spaces to lend, borrow, or remittance of payments. Value maintenance of other cryptocurrencies is done by over-collateralization and stable mechanisms.
Prediction Markets
Probability and prediction have always played an important role in any market. When any market fluctuation takes place, the indicators have an important role to play. In any blockchain-based predictive market, depending upon the crowd wisdom, the users cast the vote and trade the value based on their predictions. Augur is a famous platform used in this market for betting purposes. Results of games, elections, events revolve around the same principle and they can be integrated with such platforms.
Synthetic Assets
Synthetic assets are a subset of Stablecoins. They are also related to other cryptos and provide exposure to gold, fiat money, and other currencies. They are locked into the Ethereum based smart contracts where the terms and agreements are pre-programmed. Protocols like Synthetix enable networks to absorb sudden price shocks because the ratio of collateralization can reach up to 750 percent.
DAOs
DAO is the abbreviation for Decentralized Autonomous Organization. Automation of processes is done with the use of smart contracts. It uses an interconnected web of smart contracts to automate effective processes. DAO is currently more of an on-paper model, and the implementations are ongoing with various experiments all around the world.
Practically speaking, DAO’s business benefits are numerous. For example, a novelty stationery store would have its inventory on the unique ledger that will be able to create a smart contract that would work through each contract’s unique or specific demand. The smart contract on its own would generate an invoice for the supplier and the buyer. It will send the invoice and also mention the issued date and the date of delivery. Upon the arrival of the shipment, the smart contract will be notified using scanners or IoT and then the CRM database would get updated.
Maker and Compound have launched DAO to manage financial ops, fundraising, and decentralization of the community management.
Data and Analytics
The discovery of financial opportunities and risk management requires data and analysis. Due to the transparent nature of DeFi, gathering data about transactions and other activities is not that difficult. The DeFi applications have set a milestone by sparking the development of mosaic tools such as Codefi data and DeFi pulse. The users can track the value locked in the DeFi protocols and compare the yields, interests, and liquidity.
Future Of Digital Assets and Decentralized Finance
“A global paradigm shift” is the sole purpose of Decentralized Finance. It is in a mode to achieve the same by creating seamless transactions and ease within the financial services. As more people put their brains into understanding the concept of decentralized services, the more they will realize that the regulations are not needed to have access to their desired resources.
With regular clarity and a strong investor appetite, one would be able to achieve significant profits in the current markets. A Decentralized Financial structure needs more transparency and financial awareness. And as they are increasing day by day, through internet blogs like this one, the market cap of decentralized finance is growing exponentially. In the upcoming years, everyone would be focused on the same as it will become a crucial part of our lifestyle.
Conclusion
Decentralized finance has a future that is beyond what we can see or imagine. Technological advancements are making us techies, knowingly or unknowingly. Inefficiencies in our current financial system are obvious and now we have an alternative available to us. A decentralized fintech industry, that is permissionless, would make us reshape the financial services we are familiar with, and help us broaden several advents attached to it.
It is a productive industry with subtle paces. If your token has sufficient liquidity and volume, then you are ruling the roost. DeFi systems are borderless which reduces a significant amount of risk of failing and falling under crimes. It offers exciting opportunities, lesser threats, high interoperability, and numerous applications. Financial services are providing an upper edge towards a better tomorrow. The distributed ledgers are changing horizons. Blockchains ensure a seamless transfer through which we can create a network-friendly environment.
For now, security risk and unintended usage are something that we need to take care of. The points which we have discussed above would help the community uproot deep vulnerabilities into their system, and contribute to this ongoing improvement. Reiterating the same would potentially contribute towards a better architecture.
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