Decentralization of Finance — A Rising Disruption
In the case of finance and money, decentralization brings disruptive benefits, as there is no single centralized storage place and no single entity in charge. We have already seen a massive growth in the adoption of bitcoin and cryptocurrencies, which are currently the lone form of decentralized money. Chris Dixon, a famous Web 3 influencer and thought leader, explains decentralization is much bigger than bitcoin and crypto. He suggests it will fuel the development of the next phase of the internet, Web 3.
Overview of Decentralized Finance
Decentralized finance (DeFi) is a general term for an evolving trend that eliminates intermediaries by allowing people, traders, and businesses to perform financial transactions through emerging technology. It is a blockchain-based decentralized application (DApps) for financial services. DeFi confines a variety of technologies, business models, and organizational networks, generally replacing traditional forms of intermediation.
Decentralized finance is already redefining the future of finance. There is a significant shift in the underlying infrastructure powering financial applications, and it’s changing the way we think about permission, control, transparency, and risks. DeFi is creating a new market sector within the intersection of Web 3 technologies, digital assets, and financial services.
One of the innovative aspects of Web 3 is Smart Contracts, consisting of lines of code embedded in the blockchain. Smart Contracts have already become one of the vital functional elements in the DeFi today. They outline contract terms and conditions and monitor contracts, and can automatically set the financial transactions by executing a contract when its terms and conditions are met. Today, for example, Smart Contracts can monitor loan agreements and release collateral upon full repayment.
Some standard services offered by DeFi platforms include payments, loans, trades, investments, insurance, and asset management. The list is overgrowing and provides a tantalizing glimpse of a new era of crypto-based innovations, such as decentralized exchanges, synthetic assets, and flash loans.
While the space is evolving quickly, DeFi offers a functional description to distinguish itself from traditional financial and supplementary services. A DeFi protocol, service, or business model usually has the following four characteristics:
- Financial services or products
- Trust-minimized operation and settlement
- Non-custodial design
- Programmable, open, and composable architecture
This relatively new approach to web3-powered finance, which bypasses traditional intermediaries, has seen locked-up assets grow from less than $1 billion in 2019 to more than $100 billion just two years later, attracting at least one million investors in the process. Moreover, with an increasing number of institutional investors entering the DeFi industry, the market is expected to grow to $800 billion in 2022.
For investors considering broadening their portfolio into DeFi, it’s essential to understand the critical factors of the DeFi landscape.
Benefits of DeFi
Traditional banks are administrative and expensive to run. In addition, the transaction process takes a very high time, has multiple intermediaries, and has removed numerous individuals from the investment framework because of their rigid protocols. DeFi came as a savor for most of these issues. DeFi includes everybody in the financial system regardless of their pay, race, culture, wealth, or geographic area; they need any form of digital access. DeFi ways are often known as ‘Money Legos’ because of their adaptability to freely expand on existing protocols, customize interfaces, and integrate third-party apps.
DeFi also empowers a more prominent degree of openness and accessibility. Since most DeFi protocols are based on the blockchain — a decentralized public ledger — all transactions are available to all participants. On top, one of the most prominent causes of innovation within the DeFi area is interoperability. DeFi is an open protocol and provides valid possibilities to innovate, reuse existing frameworks and create unique DeFi services and products.
DeFi Architecture and Layers
DeFi architecture is much simpler than the traditional finance infrastructure; however, it’s not easy to develop, as it needs the most difficult cutting-edge technology as a base, the Blockchain. As per IBM, it is a shared, immutable ledger that facilitates the process of recording transactions and tracking assets in a business network. In the Blockchain, transactions are recorded in blocks and then verified by other users. If these verifiers agree on a transaction, the block is closed and encrypted; the next block usually has information about the previous block within it.
Within DeFi architecture, the base-layer blockchain system enables participants to store, exchange securely, and modify asset ownership information, replacing the settlement layer of conventional financial services. It also permits the creation of digital assets in diverse forms that can bring into DeFi applications. Apart from digital assets or cryptos, fiat currencies can also be used as assets, where stablecoins play a vital role. It is a class of cryptocurrencies that attempt to offer price stability backed by a reserve asset.
Additional layers of applications may function as aggregators, allowing users to shift among DeFi services, creating an environment where digital assets may be transferred freely, based on contractual logic, or restricted from other uses to provide liquidity or collateral, or lockups. There are also non-financial information flows that support the transaction activity. Then there are also the wallet software and interfaces that help users store, transfer and manage assets interacting with DeFi services.
We can also explore the architecture and DeFi stack from the products and application view, where we can also see some leaders. As we have seen, the Blockchain is in layer 0, which provides the trust and security level. Above this layer 0 is layer 1; the central part is about the interoperability, security, and composability, the popular Blockchain systems like Ethereum and Polkadot are some common examples. In addition, essential financial functions such as a decentralized stablecoin for payments in the DeFi ecosystem are also built on this layer, e.g., DAI and the Maker DAO protocol.
The next level, layer 2, provides users with slightly more complex functions like lending/borrowing; a good example is Compound and trading assets. This is followed by layer 3 and more sophisticated financial services built-in dApps e.g., decentralized exchanges like Uniswap or prediction markets like Augur. Finally, on aggregation layer 4, user-friendly dApps combine different functions and build a service similar to what we know from today’s banking apps: storing and sending money, investing in assets, borrowing against these assets or leverage trading, etc.
Another dimension of the DeFi environment is the implementation of decentralized governance mechanisms. Governance refers to how collective decisions are made, conflicts are resolved, and protocol changes are implemented. In DeFi, governance judges activity between the applications and underlying settlement layer, including decisions such as altering interest rates or collateral requirements.
However, this new model raises several further questions for policymakers and regulators, including:
– How are decisions made?
– How does accountability work?
– How does performance impact?
Many DeFi projects include a governance token that provides voting rights on certain governance decisions or partial decentralization with limited voting rights. Often these tokens are tradeable on exchanges, their value tied to scarcity and the activity level of the issuing DeFi service. In decentralized governance, decisions move entirely to a community of token holders by establishing a decentralized autonomous organization or DAO. The participants vote on changes to the protocol and are aligned through token incentives and rules written into smart contracts. Governance decisions are executed as Blockchain transactions, enforced through the consensus mechanisms of the settlement layer.
The Growing DeFi Ecosystem
The definition of DeFi itself is a concept of a financial ecosystem living digitally on a shared infrastructure. Creating a new world of the financial ecosystem, where the financial services like borrowing, lending, and trading operations on a public network, implying it’s accessible to anyone with an internet connection. Open-source protocols help to create and issue assets on this network. The DeFi ecosystem is growing massively; below are some with different categories.
DeFi is still a developing technology, and real-time adoption lags far behind the promising theory. Therefore, the DeFi applications have to overcome some significant obstacles and risks to gain the community’s trust. The disruption of DeFi to the traditional financial industry has led to calls for regulation, but it is unknown habitat.
A range of policy actions may be adopted for DeFi, including:
– Forbearance: the decision that no new regulations are needed
– Warnings: issuance of a warning to users/ consumers
– Enforcement: determinations that existing rules already cover the relevant actors and activities and have not been complied with
– Opt-in: provide the option to become subject to regulations in return for certain protections, even though there is no legal requirement
– Pruning regulations: eliminate regulatory requirements that are no longer essential in a DeFi context
– Limited license frameworks: the possibility of obtaining licenses of limited scope or undersize thresholds, with light-touch requirements
– Prohibitive measures: prohibit certain activities in the DeFi sector
– New license types: address risks with new categories designed for DeFi
– Issuing guidance or expectations: craft new frameworks, often with a public comment or consultation before its official release.
An effective regulatory response to DeFi is likely to involve a combination of existing regulation, retrofitted regulation, and new, bespoke regulation.
(Source: Decentralized Finance: (DeFi) Policy-Maker Toolkit, WEF)
Building Blocks of Decentralized Finance
DeFi is a good option for addressing multiple issues, including friction, document forgery, digital identity fraud, unwanted delays, exchange hacks, and private key compromisation. So when we need to consider the building blocks for decentralized finance, we really need to consider all the aspects from its value proposition, architecture, services, incentivization, governance, policy, and regulation.
DeFi is yet in the early phases of innovation, and the financial institutions, organizations, and regulators will have a prominent role in developing the ecosystem. Nevertheless, there are economic opportunities, including new services and products and operational efficiencies leveraging the existing DeFi ecosystem and infrastructure. Moreover, as this new financial ecosystem evolves, it will create significant growth opportunities for institutions that can adapt and embrace these changes.
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