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A brief description of DeFi

DeFi refers to a group of financial products and services available to anyone who can use Ethereum and has access to the internet. There are no centralized authorities that can block transfers or refuse access to something with DeFi because the markets(buying cryptocurrencies platform) are still free. Services that were once sluggish and vulnerable to human error are now automated and safer, thanks to code that anyone can audit and scrutinize.

There’s a thriving crypto-economy out there, where you can lend, borrow, invest in long/short positions, gain interest, and more. Companies have begun to broadcast their workers’ pay in real-time. Some people have also taken out and paid off multimillion-dollar loans without providing any personal information.

DeFi is often associated with blockchain and cryptocurrencies. However, it has a much broader reach. It’s necessary to understand the current state of the finance ecosystem to comprehend the thought processes that led to the emergence of decentralized finance.

DeFi and Traditional Finance: The differences –

Understanding the current challenges is one of the best ways to see the promise of DeFi.

  • Some citizens are denied the ability to open a bank account or access financial services.
  • People who do not have access to financial services will be unable to find work.
  • You may be unable to receive payment due to financial services.
  • Your data is a hidden cost of financial services.
  • Markets may be shut down at any time by governments and centralized institutions.
  • Trading hours are often restricted to various time zones’ business hours.
  • Internal human processes can cause money transfers to take days.
  • Financial services command a premium since intermediary organizations need a cut.

Components of DeFi –

DeFi’s components are similar to those of traditional financial ecosystems in which they include stable currencies and a diverse range of use cases. Stablecoins and utilities such as crypto exchanges and lending services are examples of DeFi components. Smart contracts provide the basis for DeFi apps to operate since they encode the terms and activities required for these services to function. A smart contract code, for example, has a basic code that specifies the exact terms and conditions of an individual loan. Collateral may be liquidated if such terms or conditions are not met. Rather than using a general code, all of this is done by a particular code. All of this is done through a code rather than by a bank or other institution manually.

A software stack contains all of the elements of a decentralized finance framework. The components of each layer are designed to perform a specific role in the construction of a DeFi framework. Composability is a distinguishing feature of the stack since the components from each layer can be combined to create a DeFi app.

The four layers making up the DeFi stack are outlined below:

  • Settlement Layer: The settlement layer is also known as Layer 0 because it serves as the foundation for all other DeFi transactions. It is made up of a public blockchain and a digital currency or cryptocurrency. This money, which may or may not be traded on stock markets, is used to settle transactions on DeFi apps. Ethereum and its native token ether (ETH), exchanged on crypto exchanges, are an example of the settlement layer. Tokenized assets versions, like the US dollar, or tokens that are digital representations of real-world assets, may be used in the settlement layer. A real estate token, for example, may reflect the ownership of a piece of property.
  • Protocol Layer: Software protocols are written rules and standards that regulate particular tasks or activities. This will be a set of standards and guidelines that all participants of a given sector have decided to obey as a condition of participating in the industry, similar to real-world organizations. DeFi protocols are interoperable, which means several organizations can use them to create a service or app simultaneously. The protocol layer gives the DeFi ecosystem liquidity. Synthetix, an Ethereum-based derivatives trading protocol, is an example of a DeFi protocol. It’s used to make digital replicas of real-world properties.
  • Application Layer: The application layer is where consumer-facing applications live, as the name implies. The underlying protocols are abstracted into essential consumer-focused services in these applications. This layer houses most of the cryptocurrency ecosystem’s applications, such as decentralized cryptocurrency exchanges and lending services.
  • Aggregation Layer: Aggregators bind different applications from the previous layer to offer a service to investors in the aggregation layer. They could, for example, make it possible to move money seamlessly between various financial instruments to optimize returns. Such trading activities will necessitate a lot of paperwork and planning in a physical setup. On the other hand, a technology-based architecture could smooth the investment rails, enabling traders to move between different services quickly. On the aggregation layer, lending and borrowing are two examples of services. Other examples include banking services and cryptocurrency wallets.

Defi’s Latest state –

The emergence of decentralized finance is still in its early stages. As of March 20211, the total value of DeFi contracts was more than $41 billion. The total value locked is determined by multiplying the number of tokens in the protocol by their USD value. While the total number for DeFi seems large, it is essential to note that it is only a theoretical figure since many DeFi tokens lack adequate liquidity and volume to trade on cryptocurrency exchanges.

Infrastructural mishaps and hacks continue to plague the DeFi ecosystem. In the rapidly developing DeFi infrastructure, scams abound as well. Hacker “rug pulls,” in which funds are drained from a protocol and investors cannot trade, are popular, but there are well-established protocols that can significantly reduce this risk.

The transparent and dispersed nature of the decentralized finance environment can also cause issues with current financial regulation. Current laws are based on the concept of distinct financial jurisdictions, each with its collection of laws and regulations. The borderless transaction span of DeFi raises essential regulatory issues for this form of regulation.  Another area of interest for DeFi regulation is smart contracts. Apart from Bitcoin’s popularity, DeFi is the best example of the “code is law” theorem, according to which law is a collection of rules written and implemented by immutable code. The smart contract’s algorithm is pre-programmed with the requisite constructs and terms of service for two-party transactions. Software systems, on the other hand, can fail for a variety of reasons.