An introduction to decentralised finance

Decentralised finance is a broad term for financial products and services which are built on decentralised, open-source software protocols. In the ever-evolving landscape of financial technology, the emergence of DeFi has been a ground-breaking paradigm shift, pushing society towards a future where financial transactions take place peer-to-peer and not through financial intermediaries.

However, this does not come without its own set of challenges. The evolution of DeFi services, which encompass activities such as lending, trading, liquidity provision, prediction markets, staking and yield-farming, challenges traditional regulatory approaches, which focus solely on imposing standards on intermediaries.

XReg’s latest series of articles will explore the intricate dance between innovation in DeFi and financial services regulation. It will contrast both existing traditional and progressive regulatory approaches to DeFi, delve into the essence of truly decentralised financial products and services vs. those that have certain decentralised components, and further examine regulatory strategies for both types of systems.

To start, we lay the groundwork by defining crucial terminology and setting the stage for a deeper dive.

What is DeFi?

The concept of DeFi was introduced when Satoshi Nakamoto published the Bitcoin whitepaper in 2008. The driving force behind the proposal was an ecosystem where two parties could transact using distributed ledger technology (DLT), an incorruptible record of transactions, without the involvement of any third-party financial institution. Fifteen years later, regulators and global standard-setting bodies have yet to agree on a consistent definition of DeFi.

However, most financial systems that use DLT or claim to be decentralised have individuals behind them who wield influence over certain components of the system. Regulators and industry often refer to these systems as decentralised in name only (DINOs).

We will use the term hybrid finance (HyFi) to identify systems which fall on the spectrum between traditionally centralised financial intermediaries (CeFi), where there exist accountable parties, for example, a board of directors, that are meaningfully held responsible for the operations of the institution, and true decentralised finance (tDeFi) in which there exists no individual or group of individuals responsible or accountable over the operations of the system.

What are the components of a DeFi system?

A distinction must be made between a system’s code and the system’s participants or those who interact with the code. In certain cases, participants may be readily identifiable, but not be meaningfully accountable. In DeFi systems, code executes automatically without human intervention.

Layers of code

Settlement layer

These are the base layers of a DLT system, where information and transactions are ultimately recorded. They represent a single immutable version of the truth which is relied upon by all the system’s participants.The record’s reliability derives from a consensus mechanism, which brings a majority of the system’s relevant nodes into agreement on the validity of a transaction before the transaction can be recorded in the settlement layer of code.

Asset layer

This is the section of the code that defines the parameters of the virtual assets and tokens which the DeFi system issues, accepts, interacts with and/or transacts in.

Protocol layer

Protocol layers contain one or more smart contracts. These are pieces of code that automate the execution of predefined actions based on predefined conditions, independently of any human interaction. A smart contract refers to its own code and any real-world data received from oracles.

Application layer

This layer contains the front-end tools that most people use to interact with DeFi systems (websites, decentralised applications, other interfaces). Users with a technical background in coding may interact directly with the protocol layer instead.

Participants that interact with the code

Users

Users are often individuals or businesses. A user requires an internet connection and a set of public addresses and private keys. They may use front-end interfaces or interact directly with the protocol layer.

Users may also play a role in securing a system by acting as validators in Proof-of-Stake (PoS) consensus mechanisms.

Oracles

Oracles are also external mechanisms designed to gather real-world data (e.g., asset prices, interest rates) and input it into DeFi systems. They may link data from a single source or use a decentralised consensus mechanism (analogous to the consensus mechanisms in DeFi system settlement layers) to gather the data from multiple sources and compare them.

Voting token holders

A decentralised autonomous organisation (DAO) enables token holders to collectively make decisions, allocate resources, and govern the DAO’s activities through a transparent and democratic process. Voting power is often in proportion to the holders’ ownership of the DAO-issued tokens.

DeFi systems may have governance mechanisms which interface with a DAO, granting token holders access to the protocol layer of the DeFi system. In this way, voting token holders can influence DeFi systems’ protocol upgrades and other governance-related decisions.

What’s next? Click here to read our second article in the series that covers both the traditional and innovative existing global regulatory approaches to DeFi.