In the last article, we briefly introduced decentralized finance (DeFi), and how past events have led to today’s ecosystem. We now take things a step further by outlining the DeFi stack, which should help you understand how various layers of blockchain technology intertwine to deliver value to its users and supporters. You will find below a graphic representation of the DeFi stack, which coincides with this article’s main sections.
The DeFi Stack
1. Settlement Layer
The settlement layer corresponds to “Layer-1” chains: these are blockchains like Ethereum, Solana, Terra, Aleph Zero, etc., in which transactions made through DeFi protocols (Dapps).
Blockchain trilemma (Scalability, Security and Decentralization); the Trilemma states that at any time, blockchains can only achieve 2 design specs, at the cost of neglecting the other one.
Transactions are validated through consensus mechanisms. Most notable and widespread today are Proof of Work (PoW) and Proof of Stake (PoS).
2. Asset Layer
The asset layer comprises both a chain’s native coin (ex: $ETH, $SOL, $LUNA, $ AZERO, etc.) and assets adhering to token standards (ERC-20, ERC-721, SPL, etc.). From a technical point of view, native coins all have unique configurations, which is why exchanges need more time to connect and list them. Token standards were introduced to lower the barriers to entry, making anyone able to create their own cryptocurrency overnight. In simple terms, a token standard is a template containing a defined set of variables. For example, the variables for an ERC-20 token (contract) are the following:
- Token name (optional)
- Symbol (optional)
- Number of decimal places with which the token can be measured (optional)
While the introduction of token standards facilitated innovation as founders could now spend more time on building actual use cases for their tokens, it’s important to keep in mind that they also made it easier for malicious actors to create scams (often, by raising capital for a project that doesn’t exist and running away with the funds).
Token standards made possible the use of derivatives: for example, wrapped ETH ($wETH) is an ERC-20 token worth 1:1 with $ETH. It allows $ETH holders to use their coins indirectly in DeFi protocols (such as borrowing and lending).
Stablecoins are an important of assets which are pegged to fiat currencies, most often the U.S. Dollar ($USD). Their price stability makes them excellent tools for DeFi. Stablecoin examples include Tether ($USDT), USD Coin ($USDC) and $DAI. In the next article, we will delve deeper into how they try to keep their peg in the next article of this series.
3. Protocol Layer
A wide variety of Decentralized Applications (DApps) compose the Protocol Layer. Each DApp consists of a set of smart contracts interlinked together. A DApp is typically started on a single chain, but recent advancements in interoperability (notably through bridges and new code libraries) have led to the talk of multi-chain DApps (think of softwares running on both Windows and MacOS, leading to great adoption).
Examples of DeFi Dapps include:
- Decentralized Exchanges (DEX’s)
- Borrowing & Lending
- Blockchain Derivatives (ex: Synthetic tokens)
4. Application Layer
Think of the Protocol Layer as the back-end and of the Application Layer as the front-end. It consists of User Interfaces (UIs) that allow any DeFi user to interact with the Protocol Layer, regardless of their technical skills. The Application Layer is a no-code environment most often taking the form of web clients (device-agnostic websites that can be accessed through any browser).
5. Aggregation Layer
Aggregators have appeared as a direct result of DeFi’s adoption growth: As more and more DApps emerged, users started spending more time managing their positions across all of them, as well as searching for the best options/products to use. The Aggregation Layer is considered an extension of the Application Layer in that it is also user-focused. Aggregation allows DeFi users to maximize their returns while reducing the efforts required to do so.
Is blockchain a body?
Some people say that blockchain is shaping up to make the God Protocols a reality. This idea dates back to 1997, when it was submitted by Nick Szabo. Here is another way to look at the DeFi stack.
What to Expect Next
We hope you enjoyed this article and that you are looking forward to the upcoming ones. Our DeFi Education Series will progressively get more technical, as the following topics will be covered:
- Part 3: Stablecoins, DEXs, Lending & Borrowing, Insurance, and more
- Part 4: Advanced Concepts: Flash Loans, Interest Rate Swaps, Yield Hacking & More
Have a concept or trend you’d like us to explain? Let us know on Twitter!
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DISCLAIMER: Content in this article does not constitute financial advice. Cryptocurrencies are volatile assets. Always do your own research and invest at your own risk.