Understanding DeFi: the Future of An Alternative to Traditional Finance, Episode 1: Definition and Mechanism
Author: David Zhao, Investment Analyst at Bridge Point Capital
The concept of DeFi, short for decentralized finance, has been around for years ever since the creation of Bitcoin in 2009. However, the term was previously referred to as "open finance” and was not coined until 2018 during a Telegram chat by a group of entrepreneurs and Ethereum developers. The emerging financial technology has attracted great attention within the cryptocurrency and Blockchain communities and stirred up a heated debate about its potential to disrupt the current financial system.
Tratdional Finance vs. Decentralized Finance (DeFi)
From Centralized Finance to Decentralized Finance
Before discussing DeFi, let’s start with the old financial system that has existed for hundreds of years. Centralized finance, or CeFi for short, is a centralized authority that has control over users’ assets and facilitates transactions regarding the movement of assets. All transactions, such as lending, borrowing, and trading, go through a centralized platform controlled by banks or government agencies. Three parties are involved in a transaction: a sender or lender, a receiver or borrower, and financial intermediaries that process the transaction according to multiple procedures and charge fees for using their services. For example, a credit card transaction starts with the customer’s consent to pay the merchant. The intent is sent to the customer’s bank, which forwards the card information to the credit card network. The network clears the charge and requests a payment from the customer’s bank to the merchant’s bank. The complete process takes days to be finalized, and each intermediary receives its part of the fees charged to the merchant.
DeFi, on the other hand, reconstructs the process by removing the middleman and making financial transactions directly with others, while providing most services that traditional banks support, including but not limited to lending, borrowing, earning interest, trading assets, and buying insurance. Thus, by eliminating intermediaries, DeFi promises lower transaction costs and faster processes, and the power shifts from centralized authority to everyday people via peer-to-peer exchanges.
How does DeFi work?
Cryptocurrency and blockchain are the core technologies that enable DeFi. Cryptocurrencies replace fiat currencies issued by governments and monetary agencies. Users can access their assets via secure digital wallets and take control of assets exclusively. Transactions are secured through blockchain technology with everyone holding the same copy of transaction history in encrypted code. DeFi further develops smart contracts to automate execution. These self-executing contracts on a blockchain use simple “if this … then …” statements written in code and run automatically when conditions previously set by each party are met.
Source: Fabian Schär, “Decentralized Finance: On Blockchain- and Smart Contract-Based Financial Markets,” Federal Reserve Bank of St. Louis Review, Second Quarter 2021, pp. 153-74. https://doi.org/10.20955/r.103.153-74
There are five main layers that DeFi is built upon and are crucial to its popularity:
Settlement layer: the foundation layer of the blockchain and its native digital currency that other DeFi solutions are built upon. For example, Ethereum is the network on the blockchain, and ether is its native currency.
Asset Layer: all the tokens utilized in the DeFi platforms, including the native currency of the blockchain.
Protocol Layer: a collection of rules or guidelines set for smart contracts. All the participants in a specific field must follow certain basic rules for specific activities. DeFi protocols are interoperable, meaning that all parties have access to the protocols defined in the layering and develop services or apps simultaneously. The protocol layer is essential for ensuring adequate liquidity in the DeFi ecosystem.
Application Layer: customer-facing applications that are built on the basics of the protocols. Users can engage with decentralized applications, such as lending services and cryptocurrency exchanges, through a user interface. The application layer expands the user base by making it effortless for people who are not familiar with the blockchain and coding to interact with the DeFi platforms.
Aggregation Layer: an extension of the application layer. Aggregators bring different decentralized applications together to provide users with financial services, such as borrowing and lending. Users thus have the capacity to deal with different types of transactions in a single dashboard and enjoy a faster and seamless process.
The key features, use cases, and opportunity related to DeFi will be discussed in episode 2. Please email us at info@bridgepoint.capital or subscribe to our newsletter for more regarding DeFi and Web 3.