The world of finance is adrift, moving rather fast towards digital currencies and relying more on decentralized platforms. Welcome to the world of decentralized finance (DeFi). This is a system where financial products are made available on decentralized and public blockchain networks. This implies they are available to anyone who wants to use them as opposed to only those approved by brokerages, banks, and screening firms.
Another awesome thing about DeFi is that unlike other centralized finance organizations, such as credit cards and banks, particulars such as social security number, government-issued IDs, brokerage account, and proof of address are not required. This means that even those who were initially locked outside the conventional financial system can use DeFi. It is an evolution and a change whose time has come.
How Does DeFi Work?
If you take a closer look at most banks’ operations, a lot of technology has been deployed. However, the technology is mainly used for facilitating transactions, and the financial organizations still have to contend with the legalese of operating in different jurisdictions, standards, and varying financial markets. DeFi comes to solve these challenges. It uses a stack of software protocols and blockchains that place technology at the center of every transaction in the finance industry.
Although most people tend to see DeFi from the viewpoint of cryptocurrencies, the applications are way broader than that. It uses advanced technology to decentralize centralized financial organizations’ operating design so that more people, irrespective of their location, age, ethnicity, or cultural identity, can get financial services.
DeFi platforms are mainly mounted on public blockchains and offer users greater control over their money and transactions via trading services and wallets. To put it differently, the DeFi platforms are designed to help cater to individual users as opposed to institutions, such as banks and credit card companies.
Understanding the Main Components of DeFi
From a general point of view, the components offered by DeFi platforms are in many respects similar to what most financial ecosystems provide. However, there are some stack differences, such as not being able to deal with a teller in a large banking office the way we are used to with conventional financial services providers. Instead, most operations are actuated using smart contracts, which are automated to self-execute when two parties enter into an agreement. A DeFi platform can be seen from the following four core layers, with each performing a specific task.
- Settlement Layer: Also referred to as Layer O, the settlement layeris the bottom-most layer and is the one where DeFi transactions are based on. It consists of a blockchain plus its native cryptocurrency or digital currency. This currency is the one used to settle payments on the blockchain.
- Protocol Layer: This layer comprises pre-defined standards and rules that help govern different activities. All participants have to understand and follow these principles. Notably, the DeFi protocols can easily be applied by multiple parties simultaneously. Also, it is the protocol layer that provides liquidity to DeFi platforms.
- Application Layer: In this layer, applications that target to offer specific services to clients are embedded. For example, apps for decentralized exchanges and lending are attached to this layer.
- Aggregation Layer: This is a very important layer because it is made of aggregators that connect different apps in the application layer to offer services to investors. For example, aggregators can help with the seamless transfer of funds between select financial instruments to optimize returns on investment. Unlike in conventional settings where such actions would require a lot of paperwork, DeFi allows the changes to be prompt, making it pretty easy to increase return on investment.
As you can see, DeFi has a very high potential for the finance sector, but it is only in its nascent years. For example, DeFi contracts were estimated to be more than $41 billion by March 2021. This is an area that is no doubt worth exploring, and it will be a good idea to work with a professional because of the risks and complexities involved.