DeFi Protocols: essential components of decentralized finance
By Yuliia Rokytska 2001 5 Aug 2022
DeFi is the industry of the blockchain and cryptocurrency world, with $39.5 billion being blocked. Our article explains what DeFi is, which DeFi protocols exist, and why it is needed.
What are DeFi protocols?
Over the past few years, the DeFi sphere has been intensely expanding. Blockchain technology, the Ethereum network, the dynamic spread of cryptocurrencies, and the inconvenience people face when dealing with traditional finance all contribute to this.
Suppose you want to take advantage of new, modern services or just keep up with innovative trends. In that case, it’s important to understand what DeFi is, what DeFi protocols are, and to understand the components of the new blockchain industry sector.
DeFi is an acronym for decentralized finance, which emerged in 2017, along with interest in cryptocurrencies, and means using a peer-to-peer network instead of a centralized one. Distributed ledgers, i.e., blockchain, are the foundation of the field. This means that DeFi is analogous to classical financial instruments, only without a central management body.
Instead of a client-server multirange network, decentralized finance functions in a peer-to-peer network, where people interact with each other on similar conditions, acting as a server and a client simultaneously. Other features of DeFi include public accessibility, expressed in open-source code, and the use of smart contracts.
By 2022, many credit exchanges and other platforms, as well as tokenized digital currencies and stablecoins, had emerged in the field of decentralized finance. The new direction has quickly evolved into a vast, multi-level ecosystem, with protocols as one of its components.
DeFi protocols are a series of templates that programmers use to write code in this direction designed to perform specific actions or tasks in the blockchain. DeFi protocols are necessary for convenience, reflected in the compatibility of services and apps between different companies. In this way, an appropriate level of liquidity is maintained in the ecosystem.
Decentralized applications (dApps) are the visible side of DeFi protocols. They offer financial services to users in an accessible way.
As a result, the concepts are sometimes used interchangeably.
The meaning of the term “protocol” in the DeFi world
In decentralized finance, the term “protocol” is not used quite in the same way as in IT. For the information technology sector, it is fair to say that a protocol is a typed set of instructions that defines how information is transmitted and computer codes are written. They are specific rules required to be followed for accurate operation and proper execution of tasks.
In DeFi, the protocol is the code itself, which is used to develop dApps, changing its terms to suit specific tasks. That is, a programmer who needs to write code for a particular transaction takes an existing protocol and modifies it to meet his/her requirements. This simplifies the process and makes it less resource-intensive and time-consuming.
Types of DeFi protocols
We can distinguish the following types of DeFi protocols:
- Decentralized exchanges;
- Lending and borrowing platforms;
- Peer-to-peer insurance platforms;
- Asset management services.
Decentralized exchanges (DEX) are online cryptocurrency trading platforms that connect customers directly without intermediaries. Industry leaders include players such as Uniswap, PancakeSwap, and DODO. Also, DEX can often be found as an additional tool on centralized crypto exchanges. For example, WhiteBIT has such a platform.
Decentralized lending platforms offer their services based on smart contracts, which store the terms and conditions of lending. Funds disbursement occurs without a third party and on more favorable terms: low commissions, absence of bank fees and other bureaucratic issues. Aave, MakerDAO, and Compound are popular in this regard.
Digital insurance platforms (DIPs) emerged due to recurring fraudulent transactions, hacker attacks, and smart contract failures. They are designed to minimize user risk and protect his/her digital assets. With DIP, you can insure your cryptocurrency wallet, smart contract, or protect a credit backed by cryptocurrency. The leading representatives of decentralized insurance are Nexus Mutual, Etherisc, and VouchForMe.
Asset management platforms are created for those who want to invest but do not know enough about it. Such a platform offers the most profitable investment strategies and takes care of the entire process. Currently, the company Set Protocol can be called a visible player in the market.
What are the other components of DeFi?
DeFi, as an established ecosystem, consists of many levels, each responsible for specific processes and making the entire sector work.
Decentralized finance includes components such as:
- cryptographic tokens;
- decentralized apps;
- aggregator platforms.
Blockchain is the basis for the development of DeFi apps and an essential element for the existence of decentralized finance. It is hard to imagine the whole system working without it.
Next comes the protocol, which is the standardized blockchain code. It is used to develop apps and manage specific tasks & actions.
Cryptocurrencies and other digital assets are an alternative to fiat money in DeFi, with the help of which all transactions are performed.
Decentralized apps are the interface that the end user sees. They run on the protocols used by the programmers to create them. In other words, these are apps that offer various DeFi services.
The latter component provides several opportunities in decentralized finance simultaneously and on the same platform. This accelerates certain transactions and aligns with established principles in the information technology sector.
Although all levels of the ecosystem are essential and integral, these are the DeFi protocols precisely that pave the way for creating new decentralized financial platforms.