Each day we hear on the news that DeFi is going to change the way we bank. For many people, this is great news. But for a large portion of the population, this can be very puzzling. What does “DeFi” mean; in fact, what does it even stand for? How does it work? How does it differ from our current financial systems and technology?
Goals and Challenges
While many people will agree that our current financial infrastructure is flawed and cumbersome, it is hard to think of a suitable process or set of practices to resolve the inherent issues in the system. DeFi, which is short for “Decentralized finance”, is a system that is currently under development to streamline and add security to the financial services industry.
Let’s take a look at what this means for the average user, including the meaning and philosophy behind DeFi, and the operational processes that make it tick.
A look to the Current Financial Infrastructure
In order to appreciate the differences and advantages of decentralized finance, it’s best to take a look at our current system.
Currently, the best way to describe the flow of financial services and economic activity is via the “hub and spoke” model. Picture an old-fashioned wagon wheel. At the center is the hub, with many spokes radiating out to the rim of the wheel.
Using this analogy, the “hub” would represent the areas of high financial activity, generally large cities with key input into the world economy, such as New York City, London, and Shanghai. The state of trade in these hubs radiates outwards to the rest of the world. The world headquarters of many global financial institutions are located in these hubs, while local branches bring finance to the community level. Global trading, partnerships between institutions, and investments made by key players spread their influence far and wide.
If trade is going well in these areas – and specifically between these hubs – then the rest of the world follows suit. High financial success in the centralized areas of commerce trickles down to the local level, so that those many thousands of miles away from these hubs will see a spike in sales, more competitive trade, and pricing that permits higher profits. On the other hand, if things are not going well, that effect impacts everyone around the world, as well.
The current financial infrastructure also requires a number of centralized and finite systems. Most people receive a paper paycheck, drawn on a bank. If people choose to save their money, they need to open a bank account, which is hosted by one of the major financial institutions.
They use their government-issued identification number to open the account and proof of address to verify their transactions. If you choose to cash the check, you’ll need to stop by one of the many institutions that cooperate with the bank upon which the check is drawn, and again provide government-issued identification. In this way, the financial infrastructure requires the hub to be the main resource for all monetary transactions.
Defining Decentralized Finance (DeFi)
Decentralized Finance, or DeFi, takes the hub out of the center of the wagon wheel. The DeFi system allows all members of the trade community, from buyers to sellers, to lenders and borrowers, to interact directly with each other through online software, rather than through a financial institution made up of various stakeholders, registered through the government, and backed by federal insurance.
There are various parts and pieces of the software and process designed to keep DeFi working seamlessly, though it is to be noted that putting the concept of decentralized finance into practice is still in its infancy. Since there are no bank presidents or Chief Lending Officers to direct the process, the vision of DeFi requires careful thought and planning.
DeFi is currently seen in practice in cryptocurrency exchanges and online lending programs that operate via blockchain. With all participants able to view all activity on the blockchain, the control of the financial future of these programs is placed in the hands of the participants directly.
The Four Layers of the DeFi Stack
The components of a decentralized finance system each provide specific function to the process, and are stored in what is known as a software stack. The term “stack” is used to denote that each process of a transaction builds from one level, known as “layers” to the next.
The first of these is Layer 0, or the Settlement Layer. This is the base layer upon which public blockchains and cryptocurrency formats are created. This means that all transactions build upwards from this later. The Settlement Layer may provide tokenized versions of assets, meaning that each token represents material value, including currency, land, or objects.
The Protocol Layer represents all of the rules and principles of those using a form of decentralized finance. These are stored as software protocols, and are agreed to by all of those using a particular DeFi outlet. Just as you agree to the terms of service at a bank, the Protocol Layer dictates the rules of trade.
The Application Layer is the customer-facing layer. The apps, or applications, are where consumers interact. This is where they are notified of protocol and have the opportunity to participate on the blockchain.
Lastly, there is the Aggregation Layer. This is where applications, consumers, investors, and protocol all meet to create a functioning financial system. The transfer of funds occurs on the Aggregation Layer, including crypto wallets, lending, borrowing, and purchasing.
The concept of decentralized finance can be somewhat confusing to those who have experienced centralized or “hub and spoke” style financial interactions throughout their lives. Those who are working to create a smoother system of DeFi hope that these practices will become more readily accepted over time, though critics and proponents alike note that a software-based system will need to be incredibly secure and operate seamlessly for participants around the world.
However, the advantages of a process that requires no middle-men and fewer participating entities, giving direct control of money to those who use it, is a very interesting proposition for all.