What is DeFi?

The UK’s Information Commissioner’s Office has written a report which, amongst other things, considers the privacy implications of Decentralised Finance (DeFi) ¹. The report explains that data stored as part of decentralised finance is unlikely to be anonymous and brings with it a wide range of privacy requirements. That aside, the DeFi section in the report starts with this excellent description of what DeFi is.

Traditional financial systems. Traditional centralised finance involves third parties, often banks, moving money between consumers and merchants. The third parties verify and approve the transaction, providing a layer of trust in the system and, usually, earning a fee in return.

DeFi system. DeFi uses software in the form of distributed ledger technology (DLT) to establish trust. This enables peer- to-peer transactions without a financial institution intermediary. Blockchain, the most widely-known application of DLTs, uses multiple interconnected database copies to process transactions. These databases, which might be in a number of different physical locations, are linked across a network, appearing to be a single database.

Information processed by these distributed databases is recorded in real-time within ‘blocks’ and verified by consensus. This consensus is usually reached by multiple people ‘mining’ (solving) cryptographic problems to achieve an agreed result (called ‘proof of work’), or they are put into the hands of those who have the most assets stored on, and therefore most investment in the security of the chain (called ‘proof of stake’).

If the transaction is validated, the block is written to the ledger. It is this scrutiny of financial transactions that reproduces central authorities’ traditional role of verification. Once validated, the process creates another block that has information about the previous block within it. This forms an unalterable ‘chain’ of transaction information. In a public blockchain it is this transparent, permanent and unchanging log of transactions that creates trust between everyone using the service.

Smart contracts. Some blockchains use ‘smart contracts’ which are software programs that are triggered when predetermined conditions are met (eg. a payment is made automatically when goods are confirmed as having been delivered). As long as all contractual conditions are met, smart contracts provide immediate certainty for everyone involved in a transaction, without using an intermediary such as a bank.

Governance – DAOs. In addition, often the governance of DeFi services and applications are distributed and autonomous, as is the case in decentralised autonomous organisations (DAOs). A DAO is an entity with no central governing body, that uses the blockchain to distribute decision making power across potentially thousands of ‘token holders’. Token holders are people with ownership in the decentralised protocol.

Self-sovereign systems. The evolution of DeFi and decentralised architectures could lead towards what some call ‘self-sovereign systems’. That is, people able to be their own bank, master their own information or manage their own identity. From a personal information standpoint, this would allow people to not just manage their own information but also choose how to monetise it. Such a future model could be empowering, but also puts near total responsibility for managing our information on ourselves.

1 - ico-future-tech-report-20221214.pdf – page 45-48.