DeFi protocols explained: its function and types

23 Nov 2021

In the previous article you had a chance to get a better understanding of DeFi, its history and core features. This time we are going to delve into the definition of protocols and take a closer look at the most popular and valuable ones that support the decentralized finance ecosystem. 

What are the layers of DeFi?

Every system is comprised of different parts and DeFi is no exception. Its system is designed in layers that are responsible for various processes and enable the smooth functioning of transactions and contracts. 

Decentralized finance is based on 5 layers: 

The first one is the settlement layer, the Ethereum blockchain that serves as the foundation for writing code and designing applications. This is the base layer used for the system to run, it would be impossible for DeFi to exist without the blockchain. 

This is due to the importance of the protocol layer — which is written on blockchain standardized codes (protocols). The protocol layer is responsible for programming applications and governing specific activities or tasks. Protocols enable the creation of the asset and the application layer.

The asset layer — cryptographic tokens, generated by protocols is the alternative to money in the crypto world. There are several types of them including cryptocurrencies (coins like Ether, Bitcoin, etc.) and digital assets (virtual versions of traditional stocks and shares). 

The application layer is made up of decentralized applications (dApps). In contrast to a protocol that is used by developers, an application is an interface for consumers. You can think of the protocol as the backend and the dApps as the front. In other words, it is a program we install on our gadgets to surf different websites and platforms.

And the final layer is the aggregation layer, which offers users a wide range of financial services all conveniently located in one place. A good example of this integration is a platform for lending and borrowing that allows the user to carry out both transactions simultaneously. This was created to be user-friendly and to make certain transactions faster.

What are DeFi Protocols and why are they important?

As mentioned before, the protocol layer is an essential part of the Defo ecosystem. 

The term protocol has been used in the IT-sphere for a while before the existence of decentralized finance. Simply, it is a standardized set of rules written for further codes to be created. It’s a description of specific conditions required for a code to run accurately and serve its purpose.

But is the definition of a protocol the same in the IT world as it is in DeFi? If you do research on the Internet, many articles will claim that yes, it is. But the problem is that it is only because most of them are written by people who are not insiders in the crypto world. Therefore, the definition of an IT protocol is taken for granted and copy-pasted to describe a DeFi protocol. Let’s shed some light on what exactly distinguishes them.

Firstly, a DeFi protocol is not just a list of recommendations for writing a code, it is a code itself, used for designing dApps. For instance, imagine you are a programmer and you need to write a code for a transaction that provides a loan from one person to another based on some conditions. Instead of writing a completely new code from scratch, you can just use a protocol, a code, that has already been written for the same reason earlier and has a history of running well. All you need to do is change the conditions on the protocol so that they suit your transaction. Thus, it will be a much less time-consuming, more secure, and easier process. Protocols simplify programmers’ work as well as the provision of services in DeFi.

To sum up, DeFi protocol is the background of a dApp, therefore these two words are often used interchangeably in DeFi.

The most popular DeFi protocols

Now that we have a better understanding of DeFi protocols, it is time to get familiar with the main types, their functions, and features. 

As mentioned above, DeFi protocols are represented by user-friendly decentralized applications that provide access to financial services allowing several market players (buyers, sellers, lenders, or borrowers) to be involved at the same time on peer-to-peer conditions.

Here are some of the most well known DeFi protocols: 

  • Decentralized Exchange (DEX): a platform used for trading different currencies (national and crypto), e.g. exchanging the U.S. dollar to Bitcoin and vice versa. Like all DeFi protocols, DEX links users directly without intermediaries. The leading ones are Uniswap, Binance, and Balancer.
  • Decentralized Lending / Borrowing Platform: these networks enable market players to lend and borrow money using smart contracts, in which the terms and conditions are set before the transaction. Thus, a borrower is obligated to repay a loan by a deadline and an investor earns interest. As smart contracts execute loans, third parties are eliminated from such transactions. This makes for more favorable terms such as lower rates and no bank fees. Some popular examples are: Aave, Compound, and MakerDAO.
  • Decentralized Insurance Platform (DIP): This project emerged because of numerous cases of fraud and malfunctions during transactions. These platforms are an alternative to traditional insurance. It aims to lower users’ risk in these situations and to protect their digital assets. The terms are the same — a market player is charged for a service and provided with this insurance in case of situations like smart contracts bugs or hacker attacks. DIP offers various use-cases such as crypto wallet insurance, smart contract cover, collateral protection for crypto-backed loans, etc. Nexus Mutual, Etherisc, and VouchForMe are some leading decentralized insurance providers.
  • Decentralized Prediction Market (DPM): a platform that gathers people who are willing to buy predictions rather than products or currencies. Users can bet on future events by buying those shares that align with their predictions. You can buy shares of everything from tomorrow’s weather to presidential elections. It is a modern way for the bravest and riskiest market players to try their luck and earn some extra money. Augur and Gnosis are two market leaders.
  • Asset Management Tools: is a protocol created for users who want to make investments, but due to a lack of knowledge need help. Thus, the investor is exposed to, according to the platform, the best possible investment strategies. Upon choosing their strategy the platform takes over and runs the process. Currently, the leading asset management solution is Set Protocol.

Final Words

DeFi is a complex ecosystem that is comprised of different layers that make it possible to operate. Although each one of them is crucial, the protocol layer is the one that handles the decentralized processes. As a protocol is a standardized code, used to create smart contracts and various decentralized applications, it enables access to market players on peer-to-peer conditions. Decentralized finance is currently developing and has a growing number of dApps created to solve technical issues and meet users’ demand. These applications are basically the decentralized versions of existing traditional financial institutions, such as currency exchanges, lending/borrowing, and insurance companies, prediction markets, and asset management. 

The cryptocurrency world is changing rapidly, so it is hard to predict what other platforms are going to emerge in the near future. Idealogic will be here to keep you updated on the new tendencies in DeFi.

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