Decentralized finance (DeFi) is redefining the future of finance. The underlying infrastructure that powers financial applications is undergoing major changes. It is changing the way we think about authority and control, transparency, and risk.
DeFi is a developing market segment in the intersection of blockchain technology, Crypto assets and financial services. According to data from DeFi Pulse, the value of Crypto assets locked in DeFi App has increased tenfold, from less than US$1 billion in 2019 to more than US$10 billion in 2020, and the peak value so far in 2021 has exceeded US$80 billion. However, DeFi App and underlying infrastructure are still in the early stages of its development.
The purpose of this report is to introduce the new and emerging areas of DeFi infrastructure supported by today’s DeFi App. Although it is easy to be attracted by the hype and speculation in this field, this report will focus on the key components of DeFi App, their main differences from traditional finance, the potential risks, and the long-term impact of these DeFi Apps.
The main structural commonality of DeFi App
DeFi App is a financial application without a central counterparty. In practice, this means that when you access these financial applications, there is no institution (such as a bank) to connect with you; instead, the user directly connects with the program on the agreement (such as a smart contract).
The main categories of DeFi App include decentralized exchanges, lending platforms, stable coins, synthetic assets, insurance, and more. Although the scope is different, all these DeFi App programs have a series of major commonalities, including:
- Use the underlying blockchain as the core ledger
- Open resources and transparency by default
- Interoperable and programmable (composability)
- Open and accessible to everyone (no permission required)
Use the underlying blockchain as the core ledger
Compared with traditional financial applications that use core banking systems (Fiserv, Jack Henry, FIS, etc.) as the underlying ledger of records , DeFi programs use blockchain as their underlying core ledger.
Several of the most well-known blockchains used to build DeFi apps include Ethereum, Solana, and Binance Chain. These underlying blockchains store the content of the DeFi App program, the content stored in the smart contract, and the ledger status of all transactions and withdrawals.
All core accounting functions to ensure matching input and output are handled by the blockchain itself. The DeFi App program does not need to create an external system to adjust balances, because all transactions can be queried between various block explorers.
In addition, compared with traditional systems, there is no separate settlement & clearing transaction process. When a transaction is broadcast, transaction processing, clearing, and settlement all occur at the same time. Although it is better to wait about 21 blocks or more to ensure the final result of the blockchain itself.
Open resources and transparency by default
Traditional financial applications are closed source and built on a proprietary system. In contrast, DeFi applications are usually completely open source and built on an open basic blockchain.
This leads to three interesting characteristics:
- Composability-The DeFi App itself allows forking, remixing and reuse in many other applications (more on this below).
- Transparency-Since DeFi App is open source and it is fully auditable, you can know exactly what the smart contract does in terms of functions, user permissions, and user data.
- Auditability-Since the underlying blockchain itself is open source, the entire flow of funds is fully auditable, including collateral in the system, transaction volume, defaults, etc.
Unlike the traditional financial system (not transparent) that is vulnerable to market shocks and operates under a partial reserve system, the DeFi system is completely transparent and has excessive collaterals, which allows DeFi companies to deal with the economy more effectively Decline.
Interoperable and programmable (composability)
In order for developers to gain the trust of users, most DeFi App programs are completely open source-including the front end and the smart contract itself. In addition, since the DeFi App programs are all running on a common platform (the underlying blockchain), these DeFi App programs are fully interoperable and can be programmed to operate with any other DeFi App programs in the ecosystem.
This is often referred to as the “currency building block” or “composability” of DeFi. All these DeFi App programs are like independent Lego bricks that can be remixed with other Lego bricks to build new things.
This is in sharp contrast to the traditional financial system:
- Decentralization of infrastructure-traditional financial applications are not built on a common infrastructure.
- Isolated applications-traditional financial applications are usually exclusive to a banking institution. For example, all “financial technology applications” of Wells Fargo Bank can be operated together, but cannot be used in different banking institutions.
- Unfriendly to developers—Traditional financial applications are not made for other developers to build services.
Traditional financial systems do have common standards; however, since financial institutions treat their software as a moat for their competition, rather than product as a differentiating factor, it is very difficult to reach consensus among market participants of.
One of the biggest reasons why we see so many innovations in the DeFi field is that the system is interoperable, which allows the developer ecosystem to have more creative expressions of the products and services they create. In addition, developers do not need to waste time and wasteful efforts to do repetitive work, but can focus on the things that make their products unique based on the use of a common framework.
Open and accessible to everyone
In traditional financial applications, new users often need to go through a long application process, income verification, credit check, and even in person meetings-just to be able to use a financial product.
Due to these arbitrary rules formulated by financial institutions, these application procedures are prone to deviations, including loan discrimination, refusal to provide basic banking services, opening credit lines without consent, and charging illegal fees.
Through the DeFi application, you only need a wallet address to interact with these systems. The DeFi App program does not require income verification, they do not need a credit check, and in most cases, they don’t even need to know who you are, except for the wallet address you use.
DeFi App programs are usually said to be license-free. If you have funds for the transaction you want to make in your wallet, you can do it. There is no agency or intermediary to stop or refuse to provide services to you. No matter what your background is, and no matter which country you are from, the DeFi App program will not make any difference.
This is one of the least valued aspects of DeFi products.
Comparison of traditional financial technology architecture and DeFi architecture
Below is a more architectural diagram (simplified for the sake of brevity) about the main technical differences between traditional Fintech App programs and DeFi App programs:
Here is a more direct comparison of some key differences between centralized and decentralized financial applications:
DeFi Infrastructure-Map Report
Below is a map report of two different DeFi ecosystems, one is based on the Solana ecosystem and the other is based on the Ethereum ecosystem.
The reason why I chose these two ecosystems to focus on is to show the breadth of DeFi applications built on two different underlying protocols. I also believe that Solana is the most interesting new Layer 1 protocol because of its high transaction throughput (more than 50K transactions per second), sub-second latency and transaction confirmation time, and the speed of building DeFi applications on top of the Solana protocol. Growing developer ecosystem.
Although the structure is similar, each underlying protocol has its own ecosystem, which is largely independent of other protocols. Below are some further explanations of each layer and the trade-offs between them.
Basic layer (Layer1)
The base layer is the blockchain where the core ledger is located. Ethereum is today’s most important Layer 1, and Solana is the most promising new entrant. Its transaction speed is faster, throughput is greater, and transaction costs are lower.
Node infrastructure
It is necessary to perform non-stop data query on the underlying ledger (retrieving blocks, finding transactions, synchronizing data, writing transactions, etc.). In the Ethereum ecosystem, the entire industry has emerged to address this need (Infura, Alchemy, etc.).
In contrast, Solana’s underlying ledger is fast enough and synchronized so that the team can directly query Solana’s RPC nodes (but this may not last forever).
Layer2
On Ethereum, there are various Layer 2 solutions mainly for expansion, because Ethereum itself cannot handle all transactions. Two of the promising expansion solutions include Matic and Optimism.
On Solana, since only one layer can be established (without the need for Layer 2 extension solutions), there is no need for special integration, and there will be no mismatch with the underlying ledger that is processing settlement.
Order book aggregation
For Solana, there is an extra 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 Solana (DEX, AMM, Options, etc.), they can pull orders from Serum and push them back to Serum, which greatly reduces the cold start challenges faced by most new financial applications.
The best way is to think of it as the “networked liquidity” and “order management” system used by most projects in the Solana ecosystem.
A more innovative example 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.
DeFi toolset
From the perspective of developers or end users, a common set of tools is needed to operate most DeFi App programs. These services have no direct traditional financial analogs, but they include:
- Wallet -the main interface people use to store assets and interface with DeFi App.
- Oracles -The on-chain data feed used by DeFi App programs to reference prices and execute transactions (for example, clearing).
- Block Explorers and Analysis -Tools such as Block Explorers were created to allow people to directly query the blockchain ledger itself, which are most commonly used when verifying transactions.
- Stable currency -The two main assets used in the DeFi ecosystem include the underlying native protocol token (ETH or SOL) and the ideal chain stablecoin (USDC, Dai or Pai).
- Front End -A newly emerging layer that creates easy-to-use front-end applications that can interact with multiple DeFi projects at the same time or simplify transactions. This includes Zapper.fi in the Ethereum ecosystem or Step Finance in the Solana ecosystem.
DeFi App
The DeFi App itself consists of all core financial applications, which can be used directly or embedded in various applications in other cryptocurrency ecosystems.
Potential missing parts of DeFi infrastructure
When comparing DeFi infrastructure with traditional financial infrastructure, there are several parts worth exploring that do not yet exist in the decentralized world.
Here are some parts that need to be emphasized:
- Consumer application software -In the traditional financial sector, consumers usually act through consumer applications (such as Robinhood, Chime, Transferwise) rather than the underlying protocol itself. The front end of the DeFi space can be greatly improved and more consumer experience can be integrated into it. Generally speaking, from a consumer’s point of view, the UI/UX of most DeFi App programs is still very difficult to use.
- CRM (Customer Relationship Management) -The DeFi space does not have a true concept of customer relationship management, nor does it collect any consumer data. While it’s great from a privacy perspective, there is also great value in getting to know your customers better.
- Notifications -In the DeFi world, notifications or alerts don’t actually exist. On a broader level, there is also no good way to communicate with users.
- Product analysis -there are tools to measure blockchain activities, but no tools to measure participation in DeFi App.
- Security -DeFi products usually conduct security audits; however, no security audit can guarantee the most common protective measures that consumers are accustomed to in the traditional financial world. In addition, the demand for security auditors exceeds the supply, which is a big bottleneck.
- Transaction rollback -In traditional finance, if you make a mistake, the financial institution can initiate a transaction rollback. This does not yet exist in DeFi.
- Custody -Now, most DeFi projects need to interact from the perspective of a personal wallet. There is no custodian that allows you to interact with the DeFi App program.
- Developer platform -Most developers in the cryptocurrency field are built on the basis of the Layer 1 protocol itself. There is currently no concept of a developer platform or middleware.
- Embeddable wallets -wallets are regarded as these external services, and there is no white-label wallet product that can be directly embedded in the DeFi App itself. There are several initiatives, such as Torus, but these are still in their infancy.
- Identity -One of the biggest complaints against DeFi in the traditional financial world is the issue of users’ pseudonyms. 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 made by the team, it became clear that DeFi’s innovation speed is 10 times faster than traditional financial technology applications.
In traditional finance:
- The underlying ledger is not open source, and it is not friendly to developers.
- There are a large number of “banking services” applications just to package the underlying cooperative banks in a developer-friendly platform.
- The application of financial technology is very challenging in terms of regulation and usually requires years of development before a single product is released.
DeFi is the opposite:
- Everything is open source, including the ledger itself.
- All transactions are public.
- Everything starts from the perspective of developers building applications on top of the protocol.
- The new DeFi App program was created and released in a few weeks, not a few years.
We believe that DeFi developers will forever change the way the financial world works . We are very optimistic about DeFi’s infrastructure stack and community.