What are the Building blocks of Decentralized Finance?

In today’s world, we hear skepticism about Decentralised Finance (DeFi) practically everywhere. The emergence of DeFi has been considered by regulators as posing a risk to the traditional banking system. DeFi has set out to overcome all the obstacles one would face while using Traditional Finance, but people still have their doubts.

DeFi is a relatively new field to all of us, developers and investors alike. It’s important to us to know everything about technology before we start utilizing it. That’s what we aim to do today. We know what DeFi is, but today we’ll learn what it’s made of. The services which make up the technology are familiar to us in one way or the other. But before that, while learning about DeFi, a technology so similar yet so different from our traditional banking and finance, it only makes sense to clear our concepts by comparing these two together first.

Traditional vs Decentralised Finance

When it comes to distinguishing between the two, there are a few crucial aspects to consider. Let’s list them out accordingly.

1. When it comes to holding the Custody of Assets, Traditional Finance holds and regulates it via a service provider or a custodian on behalf of the asset holder. But when it comes to DeFi, the assets are held by the users themselves in non-custodial wallets or via smart contract-based escrow wallets.
2. Traditional finance has fiat (government-issued currency) as the Unit of Account. DeFi uses digital assets or stable coins. We’ll talk about stable coins in detail shortly.
3. Intermediaries Execute and process the transactions between parties in Traditional Finance. DeFi uses self-executing smart contracts to do so.
4. A public blockchain serves as the trusted source in decentralized finance, controlling all financial transactions. In traditional finance, on the other hand, Public Governance, which includes regulations and recognized financial organizations, serves as the source of trust, governing all operations.
5. Traditional finance is opaque and closed. DeFi is transparent and open. Because there are no hurdles to entry, anyone with programming skills can contribute to the development of financial services and tools and implement them on public blockchains networks. This allows for enhanced Cross-Service Interaction.
6. Many entry-level restrictions exist in the traditional financial system, including proper licensing and authorization from regulators, leaving established institutions with little room for Innovation.

In addition, developers can create financial instruments that can operate digital assets without restrictions thanks to decentralized finance. Tokenization of almost everything, from loans to collateral and financial obligations, is a possibility. Because blockchain technologies are open and transparent, they can make loan issuance, repayments, and terms understandable by both machines and people.

As an example of financial paradigm-shifting, let’s talk about platforms like XinFin, a hybrid blockchain network. XinFin in 2018 introduced a project called Project Sandbox for Asset Tokenization of Public Infrastructure Assets. XinFin said that asset tokenization of physical infrastructure can assist development institutions in removing riskier loans from their books, which can then be sold on to insurance companies looking for a utility-type rate of return. This is only possible now because of the technology of Decentralised Finance.

To understand more about DeFi, we will now be talking about the building blocks of DeFi and how they shape the technology into what it is today.

The bricks of the DeFi tower

DeFi typically makes use of a number of blockchain-related technologies. All of them have uses outside of DeFi but are critical components of the DeFi ecosystem.

1. Blockchains:

In the simplest sense, a blockchain is a chain of blocks that contain information. A blockchain is a distributed ledger shared among nodes of a network of computers. Blockchain functions like a database that stores data in a digital format. The most famous reference for the work of a blockchain is its role in maintaining a safe, secure, and entirely decentralized transaction history for cryptocurrency systems like Bitcoin. The USP of blockchain is its surety of adherence and the security of storing data records, while simultaneously building up the confidence of proceeding without requiring a trusted third party. Blockchain is where DeFi lives.

2. Digital Assets:

Individuals can possess and transfer digital assets, which can be used as a kind of currency in transactions or as a storage medium for intangible content such as computerized artworks, video, or contract documents.

Cryptocurrencies like bitcoin, asset-backed stable coins like tether, and non-fungible tokens (NFTs) — certificates of ownership of original digital media — are examples of digital assets.

3. Wallets:

A DeFi wallet is a digital wallet where you can store your cryptocurrency and assets while holding complete control over them. It is viewed as one of the safest storage options available today. This wallet, as an access point, provides users with a solution that puts the entire control in their hands. A typical bank, on the other hand, retains control of the user’s assets in its holdings and requires user verification and other related information to access them.

Some examples of DeFi wallets are MetaMask, Coinbase, Argent, etc. These wallets allow users to store crypto coins as well as manage assets effectively.

4. Smart Contracts:

A smart contract is a computer program or a transaction agreement that self-executes when the conditions of the agreement are met. These conditions are coded directly onto the program. The code, as well as the encoded buyer-seller agreements, are shared throughout a decentralized blockchain network. Transactions are traceable and irreversible, and the programming controls how and when they are carried out.

Smart contracts don’t require a central authority, legal system, or any private external regulation to execute trustworthy transactions and agreements between anonymous participants located anywhere geographically.

5. Decentralized Applications (DApps):

Decentralized applications (dApps) are digital applications that run on a blockchain or peer-to-peer (P2P) network of computers rather than on a single computer. A single authority cannot control DApps, as they thrive beyond the jurisdictions of a central authority. Blockchain technology is utilized for DApp’s data storage and processing. This is implemented using smart contracts. They are open-source, meaning the code is available to everyone.

6. Governance Systems:

Governance procedures are used by DeFi initiatives to make critical choices like protocol updates, hiring developers, and even changing governance frameworks. On-chain governance was created to provide individual users more control over the governance process by allowing stakeholders to vote for protocol updates directly on the blockchain. Governance ideas are frequently coded into smart contracts under this system, and they are implemented if they acquire the required figure of votes to be ratified.

7. Decentralized Autonomous Organizations (DAOs):

DAO (Decentralized Autonomous Organization) is an organization that is governed by rules encoded in a transparent software program. It is managed by its members and not influenced by a central government. No managers are required because the rules are encoded in the code, hence there is no need for bureaucracy or hierarchy.

8. Stablecoins:

Stablecoins are cryptocurrencies supported by real-world assets, such as commodities, government-issued fiat currency, gold, or other cryptocurrencies. Stablecoins are digital assets with a fixed value, similar to fiat money, but with the usefulness and mobility of a cryptocurrency. Simply put, they serve as a link between volatile cryptocurrencies and stable fiat currencies.

Stablecoins are of three types, namely, Custodial, Asset-backed, and Algorithmic.

9. Oracles:

Oracles are third-party services that enable smart contracts on blockchains to receive data from outside their ecosystem. Oracles serve as a data source that may be fed into a smart contract, acting as an information bank, enabling them to access real-time data that isn’t available on the blockchain, such as asset prices that keep changing in real-time. Oracles are layers that check on-chain data connected to real-world events and then transmit the accumulated data to smart contracts, although they are not data sources themselves.

Embracing advancement

These services make DeFi into what it is today. Even though we’re familiar with most of them individually, it’s always interesting how they come together to create a technology that is predicted to replace the age-old traditional financing as we know it. Countries have already started making moves to recognize decentralized services, and it’ll only be a matter of time before we fully embrace DeFi into our lives.