What Is DeFi

What Is DeFi (Decentralized Finance)?

7 min read

What is DeFi, and why do we need it? If you’ve been keeping up with the latest trends in finance, you’ve likely already met the term DeFi. DeFi is an abbreviation of Decentralized finance, which is a form of finance that’s blockchain-based. It eliminates the need for central financial intermediaries such as brokerages, exchanges, or banks to offer traditional financial products and services. And instead utilizes smart contracts on blockchains. The most common of these is Ethereum. In a nutshell, Defi refers to a system that makes it easier for financial services providers such as lenders and customers such as borrowers to interact supported by software written on blockchains. In other words, the DeFi software functions as the middleman.

To decentralize finance systems, various technologies and protocols are used, including. For example, but not limited to open-source technologies, proprietary software, and blockchain. Smart contracts facilitate collaboration and interaction, including automated agreement terms.

For example, each smart contract has a specific code that establishes and outlines a loan agreement’s exact terms and conditions between the relevant parties. If certain terms or conditions aren’t met, collateral could be liquidated.

This is conducted through specific codes rather than manually by a bank or other institution. In essence, you eliminate “the middle man” that comes with banks and brokers.

However, some things remain constant as you shift from traditional financial operations to DeFi. From a wider perspective, the components of DeFi are the same as those of existing financial ecosystems.

Meaning they need stable currencies and a wide variety of use cases. Decentralized Finance components take the form of stablecoins and services like crypto exchanges and lending services.

What Is Defi

What Is DeFi Ethereum?

DeFi is access to anyone who uses Ethereum. What is Ethereum? It’s the second largest cryptocurrency there is. With people like Elon Musk hinting at potential Dogecoin and other cryptocurrencies being used as payments, it could be a game changer.

Of course, the government isn’t going to want something monetary that they don’t have a hand in. So, while it’s unregulated now, that could change. We’ve seen certain governments put their foot down where cryptocurrencies are concerned. So it’s something to keep an eye on for sure.

Key Elements of DeFi Systems

In a typical decentralized finance system, all components belong to one software stack. Each component in this stack has an assigned role in building the DeFi system. 

DeFi stacks, by nature, must be composable. Each layer must fit into the others to achieve the overarching purpose.

There are four layers in the system. There are the settlement, protocol, application, and aggregation layers. We’ll dive more in-depth into each later and what they do.

With cryptocurrency gaining momentum, we could see a change in how we buy and sell. What could it do to our jobs? What can it do to our trading?

We’ve seen people become bitcoin millionaires. Then we get FOMO and want to jump on the Bitcoin train. What happened was a lot of people initially got in at the top.

And down it came. Will DeFi layers help people who don’t know how to read charts? Probably not. But what do these layers have that could help us?

1. Settlement Layer

The first layer, the Settlement Layer, is placed at Layer 0 because it’s the first layer on which other DeFis are built. It consists of a public blockchain and still has its original digital currency or cryptocurrency. Transactions occurring on DeFi apps are carried out using this currency.

It has optional trading options on public markets. An example of the settlement layer is Ethereum and its original token, ether (ETH). These can be traded on crypto exchanges. The settlement layer can also represent assets as tokens. For example, the U.S. dollar, or digital tokens, can also be used for assets such as representing ownership of a parcel of land. 

2. Protocol Layer

Software protocols are rules and regulations created to maintain the legalities of certain tasks or activities. In this regard, DeFis operates similarly to the real world. There are rules to abide by. These rules contribute to the establishment and maintenance of a functioning society.

DeFi protocols are interoperable. This means that they can be used for multiple different purposes, concurrently or simultaneously. The protocol layer makes it easier for the DeFi system to liquefy assets. One example of a DeFi protocol is Synthetix, a derivatives trading protocol on Ethereum. It’s used to create virtual or digitized versions of real-world assets.

3. Application Layer

The application layer is where applications used for consumer interaction are based. These applications convert seemingly complicated protocols into simpler, consumer-friendly services. The more common applications used in cryptocurrency, such as decentralized cryptocurrency exchanges and lending services, can be found in this layer.

4. Aggregation Layer

The aggregation layer, as the name suggests, consists of aggregators. This creates a network between the applications from the application layer to provide a service to investors. For example, they might enable the smooth money transfer between different financial instruments to maximize returns.

If it were a physical setup, there’d be countless amounts of paperwork. Instead, a technology-based framework should reduce the information traffic. This allows traders to switch between different services quickly. Examples of services in the aggregation layer are lending banking services and crypto-wallets.  

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Why Is DeFi So Popular?

Financial freedom. It’s what we all strive for. DeFi is here for us as a way to achieve that. The tools they offer are here to protect our wealth from tough regulations and control.

You’ve heard the term “taxation is theft.” You’re protecting yourself if your money goes into something like decentralized finance.

That probably means tough regulations are coming, which is a little unfortunate. We work hard for what we have. And that’s while you’ll see people pumping trading styles and whatnot.

There’s a demand for financial freedom. But that doesn’t mean you’ll get rich overnight. Not even with trading. You could even say it is especially not trading.

This takes more work than working many 9-5 jobs. You have to learn how to do it properly to succeed. However, many people want someone to place winning trades for them. And that doesn’t work. However, something like DeFi could be a great way to house your money if you do the work.

It’s popular for a reason. Who knows what could happen if CEOs decide to go this route for commerce? Elon Musk is a visionary for a reason. And sometimes, visionaries are seen as crazy. Until they’re not.

Final Thoughts: What Is DeFi?

For many entrepreneurs and companies, opting for DeFi equates to transitioning into a truly open, transparent, and sturdy financial infrastructure. In other words, it’s the modern-day response to industry players’ demand for ease of access, accountability, and smooth transactions. Will we see more people and employers move in that direction? Only time will tell. But it seems to be gaining momentum.

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