In a cryptocurrency roundtable, there’s one term that will surely come up: Decentralized.
Decentralized finance (or DeFi, as it’s also commonly called) is a blockchain-based financial infrastructure. It’s available across nations and cultures and does not require the oversight of an organization like a bank or other institution to manage it.
Decentralized finance has grown in its scope and reach. Regulators see DeFi as riskier than traditional financial systems, while proponents believe it’s superior for its transparency and accessibility.
- Decentralized finance, or DeFi, refers to the system of financial products made available to the public through blockchain networks.
- Some people prefer DeFi because it enables individuals to interact on a peer-to-peer basis regarding financial matters, avoiding big institutions and middlemen.
- Technology is central to DeFi, facilitating financial transactions between parties without the need for banks or brokerages.
- DeFi is often associated with cryptocurrency due to its use of blockchain technology, but its impact is much broader.
- Decentralized finance is less regulated than traditional finance.
How does decentralized finance work?
To understand decentralized finance, it’s important to consider how financial systems typically operate.
Generally, large banking institutions are located in major global hubs. From there, their economic influence ripples out. Jurisdictions, where these hubs are located, impose legal requirements that influence operations. Ultimately, these large organizations can have an outsized impact (positive or negative) on global economies.
Decentralized finance removes the need for this centralized model in which location and organization have so much influence. The goal is to provide a more equitable system in which anyone can have access to financial services no matter their age, ethnicity, credit, or societal status. Individuals often use DeFi to have greater control over their finances.
The layered structure of DeFi
The DeFi system is made up of a multi-layered software stack. Within DeFi, investors will find smart contracts which are usually small applications stored within the blockchain that validators execute.
DeFi is composed of five distinct layers, each of which serves its own purpose. Every layer depends on the layers beneath it, and if any lower layer becomes compromised, it causes problems with the next layers and the overall system’s security.
Here are the five layers of a DeFi system:
- Settlement layer: The foundational level, where you’ll find the blockchain and its native protocol asset (for example, ETH on the Ethereum blockchain)
- Asset layer: Any and all assets on that particular blockchain, including the native protocol asset and any other tokens issued on that blockchain
- Protocol layer: The layer where the system issues DeFi standard protocols, usually as part of smart contracts
- Application layer: Consumer-facing applications are found in this layer, typically made more user-friendly by a front-end web display
- Aggregation layer: This is a layer of aggregators that connects applications from the previous layer to provide a service to investors (like lending and borrowing, banking services, and crypto wallets).
Benefits of decentralized finance
DeFi fans talk about several attractive attributes of the infrastructure.
- It’s a permissionless system, meaning that people don’t need to rely on the approval of a bank or other middleman to take advantage of financial services.
- It’s more accessible to everyone, including those living in parts of the world with minimal economic infrastructure. (You may have seen that Ukranians are poised to have legal access to cryptocurrency without the gray area. For a country with the lowest GDP per capita in Europe, that’s a big deal.)
- Decentralized finance enables users to trade, transfer, borrow, and lend cryptocurrency without the parameters of traditional financial institutions or governmental oversight.
- DeFi and crypto finance can provide greater financial inclusion, serving those who are underbanked.
- DeFi is also praised for its transparency, since every transaction on a blockchain is unchangeable and verifiable.
- The broad range of uses for DeFi includes peer-to-peer lending and borrowing solutions, savings applications, and tokenization.
Drawbacks of DeFi
Decentralized finance isn’t all butterflies and roses. In general, there’s a lack of regulation and liquidity. Plus, there’s uncertainty due to a blockchain’s potential instability, concerns over scalability, and lack of protection from human error.
However, the most obvious negative is its lack of regulation. Only about 2% of DeFi holdings are currently insured. That’s different from the FDIC-insured brokerage accounts many investors know and love. With the presence of illicit activity in some cryptocurrency environments, this is a valid risk.
Users must take responsibility for their own DeFi transactions, which means they are potentially vulnerable to mistakes, and there’s no central figure monitoring activity that can save you from damages.
Despite its growth, DeFi hasn’t been widely adopted yet. Some people worry it’s not liquid enough. A relatively small amount of assets are available in this ecosystem.
Scalability may prove difficult with decentralized finance because DeFi transactions require a significant amount of time for verification. This means the more the technology is adopted, the greater the potential for congestion on the blockchain.
And finally, many blockchain consensus mechanisms are also energy-guzzling, so impact investors will need to see a big shift moving forward.
DeFi still has some kinks to work out. Minimal regulation in a borderless financial ecosystem is just one of them. But despite the need for adjustments, DeFi has potential across all applications.
With enough people behind DeFi driving improvement and innovation, the technology is preparing for even more widespread adoption.