To understand how DEFI borrowing and lending work it helps to summarise how decentralised finance functions. There are five distinct layers:
The Settlement Layer
This is where any transactions and balance changes are recorded. In traditional finance, this would be a bank, but in DEFI the role of the central authority is replaced by a blockchain, such as Ethereum.
In order for transactions to be settled on a blockchain, users must pay fees for their transactions to be added to new blocks of data. Fees will vary depending on how individual chains work and the demand at the time for limited block space.
The Settlement Layer is often described as Layer 1 or L1. It provides security for all layers above.
The Asset Layer
In order for financial transactions to take place, the Settlement Layer must support digital assets. Each blockchain has a native asset, for example, Ethereum’s native token is ETH, but in order to create a wider interoperable ecosystem, Ethereum supports a specific asset standard known as ERC-20 allowing for the creation of assets that function in a similar way.
The Protocol Layer
Blockchains like Ethereum rent out the computing power for protocols which provide the logic for DEFI services. You can think of protocols like the backend in computing terms, the engine that the user doesn’t see.
Protocols are collections of Smart Contracts written to execute the specific logic for borrowing funds or lending funds. Some Protocols also have their tokens used to manage Governance, giving holders a vote on how the Protocol is run.
The function of the tokens is again dictated by Smart Contract and the Governance is managed through a DAO – Decentralised Autonomous Organisation – that handles proposals and voting.
The Settlement Layer is often described as Layer 2 or L2.
The Application Layer
Where the protocol layer is the backend, the application layer is the front end. This is the dApp – digital application – that a user sees online. A dApp will provide an interface (website) for users to connect their wallets in order to execute transactions.
The User/Wallet Layer
As DEFI has no central point of control users don’t create accounts or share personal information as in traditional banking arrangements. Instead, a user simply connects their crypto wallet to the dApp and approves certain actions e.g depositing funds under agreed terms, and paying the Settlement Layer to confirm each transaction.
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