Decentralised finance, or DeFi, is a system whereby financial products are available on a decentralised public blockchain network.
This makes them open for anyone to use, rather than going through intermediaries such as banks or the state itself.
DeFi refers to a system whereby software written on blockchain makes it possible for buyers, sellers, lenders and borrowers to interact peer-to-peer or with a strictly software-based intermediary rather than a company or institution facilitating a transaction.
Multiple technologies and protocols are used to achieve the goal of decentralisation. For example, a decentralised system may consist of a combination of open source, blockchain and proprietary software technologies.
Smart contracts that automate the terms of agreement 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 eliminate intermediaries between transacting parties.
Although the volume of trading tokens and smart contract blockchain money in its ecosystem has been growing steadily, DeFi is a nascent industry whose infrastructure is still being built.
- Decentralised finance, or DeFi, aims to use technology to eliminate intermediaries between parties in a financial transaction.
- The components of DeFi are stablecoin, use cases and software that enables application development.
- DeFi’s infrastructure and use cases are still under development.
What are the components of DeFi?
At a broad level, the components of DeFi are the same as those of existing financial ecosystems, meaning that they require stablecoins and a wide variety of use cases.
DeFi components take the form of stablecoins and services such as crypto exchanges and lending services.
Smart contracts provide the framework for the operation of DeFi applications because they encode the terms and activities necessary for the operation of these services.
For example, a smart contract code has a specific code that sets out the exact terms and conditions of a loan between individuals. If certain terms or conditions are not met, the collateral could be liquidated. All of this is done through a specific code rather than manually by a bank or other institution.
All components of a decentralised financial system belong to software. The components of each layer are intended to perform a specific function in the construction of a DeFi system.
The four “layers” that make up DeFi are described below:
- 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. One example of the settlement layer is Ethereum and its native token ether (ETH), which is traded at crypto exchanges. The settlement layer can also have tokenized versions of assets, such as the U.S. dollar, or tokens that are digital representations of real-world assets.
- Protocol Layer: Software protocols are standards and rules written to govern specific tasks or activities. In parallel with real-world institutions, this would be a set of principles and rules that all participants in a given industry have agreed to follow as a prerequisite 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.
- 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 the seamless transfer of 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.