The infrastructure that makes decentralised finance (DeFi) work remains mysterious to many. Hint: it’s about more than delivering yields on cryptocurrency, but it probably won’t make banks obsolete any time soon.
This article offers a run-down of what makes up DeFi infrastructure, how it differs from financial systems of today, gaps to be bridged, and what the future holds when it comes to finance and blockchain.
What is decentralised finance?
Decentralised finance, commonly referred to as DeFi, is an emerging alternative to traditional financial systems that provides financial services such as lending, payments, trading and insurance. DeFi is powered by decentralised protocols and uses blockchain as the settlement layer.
DeFi is fundamentally different from the traditional, centralised financial system (TradFi) — it operates without any centralised intermediaries such as banks or other institutions, relying instead on blockchains, smart contracts, open protocols and public APIs to function.
It can broaden access to financial services and speed up financial innovation. For example, DeFi could be used to enable institutional repurchase agreements (Repos) to be settled within the same day.
When I think about other reasons to like #DeFi I think of the following
• wider distribution of ownership – imagine AirBnB/Uber users owned the platform the more they used it
• inclusivity in company governance
• rapid innovation
• real world impact potential— Captain DeFi (@CaptDeFi) January 14, 2022
DeFi’s open, interoperable design and reliance on code rather than institutions gives it several advantages over traditional financial systems (TradFi). Core features and benefits include:
- Automation, such as automatic payment distributions.
- Easier value transfer, with payments made directly to Web3 wallets.
- Transparency and less need to put trust in others because blockchain enables visibility of funds in escrow. Access to immutable information could also fast-track insurance claim settlements.
- Composability, due to the inherent open source nature that enables fast project development.
- Traceability, by being able to easily see where funds are moving.
- Security of underpinning ledgers, especially those on large, cryptographically-secured public blockchains that rely on many decentralised nodes to validate and store transactions.
The composability of decentralised finance infrastructure has enabled rapid innovation, as projects are being built in the open using building blocks that can be re-used by others. According to Mark Monfort, Co-founder of the Australian DeFi Association, “Inherently, they are able to be seen, copied and edited by anyone and that’s added to the rapid experimentation that’s gone on in this space these past few years.”
CTO and co-founder of Australian non-custodial crypto exchange Elbaite, Samira Tollo, said DeFI’s interoperability essentially ‘democratises’ software.
“Currently, infrastructure services are reinvented multiple times, wasting time, money and resources. The lack of transparency and sharing allows for the monopolisation of key technologies,” she said.
“DeFi information sharing means that problems only need to be solved once and are shared with everyone. This not only saves on time, costs and resources, it removes entry barriers for new players and minimises monopolies from forming.”
—Samira Tollo, CTO and co-founder of Elbaite
What is decentralised financial infrastructure?
Decentralised financial infrastructure refers to the systems and technologies that underpin DeFi. While there’s a wide range of financial products and services available through DeFi systems, they all rely on a common infrastructure to function.
Broadly speaking, DeFi infrastructure falls into four key components:
- Decentralised applications (or dApps)
For the sake of simplicity, we’ll focus our discussion on the Ethereum DeFi ecosystem as it’s currently the dominant blockchain for decentralised finance. However, the DeFi infrastructure for other chains is similar to that of Ethereum and they generally have their own implementations of these same key components.
Key components of decentralised finance’s infrastructure
The blockchain is the most fundamental component on which DeFi systems are built. Blockchains are a type of distributed ledger that securely record all transactions flowing through them in a way that ensures the details cannot be changed. In DeFi, the blockchain functions as a decentralised transfer, settlement and record-keeping layer.
This means DeFi systems don’t need to implement separate record keeping functionality that requires human intermediaries that’s common in TradFI — they simply take advantage of the contracts inherent to the blockchain.
Assets in DeFi refer to cryptocurrency tokens which exist on a blockchain. Blockchains such as Ethereum have a native token, which in Ethereum’s case is Ether (ETH). Most blockchains also support other user-created tokens and stablecoins.
Crypto assets are used to interact with smart contracts — via cryptocurrency wallets and decentralised applications — to access decentralised financial services.
DeFi protocols are run by smart contracts — computer code that defines and controls certain transactions/rules — running on a blockchain that makes it possible to perform particular financial services. In essence, the smart contract in DeFi takes care of functions that would be performed by a financial institution in TradFi systems, but DeFi transactions are predominantly publicly visible.
On Ethereum there are now hundreds of DeFi protocols providing a huge range of financial services to users, some of which replicate traditional financial services and some which are entirely new, like flash loans (self-executing smart contracts for uncollateralised loans designed to take advantage of arbitrage trading opportunities by borrowing and repaying funds in a single transaction). Because all the protocols on a given blockchain share a common coding language and infrastructure, they can interact with each other, creating synergies and efficiencies not possible in TradFi.
On many blockchains, including Ethereum, smart contracts cannot be edited once they’ve been deployed to the blockchain so DeFi protocols can continue to consistently perform the same function indefinitely. Smart contracts are also generally open-source and are therefore highly scrutinised by technical users, reducing (but not eliminating) the risk of bugs and vulnerabilities.
Decentralised Applications (dApps)
Essentially, decentralised applications provide access to DeFi via a front-end user interface that looks and feels the same as a website or mobile app. dApps allow users to easily interact with blockchain-based smart-contract code to access DeFi products and services. dApps can mix and match various protocols to create entirely new kinds of financial products and services.
Traditional fintech architectures vs. DeFi architecture
So, how do traditional fintech architectures compare with how DeFi is structured? They both share what could loosely be classified as a customer-facing layer, a management layer, an application layer and a settlement layer — however the implementation of these layers across the two paradigms is very different.
Managing your money today involves using ATMs, bricks and mortar branches and banking websites, all of which are centralised and use proprietary, siloed software to function. Dealing with banks and other TradFi systems also means meeting certain requirements, including handing over sensitive identity documents.
DeFi customers instead use dApps and crypto wallets to interact with decentralised finance protocols. The DeFi customer-facing layer is open and accessible to anyone with a compatible Web3 wallet, such as MetaMask if using Ethereum-based dApps.
How do banks keep things in order in the back-end? Typically they’ll use systems like customer relationship management (CRM) software, contract management systems, and large databases. Again, these systems are centralised, proprietary and fully controlled by the financial institutions.
Whereas DeFi’s management layer includes:
- Block explorers, which allow anyone to scrutinise any transaction on the blockchain; and
- On-chain analytics, which provide insights into on-chain activity for any user.
The application of TradFi is seen through services like depositing, lending, investing, and insurance. These services are often opaque — in other words, it’s not clear where the money comes from, or goes to.
Additionally, the fractional reserve system (where banks only hold a small fraction of customer deposits as cash that’s available for withdrawals) used in TradFi — although efficient — leaves it open to market shocks and bank runs.
In DeFi, the application layer is the smart contracts containing the code to provide the financial services. Because these smart contracts are open source, the DeFi application layer is transparent — in the sense that the code can be examined to see precisely what will be done with assets. Of course, code can’t be made sense of by many — but it still provides an advantage over traditional infrastructure.
In contrast to TradFi’s fractional reserves, DeFi is almost always over-collateralised: it’s typical for DeFi users to be required to front more collateral than a loan is worth.
In the wake of high-profile collapses of crypto lenders and exchanges, it may seem like DeFi’s application layer is significantly more vulnerable than TradFi’s. Mark Monfort said most failures and scams are due to poor adoption of proper processes and bad actors in the space, rather than any technological issue.
“None of the issues we’ve seen with FTX, Celsius, 3AC and other failures of centralised exchanges or brokers was due to DeFi failures. DeFi loans [have been] automatically paid back when margin called and performed what the code was written to do.”
Mark Monfort, Australian DeFi Association
Perhaps the most fundamental infrastructure difference between TradFi and DeFi is the settlement layer. Traditional financial institutions use centralised, private software platforms, such as FIS and Fiserv, to settle transactions.
DeFi uses the blockchain for settlement, meaning all transactions are public, transparent, immutable, and auditable. Using a common settlement layer across all dApps also makes interoperability much easier than in TradFi.
Samira Tollo adds that while anyone can look at the underlying smart contract code to audit a DeFi project’s financial position, she envisions the emergence of a simplified, non-technical option.
“Auditing code might currently require trained professionals. In the future I hope to see applications or services that can conduct audits on DeFi applications, and through UX/UI make it easy for the everyday user to understand: similar to many comparison websites that exist for credit cards or insurance.”
DeFi Infrastructure — market map
Over the past few years, DeFi has grown quickly and now provides decentralised versions of a wide variety of financial products and services. Let’s take a quick look at the Ethereum DeFi market to get a sense of its diversity.
Automated market makers (AMMs) or decentralised exchanges
AMMs are decentralised exchanges (DEXs), which allow for automated, 24/7 trading through the use of liquidity pools. Liquidity providers can earn passive income for contributing assets to these pools through trading fees and yield farming, which incentivises users to add liquidity, increasing the overall liquidity of these protocols.
AMM examples include:
Now that Ethereum has become a proof of stake network (PoS), users can stake their Ether to a validator node to contribute to securing the network. Rewards are paid to users who stake their Ether.
Staking platforms include:
DeFi allows for automated borrowing and lending of crypto assets, with smart contracts defining preset rules for how funds are distributed, how collateral and liquidations are handled, and how fees are applied.
Examples of lending protocols:
DeFi asset management protocols aim to automate asset management using smart contracts, allowing users to take advantage of advanced investing strategies to maximise their returns.
Examples of DeFi asset management protocols:
DeFi prediction markets are essentially automated betting platforms which allows users to gamble on the outcome of a wide range of events such as sports and elections.
DeFi insurance protocols allow users to insure their DeFi investments against risks such as smart-contract exploits, credit defaults and stablecoin insolvency. These protocols don’t have a centralised insurance company: the risk is shared among users and often users decide which claims will be paid out.
DeFi margin trading platforms work similarly to centralised margin trading, the primary difference being that there is not a centralised intermediary lending funds to investors. In DeFi margin trading, loans are either made directly peer-to-peer or through shared lending pools.
Decentralised options and derivatives protocols allows users to trade options and other derivatives contracts. The underlying assets for DeFi options are cryptocurrencies such as Ethereum and Bitcoin.
Examples of DeFi options platforms include:
Potential missing pieces of DeFi infrastructure
Despite having grown and matured significantly recently, DeFi as a whole still lacks some important pieces of infrastructure compared to TradFi. Some of the most important additional to existing DeFi infrastructure include:
- Truly user-friendly apps: The DeFi space still feels complex and intimidating for many people and great front-end interfaces are needed to help users interact with protocols. TradFi service users are accustomed to user-friendly interfaces (think of an app like Robinhood) that abstract away much of the complexity.
- Strengthened security and consumer protections: DeFi users have very few consumer protections. There’s nothing like a government-backed bank deposit guarantee and there’s no centralised institution to complain to should something go wrong. Plus, while smart contracts are routinely audited by security firms, these audits don’t ensure any of the standard protections consumers are accustomed to from traditional financial institutions.
- Transaction rollbacks: In the world of DeFi, when a user makes a mistake, for example sending assets to the wrong address, no infrastructure exists to easily and reliably rollback the transaction. This makes DeFi inherently more risky for users than TradFi where institutions can usually rollback mistaken transactions.
- Identity solutions: The anonymity and openness of DeFi is a strength in some contexts, but in others it can be a liability, allowing bad actors to get away with things that would be much more difficult in a TradFi setting. Being able to identify users, while also preserving their privacy as much as possible, would discourage criminal behaviour in DeFi and could lead to a more efficient allocation of capital as risks to lenders could be reduced.
Samira Tollo argues that making DeFi infrastructure more reliable hinges on better user experiences, improved awareness and support for self-custody, and multiple layers of consumer protections.
“I believe it is only time until Apple, and Android integrate blockchain wallets into their native mobile apps,” she said.
“Layers of protection should be built into the app natively. They can look like having an option for simple or advanced views, additional confirmation windows to avoid accidental transfers, popups and warnings regarding scams, or even potentially integrating a database of known scammers so that users can be warned.”
Future of financial applications
Tollo said DeFi technology works but requires refinement before it’s completely usable by the wider public: “DeFi services are currently where early internet banking was in the mid-late 90’s.”
She’s confident the day will come when individuals are empowered by easy access to decentralised financial services and global commerce becomes more equitable.
“Eventually what we currently think of as DeFi; the technical jargon, acronyms and perceived complexity will disappear into the background,” Tollo said.
“The technology will integrate into mainstream society, shifting the focus towards consumer benefits and how much it improves everyday life. Similar to how online banking is no longer thought of as high-tech, dangerous, and complicated.”
Monfort says that DeFi must address its infrastructure shortcomings if the space is to truly mature and attract interest from more mainstream businesses and consumers:
“Overall, we’ll see blockchain and crypto grow up if we address these problems. It will enable more mainstream businesses the confidence to use blockchain tech and we’ll witness more ways that our everyday lives can be improved and made easier. Addressing these issues ensures that we are less likely to just be in an industry that only has projects out to make a quick buck.”
Monfort believes DeFi can realise its transformational potential by creating protocols that programmatically enforce regulation and consumer protections while maintaining its innovative advantage and efficiency.
“Initially, this was a retail-driven industry that performed phenomenally well to garner the interest and growth that it did. However, that came with a lack of regulation and compliance which is why we saw so many scams take place,” he said.
“Something I believe we’ll now start to see are systems that support on chain compliance. These will be protocols that ensure tokens are compliant with regional regulations.”
Mark Monfort, Co-founder, Australian DeFi Association