What Is Decentralized Finance (DeFi)?

What Is Decentralized Finance (DeFi)?

Decentralized finance has grown to an $80 billion industry in 2021. It is easy to see why there is so much to speculate on, but what is DeFi? Decentralized finance (DeFi) upends the notion that a central authority must regulate the movement and value of the financial system.

Instead, DeFi’s widely distributed power is vested in the base of users who design, build, and operate the DeFi system’s (primarily blockchain) networks through a series of layers supported by code, algorithms and computational power rather than a “standard” like gold or a currency like the U.S. dollar.

Many DeFi systems emerged from a small number of users with access to massive amounts of computational power and intricate network systems. But the growing accessibility of DeFi’s application and aggregation layers is encouraging even casual investors to expand the worldwide DeFi user base, with billions of individuals involved in trillions of dollars’ worth of financial transactions on an almost daily basis.

What is DeFi?

Most of us have used a bank to manage our finances. Whether you deposit, withdraw, invest, or simply move money around, you typically accomplish these tasks through a public or private authority, such as a credit union or publicly traded banking corporation.

This is the traditional hub-and-spoke model: financial organizations are concentrated in cities like New York or London that act as central “hubs” for the financial activities of millions of users, acting as middlemen between all those users and their money who access their finances at banks throughout the world – the “spokes.”

Imagine that the hubs and all their spokes are removed. Now, all those millions of users have direct access to systems that let them buy, sell, trade and invest with each other. In fact, they can even access public systems that let them contribute to the design and operation of the financial system itself. That’s the idea of DeFi: the absence of centralized financial authorities and the empowerment of a public, more democratic financial system.

What are the components of DeFi?

Decentralized finance consists of four discrete layers: Settlement, Protocol, Application and Aggregation.

Settlement Layer

This layer is what underlies all transactions that happen in a DeFi system, allowing you to publicly carry out financial activity using an open-source blockchain and its associated cryptocurrency, such as Bitcoin (BTC) or Ether (ETH).

These can range in size from the enormous Bitcoin blockchain network to tiny, homemade blockchains like Dogecoin that scale up quickly based on user interaction with the underlying computational protocols that generate the value of the digital tokens that they support.

Protocol Layer

DeFi systems are often based on software (layer one, or implementation) protocols.

These provide a consistent foundational architecture and set of “rules” that the blockchain network is based on and that both users and developers can use to perform transactions with digital tokens. In this sense, the protocol layer allows digital currencies to be “liquid” and carry an actual monetary value.

Application Layer

This layer consists of all the public-facing applications (apps) that you can use to buy, sell or trade the digital tokens (usually cryptocurrencies) that are generated by and managed in blockchain networks.

Aggregation Layer

The aggregation layer is primarily made of services that collect (or aggregate) consumer-facing applications so that users can buy, sell and trade multiple digital tokens and currencies from multiple underlying blockchain networks. This is typically considered the very topmost layer of the DeFi system that most users will view and access – often without ever having to interact with the underlying blockchain networks and software protocols that undergird the entire DeFi system.

The Takeaway

DeFi is becoming commonplace – at least for users of cryptocurrency, especially in major economies like the United States. In some countries, DeFi system tokens like Bitcoin and Ether are publicly traded on stock exchanges and easily accessible through popular securities trading apps.

Though DeFi has not yet become central to the operation of the global financial system, the underlying principles are widely accepted and utilized even by major financial hubs to increase the security and consistency of their trading platforms. With some believing that is has the potential to be even more valuable given the many use cases and potential to digitize, democratize and transform global finance – it is certainly a market to watch.

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