Decentralized Finance (DeFi) is redefining the future of finance. There is a major shift going on in the underlying infrastructure powering financial applications, and it’s changing the way we think about permission and control, transparency and risks.

DeFi is a developing market sector within the intersection of blockchain technologies, digital assets, and financial services. According to DeFi Pulse, the value of digital assets locked into DeFi applications grew 10X from less than $1 billion in 2019, to over $10 billion in 2020, and over $80 billion at its peak thus far in 2021. Yet the DeFi applications and underlying infrastructure are still in its nascent stage of development.

The goal of this report is to provide an introduction of the new emerging area of DeFi infrastructure powering DeFi apps today. While it’s easy to get caught up in the hype and speculation within the space, I’ll focus on the key components of DeFi applications, their key differentiation compared to traditional finance, potential risks, and longer term implications these DeFi apps are causing.

DeFi apps are financial applications with no central counterparties. In practice this means there is no institution (e.g. banks) you are interfacing with to access these financial applications; instead users interface directly with the programs (e.g. smart contracts) on top of the protocol itself. For more of a DeFi 101 primer I highly recommend this report.

The major categories of DeFi apps include decentralized exchanges, lending platforms, stablecoins, synthetic assets, insurance, among others. While diverse in scope, all of these DeFi apps share a major set of commonalities including:

1. Using underlying blockchains as the core ledger
2. Open source and transparent by default
3. Interoperable and programmable (composability)
4. Open and accessible to all (permissionless)

Using Underlying Blockchains as the Core Ledger

Compared to traditional financial applications which use core banking systems (Fiserv, Jack Henry, FIS, etc.) as the underlying ledgers of record, DeFi apps use blockchains as their underlying core ledger.

A few of the most prominent blockchains used to build DeFi apps include Ethereum, Solana, and Binance Chain, etc. These underlying blockchains store the ledger state of what is deposited into the DeFi apps, what is stored within the smart contracts, all of the transactions, and withdrawals.

All of the core accounting functions to ensure matching inputs and outputs are handled by the blockchain itself, the DeFi apps don’t need to create external systems to reconcile balances, because all of the transactions are queryable across the various block explorers.

In addition, compared to the traditional system there is no separate process of settling & clearing transactions. The transaction processing, clearing, and settling all happen at the same time when the transaction is broadcasted. Although it is advisable to wait around ~21 blocks or more to ensure finality on the blockchain itself.

Open Source and Transparent by Default

Compared to traditional financial applications which are all closed-source and built on top of proprietary systems, DeFi applications are typically entirely open sourced and built on top of open underlying blockchains.

This causes three interesting properties:

1. Composability — The DeFi app itself can be forked, remixed, and reused in many other applications (more on this below).
2. Transparency — Since the DeFi app is open source, it is completely auditable to know exactly what the smart contract is doing in terms of functions, user permissions, and user data.
3. Auditability — Since the underlying blockchain itself is open sourced, the entire flow of funds is completely auditable including collateral in the system, trading volume, defaults, etc.

Unlike the traditional financial system (which is opaque), runs on a fractional reserve system, and is prone to market shocks — the DeFi system is completely transparent and over-collateralized — which allows DeFi companies to weather downturns much more efficiently.

Interoperable and Programmable

In order for developers to gain the trust of users, the majority of the DeFi apps are completely open source — including the front end and the smart contracts themselves. In addition, since DeFi apps all run on top of a common platform (the underlying blockchain) these DeFi apps are completely interoperable with each other and can be programmed to work with any other DeFi app in the ecosystem.

This is commonly referred to as the “money legos” or “composability” aspects of DeFi. All of these DeFi apps are like individual lego pieces which can be remixed to work with other lego pieces to build something new.

Contrast this to the traditional financial system where;

• Infrastructure Fragmentation — Traditional financial apps are not built on top of common infrastructure.
• Siloed Applications — Traditional financial apps are typically proprietary to one banking institution. For example, all of Wells Fargo’s “fintech apps” work together but not across different banking institutions.
• Developer Unfriendly — Traditional financial apps are not made for other developers to build services on top of.

The traditional financial system does have common standards; however, it’s extremely hard to reach consensus across market participants because financial institutions view their software as their competitive moat instead of using products as a differentiating factor.

One of the biggest reasons why we have seen so much innovation within the DeFi space is because the systems are interoperable, it allows the developer ecosystem to have more creative expression on the products and services they create. On top of this, developers don’t need to waste time reinventing the wheel, but rather can build upon common frameworks and focus on the things that make their products special.

Open and accessible to all

With traditional financial applications, new users typically need to go through a lengthy onboarding process, income verifications, credit checks, or even in person meetings — just to be able to use a given financial product.

Because of these arbitrary rules set by financial institutions, these onboarding processes are prone to bias including lending descrimination, denial of basic banking services, opening credit lines without consent, charging illegal fees, etc.

With DeFi applications, all you need is a wallet address to interact with these systems. DeFi apps don’t ask for income verification, they don’t need credit checks, and in most cases they don’t even need to know who you are outside of the wallet address you are using.

This is commonly referred to as DeFi apps being permissionless. If you have the funds inside your wallet for the transaction you want to do, you can do it. There are no institutions or intermediaries to stop or deny service to you. It doesn’t matter what your background is or what country you come from, DeFi apps do not discriminate.

This is one of the most under-appreciated aspects of DeFi products.

Here is a more architectural diagram on the main technical differences between a traditional fintech app and DeFi app (simplified for brevity’s sake):

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Source: https://medium.com/racecapital/defi-infrastructure-101-overview-market-landscape-78e096a85834?source=rss——-8—————–cryptocurrency