Decentralized Finance (DeFi) is redefining the future of finance with a major shift in the underlying infrastructure that powers financial applications.
It is changing the way we think about permissions and controls, transparency and risk.
DeFi is a developing market segment at the intersection of blockchain technology, digital assets and financial services. According to DeFi Pulse, the value of digital assets locked in the DeFi App has grown tenfold, from less than $1 billion in 2019 to more than $10 billion in 2020, with a peak of more than $80 billion so far in 2021. However, DeFi App and the underlying infrastructure are still in the infancy of their development.
The purpose of this report is to provide an introduction to the new and emerging area of DeFi infrastructure that today’s DeFi App provides support for. While it is easy to get caught up in the hype and speculation in this space, this report will focus on the key components of DeFi App, their key differences from traditional finance, potential risks, and the long-term impact these DeFi Apps pose.
Key structural commonalities of DeFi App
DeFi App is a financial application without a central counterparty. In practice, this means that you access these financial apps without an institution (such as a bank) interfacing with you; instead, the user interfaces directly with a program (such as a smart contract) on top of the protocol.
The main categories of DeFi App include decentralized exchanges, lending platforms, stable coins, synthetic assets, insurance, and more. While the scope varies, all of these DeFi App programs share a set of key commonalities, including
Use of the underlying blockchain as the core ledger
Open resources and transparency by default
Interoperable and programmable (composability)
Open and accessible to all (no licensing required)
Use of the underlying blockchain as the core ledger
In contrast to traditional financial applications that use core banking systems (Fiserv, Jack Henry, FIS, etc.) as the underlying ledger of record, the DeFi app uses the blockchain as its underlying core ledger.
A few of the most well-known blockchains used to build the DeFi App include Ether, Solana, and Binance Chain. These underlying blockchains store the content of the DeFi App program, the content stored in the smart contracts, and the ledger status of all transactions and withdrawals.
All the core accounting functions that ensure matching inputs and outputs are handled by the blockchain itself, and the DeFi App program does not need to create external systems to reconcile balances, as all transactions can be queried between the various block browsers.
In addition, there is no separate process for settling & clearing transactions compared to traditional systems. When a transaction is broadcast, transaction processing, clearing and settlement all occur at the same time. Although it is best to wait for about 21 blocks or more to ensure the final outcome of the blockchain itself.
Open resources and transparency by default
In contrast to traditional financial applications that are closed source and built on top of proprietary systems, DeFi applications are typically fully open source and built on top of an open underlying blockchain.
This leads to three interesting features.
Composability- The DeFi App program itself allows for forking, remixing and reusing in many other applications (more on this below).
Transparency – Since the DeFi App is open source and it is fully auditable, it is possible to know exactly what the smart contract is doing in terms of functionality, user permissions, and user data.
Auditability – Since the underlying blockchain itself is open source, the entire money flow is fully auditable, including collateral, transaction volume, defaults, etc. in the system.
Unlike traditional financial systems that are vulnerable to market shocks and operate under a fractional reserve system (opaque), – the DeFi system is fully transparent and over-collateralized – which allows DeFi companies to respond more effectively to economic downturns.
Interoperable and programmable (composability)
The majority of the DeFi App programs are fully open source – both the front-end and the smart contracts themselves – in order for developers to gain the trust of users. In addition, since DeFi App programs all run on top of a common platform (the underlying blockchain), these DeFi App programs are fully interoperable with each other and can be programmed to operate with any other DeFi App program in the ecosystem.
This is often referred to as DeFi’s “cryptocurrency building blocks” or “composability”. All of these DeFi App programs are like individual Lego blocks that can be remixed with other Lego blocks to build something new.
This is in stark contrast to the traditional financial system :
Decentralized infrastructure – traditional financial apps are not built on a common infrastructure.
Siloed applications – Traditional financial applications are typically exclusive to one banking institution. For example, all of Wells Fargo’s “fintech applications” can operate together, but not across different banking institutions.
Unfriendly to developers – Traditional financial applications are not made for other developers to build services.
The traditional financial system does have common standards; however, because financial institutions view their software as a moat for their competition, rather than the product as a differentiator, it is very difficult to reach consensus among market participants.
One of the biggest reasons why we are seeing so much innovation in the DeFi space is that the system is interoperable, which allows the developer ecosystem to have more creative expression of the products and services they create. On top of that, instead of wasting time doing repetitive work for nothing, developers can focus on what makes their products different, based on using a common framework.
Open and accessible to all
In traditional financial applications, new users often have to go through lengthy due diligence processes, income verification, credit checks, and even in-person meetings – just to be able to use a particular financial product.
Because of these arbitrary rules set by financial institutions, these check-in processes are prone to deviations, including lending discrimination, denial of basic banking services, opening lines of credit without consent, charging illegal fees, and more.
With the DeFi App, all you need to interact with these systems is a wallet address. the DeFi App program does not require income verification, they do not require a credit check, and in most cases, they don’t even need to know who you are, other than the wallet address you use.
DeFi App programs are often referred to as being permissionless. If you have the funds in your wallet for the transaction you want to make, you can do it. There is no institution or intermediary to stop or deny you the service. It doesn’t matter what your background is or what country you are from, the DeFi App program makes no difference.
This is one of the most under-appreciated aspects of the DeFi product.
Traditional Fintech Architecture vs. DeFi Architecture
Here is a more architectural diagram of the main technical differences between the traditional FinTech App program and the DeFi App program (simplified for brevity):
Here is a more direct comparison chart of some of the key differences between centralized and decentralized financial applications.
DeFi Infrastructure – Map Report
Below is a map report of two different DeFi ecosystems, one built on the Solana ecosystem and the other on the Ether ecosystem.
The reason I chose these two ecosystems to focus on is to show the breadth of DeFi applications built on the two different underlying protocols. I also believe Solana is the most interesting new Layer1 protocol because of its high transaction throughput (50K+ transactions per second), sub-second latency and transaction confirmation times, and the fast-growing developer ecosystem building DeFi apps on top of the Solana protocol.
While similar in structure, each underlying protocol has its own ecosystem and is largely independent of the others. Here are some further explanations of each layer and the trade-offs between them.
Foundation Layer (Layer1)
The base layer is the blockchain where the core ledger resides. Ether is the dominant Layer1 today, while Solana is the most promising new entrant with faster transactions, greater throughput, and lower transaction costs.
Never-ending data queries (retrieving blocks, finding transactions, synchronizing data, writing transactions, etc.) are needed for the underlying ledger. In the Ether ecosystem, entire industries have sprung up to address this need (Infura, Alchemy, etc.).
In contrast, Solana’s underlying ledger is fast enough and synchronized enough that teams can query Solana’s RPC nodes directly (though this may not last forever).
On Ether, there are various Layer2 solutions used primarily for scaling, as Ether itself cannot handle all transactions. Two of the promising scaling solutions include Matic, Optimism, etc.
On Solana, since only one layer can be built (no Layer2 extension solutions are needed), there is no need for specialized integration and no mismatch with the underlying ledger that is processing settlements.
Order Book Aggregation
For Solana, there is an additional layer occupied by a DeFi project called Serum, which provides a CLOB (Central Limit Order Book) that is used by all DeFi projects built on the upper layer.
When new DeFi projects are built on top of Solana (DEX, AMM, Options, etc.), they can pull orders from and push orders back to Serum, thus greatly reducing the cold start challenges faced by most new financial applications.
It is best thought of as the “networked liquidity” and “order management” system used by most programs in the Solana ecosystem.
A more innovative example of combining CLOB (Serum) and AMM is Raydium (very similar to Uniswap v3). The combination of these systems allows passive LPs to use Serum for active market making.
A common set of tools is needed to operate most DeFi App programs, both from a developer and end-user perspective. These services do not have direct traditional financial analogs, but they include
Wallets – the primary interface that people use to store assets and interface with the DeFi App.
Oracles — the on-chain data feeds that DeFi App programs use to reference prices and execute transactions (e.g., clearing).
Block Explorers and Analytics — Tools such as Block Explorers were created to allow people to directly query the blockchain ledger itself, and these are most often used when verifying transactions.
Stable Coins — The two main assets used in the DeFi ecosystem include the underlying native protocol tokens (ETH or SOL) and the ideal on-chain stable coins (USDC, Dai or Pai).
Front End – An emerging layer that creates easy-to-use front-end applications that can interact with multiple DeFi projects simultaneously or streamline transactions. These include Zapper.fi within the Ether ecosystem or Step Finance within the Solana ecosystem.
The DeFi App itself consists of all core financial applications that can be used directly or embedded into various applications within other cryptocurrency ecosystems.
Potential Missing Pieces of DeFi Infrastructure
When comparing DeFi infrastructure with traditional financial infrastructure, there are several parts worth exploring that do not yet exist in a decentralized world.
Here are some of the parts that need to be highlighted:
Consumer applications – In traditional finance, consumers typically act through consumer applications (e.g., Robinhood, Chime, Transferwise) rather than the underlying protocol itself. the front end of the DeFi space could be greatly improved and incorporate more of the consumer experience into into it. In general, the UI/UX of most DeFi App programs is still very difficult to use from the consumer’s perspective.
CRM (Customer Relationship Management) – The DeFi space does not really have a concept of customer relationship management and does not collect any consumer data. While great from a privacy perspective, there is also great value in understanding customers better.
Notifications – In the DeFi space, notifications or alerts don’t really exist at all. Nor is there any good way to communicate with users on a broader level.
Product Analytics – There are tools to measure blockchain activity, but no tools to measure engagement in the DeFi App.
Security – DeFi products are typically audited for security; however, none of the security audits ensure the protections that consumers are used to and most commonly found in the traditional financial world. On top of that, the demand for security auditors exceeds the supply, which is a major bottleneck.
Transaction Rollback – In traditional finance, if you make a mistake, a financial institution can initiate a transaction rollback. This doesn’t exist yet in DeFi.
Escrow — Right now, most DeFi programs require interaction from a personal wallet perspective. There is no custodian for you to interact with the DeFi App program.
Developer Platform – Most developers in the cryptocurrency space are built on top of the Layer1 protocol itself. There is no concept of a developer platform or middleware.
Embeddable Wallets – Wallets are considered to be these external services and there are no white label wallet offerings that can be directly embedded into the DeFi App program itself. There are a few initiatives, such as Torus, but these are still in their infancy.
Identity – One of the biggest complaints about DeFi from the traditional financial community is the issue of pseudonyms for users. Ideally, there needs to be a way to keep bad actors out while protecting consumer privacy.
The Future of Financial Applications
After meeting with hundreds of founders and seeing the progress the team has made, one thing is very clear: DeFi is innovating at 10 times the rate of traditional financial technology applications.
In traditional finance.
The underlying ledger is not open source and not developer friendly.
There are a ton of “banking services” applications that are just designed to wrap the underlying partner bank in a developer-friendly platform.
Fintech applications are very challenging to regulate and often require years of development before a single product is released.
DeFi is the opposite of that.
Everything is open source, including the ledger itself.
All transactions are public.
Everything is built from the perspective of the developer building the application on top of the protocol.
New DeFi App programs are built and released in weeks, not years.
We believe that DeFi developers will change the way the financial world works forever. We are very bullish on DeFi’s infrastructure stack and community.
Posted by:CoinYuppie，Reprinted with attribution to:https://coinyuppie.com/defi-is-innovating-at-10-times-the-rate-of-traditional-finance/
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