Protocol Layering

Protocol Layering refers to the architecture where new financial services are built on top of base-layer protocols, similar to how applications are built on top of operating systems. A base layer might provide simple lending or exchange services, while a higher-layer protocol might offer automated asset management or synthetic derivatives based on those services.

This structure allows for modularity and specialization, as each layer focuses on solving a specific problem. However, it also creates deep dependencies where the failure of a lower layer can collapse everything built above it.

This layering effect is what gives DeFi its immense complexity and potential for both high yield and high risk. It requires a deep understanding of the stack to identify where risks are concentrated and how they propagate upward.

It is the digital equivalent of complex financial engineering in traditional markets, but implemented through code rather than legal contracts.