Interoperability difficulty is a significant impediment to the growth and development of the finance industry. This article looks into the implications of interoperability on decentralized finance (DeFi).

In recent years, decentralized finance (DeFi) has become prominent, offering a new way to coordinate financial transactions without using traditional intermediaries like banks.

However, interoperability, or the capacity of different DeFi protocols and blockchains to interact and work successfully, is one of the most difficult challenges confronting the DeFi industry.

Before we delve into the main discussion of this article, let us gain basic knowledge as to what decentralized finance and interoperability are.

What is Decentralized Finance (DeFi)?

Decentralized finance, sometimes called “DeFi,” is an open global alternative to the constrained, controlled, and centuries-old traditional financial system most people are accustomed to.

Anyone with a smartphone and internet connectivity can use DeFi to invest, borrow, lend, and trade their money on their terms.

Instead of employing banks as intermediaries, DeFi sets intelligent contracts at the heart of a peer-to-peer financial system built on open-source blockchains like Ethereum.

It is a system that allows people to invest, borrow money, transfer money internationally, and generally do anything (related to digital money) without leaving their homes.

DeFi is analogous to a bank with several businesses but no physical locations. It facilitates trading, streamlines exchange operations and pays interest on investments without requiring a physical office or human people.

A decentralized blockchain network underpins this financial system. Cryptocurrencies and blockchains are closely tied to DeFi. When you communicate with a DeFi protocol, you simply interact with software.

Blockchain and other open technologies, such as artificial intelligence (AI), machine learning, and smart contracts, can be used to develop a decentralized system.

In a nutshell, DeFi strives to eliminate the need for middlemen or other forms of intermediary or third-party interference in transactions.

For example, while opening an account or applying for a bank loan, an individual must go through a long list of procedures (in centralized finance), such as submitting original IDs, proof of address, Biometric IDs such as fingerprints, and so on.

DeFi, however, does not demand any of this information (or meet these KYC criteria) when opening an account. Instead, after creating a DeFi app account, a user can trade and lend without providing any identification.

Furthermore, the entire onboarding process is performed without the involvement of a third party.

DeFi has also introduced a new concept known as Open Banking. Everyone who uses DeFi has their wallet. Financial transactions in the DeFi ecosystem are only possible with this wallet, which grants users access to private crypto keys.

A DeFi wallet is comparable to a physical one, except that it carries digital rather than fiat currency. With your DeFi wallet, you can send bitcoins and conduct other financial operations.

The Ethereum blockchain network infrastructure supports most DeFi apps; however, DeFi applications can also be hosted on other blockchain networks such as Solana, Cardano, and others.

Finally, DeFi delivers to the financial system a level of transparency previously unavailable in centralized finance.

How DeFi Works

Blockchain technology, also employed as the underlying infrastructure for cryptocurrencies, is applied in decentralized finance.

Blockchain is simply a distributed and secure database or ledger in which transactions are recorded.

However, decentralized applications (dApps) are hosted on blockchain to facilitate transactions stored in separate blocks. Each transaction is validated before storage by other users known as validators/miners/nodes.

If all verifiers agree on a transaction, the block is closed and encrypted, and a new block using information from the previous block is generated.

The information in each following chain” is interconnected, which explains the ‘blockchain’ appellation.

A blockchain cannot be altered because the information in prior blocks cannot be modified without impacting subsequent ones.

This notion, as well as other security procedures, contribute to the secure aspect of a blockchain.

What is Interoperability?

Interoperability is the capacity of various systems, devices, applications, or products to connect and interact in a coordinated manner without the end user’s intervention.

Data access, transmission, and cross-organizational collaboration are all functions of interoperable components, regardless of their developer or origin.

Interoperability, like compatibility, assists companies in achieving greater efficiency and a more comprehensive perspective of information.

Interoperability is the ability to freely share and use data or resources between heterogeneous systems over local area networks (LANs) or wide area networks (WANs).

Effective automatic data sharing between applications, databases, and other computer systems is critical to networked computerized systems.

How Interoperability Works

To be interoperable, two or more systems must be able to exchange, interpret, and present shared data in a form that the other can understand.

This is accomplished by adopting a single data format and standard data structure protocols, followed by semantic interoperability, which entails adding information that links each data element to a controlled, shared language.

This common vocabulary contains links to an ontology, a data model that defines a set of concepts within a domain and their relationships.

Adherence to these universal standards allows for transferring meaningful information independent of any information system.

Interoperability benefits include higher productivity, lower costs, and fewer errors.

What is Interoperability in Decentralized Finance?

Today, the DeFi ecosystem is worth $40.82 billion, with Ethereum accounting for approximately 58% of that total.

However, blockchain interoperability is necessary for users of non-Ethereum blockchains like Polygon and Avalanche to partake in the wealth created in the most excellent DeFi ecosystem.

Consider each DeFi ecosystem to be its economy, but such economies will only develop tremendously if they can connect.

Interoperability has the potential to increase DeFi adoption. Allowing users to use DeFi protocols across blockchain networks freely increases the utility of interacting with DeFi.

This ease of access may attract more users to Web3 and DeFi. More users means more liquidity in the DeFi ecosystem, enabling larger lending, staking, yield farming, and borrowing operations.

Interoperability also enables users to overcome the various limits of individual blockchains; they are no longer restricted by Ethereum’s higher gas prices or other networks’ fewer users and poor liquidity.

Developers can also design primitives that allow digital assets to be exchanged between chains.

Implications of Interoperability on Decentralized Finance (DeFi)

Some implications of interoperability on decentralized finance are;

Liquidity
More options for consumers
Risk diversification
Competition and innovation
Efficiency and cost savings

Liquidity

Interoperability enables DeFi applications to access liquidity from various blockchains, not just the one on which they were developed.

This increases the quantity of capital accessible for lending, borrowing, and other financial operations dramatically.

More Options for Consumers

With interoperability, consumers are not confined to DeFi applications on a single blockchain.

They can select from a broader selection of apps across several blockchains to identify the best fit their requirements.

Risk Diversification

Interoperability can help lessen the risk associated with any blockchain by allowing users to disperse their assets across various blockchains.

Competition and Innovation

Interoperability increases competition among blockchains and DeFi applications, promoting innovation and improved user service.

Efficiency and Cost Saving

Interoperability can eliminate the need for middlemen and the costs associated with them. It can also improve transaction efficiency by permitting direct transfers between blockchains.

What The Future Holds for Interoperability on Decentralized Finance (DeFi)

Although interoperability in DeFi is gaining popularity, much work remains to be done before it becomes the norm in the cryptocurrency sector.

Many popular decentralized applications do not support transactions over multiple blockchains, and those that do encounter numerous challenges.

If interoperability is to have a bright future in crypto, it must strengthen its core foundation, the cross-chain bridge mechanism.

Bridges are critical infrastructure in the cross-chain DeFi ecosystem, serving as the foundation for asset transfer between various chains.

Bridges essentially lock assets on one network while minting assets on another. They can be unidirectional (only allow transactions in one direction) or bidirectional (enable transactions between two networks).

Hackers have recently targeted cross-chain bridges, the cornerstone of DeFi interoperability.

Although they have helped DeFi’s scalability, solutions spanning various blockchains introduce privacy and transparency concerns, and some known bridges even need KYC verification for prospective users.

Decentralization of cryptocurrencies will continue to grow soon. The interoperability of blockchains will be critical in leveling the DeFi playing field for users and protocols.

Final Thoughts

Interoperability is crucial for DeFi application growth and adoption. DeFi applications need interoperability to take advantage of the benefits of diverse blockchain networks.

Interoperability allows DeFi apps to exploit the strengths of various blockchain networks, facilitating the expansion of the DeFi ecosystem.