DeFi is a developing market sector within the intersection of blockchain technologies, digital assets, and financial services. Harvey et al. (2020) identify five key problems of Centralized Financial Systems. The first is the Centralized control by a limited number of financial institutions. Further, the US banking system is highly concentrated, considering that the four largest banks have a 44% share of insured deposits compared to 15% in 1984. (Harvey et al. 2020). In addition, still limited access to financial resources, if today more than 1.7 billion people are unbanked, making it very challenging for them to obtain loans and operate in internet commerce. Other areas include inefficiency, lack of interoperability, and opacity (Harvey et al., 2020). The implications of these five problems are twofold. First, many of these costs lead to lower economic growth, and second, these problems perpetuate and/or exacerbate inequality considering the low level of transparency (Harvey et al., 2020).
In approaching these problems, we must consider the innovation trilemma challenge (Brummer and Yadav 2018). The trilemma arises from our hypothesis that between the three objectives or values highlighted—financial innovation, market integrity, and rules simplicity— regulators can achieve at most two at any given time. If regulators prioritize market safety and clear rulemaking, they do so through broad prohibitions, invariably inhibiting financial innovation. Alternatively, suppose regulators wish to encourage innovation and provide rules clarity. In that case, they must do so in ways that ultimately result in simple, low-intensity regulatory frameworks, increasing risks to market integrity and consumers. Finally, suppose regulators look to enable innovation and promote market integrity. In that case, they must do so through a complex matrix of rules and exemptions, raising compliance costs and disproportionately impacting smaller firms and upstarts. (Brummer and Yadav 2018)
As reported by Katona (2020), there is no uniformly accepted definition of DeFi and the term is normally used to refer to a stack of applications run primarily on blockchains that are emerging as an alternative to the traditional banking ecosystem. Schär, suggest that Defi “The term decentralized finance (DeFi) refers to an alternative financial infrastructure built on top of the Ethereum blockchain. DeFi uses smart contracts to create protocols that replicate existing financial services in a more open, interoperable, and transparent way (page 1, 2020). The backbone of all DeFi protocols and applications is smart contracts. Smart contracts generally refer to small applications stored on a blockchain and executed in parallel by a large set of validators (Schär 2020).
The aggregation layer (Layer 5) is an extension of the application layer. Aggregators create user-centric platforms that connect to several applications and protocols. They usually provide tools to compare and rate services, allow users to perform otherwise complex tasks by connecting to several protocols simultaneously, and combine relevant information in a clear and concise manner.
The application layer (Layer 4) creates user-oriented applications that connect to individual protocols. The smart contract interaction is usually abstracted by a web browser-based front end, making the protocols easier to use.
The protocol layer (Layer 3) provides standards for specific use cases such as decentralized exchanges, debt markets, derivatives, and on-chain asset management. These standards are usually implemented as a set of smart contracts and can be accessed by any user (or DeFi application)
The asset layer (Layer 2) consists of all assets that are issued on top of the settlement layer. This includes the native protocol asset as well as any additional assets that are issued on this blockchain (usually referred to as tokens).
The settlement layer (Layer 1) consists of the blockchain and its native protocol asset (e.g., Bitcoin [BTC] on the Bitcoin blockchain and ETH on the Ethereum blockchain). It allows the network to store ownership information securely and ensures that any state changes adhere to its ruleset.