DeFi vs Traditional Finance
The financial system has advanced over the years. New technologies have emerged, making financial services more secure, reliable, and trustworthy. Decentralized finance (DeFi) is among the latest changes in the industry that has caused mixed emotions. Some people think it could be the long-awaited financial freedom, while others, especially governments, fear it might interfere with the traditional financial system. There are also people who don’t even know what a decentralized finance system means. Despite where you fall, you are in the right place.
Decentralized and traditional finance are two separate worlds that operate differently. This article will discuss all the major things you need to know about decentralized and traditional finance. This will help you understand how they work and their differences. Read on to learn.
What Is Decentralized Finance?
Traditional finance primarily operates under a Centralized Finance (CeFi) model and this is the main point of difference. Decentralized finance (DeFi) is a new financial technology built on a blockchain. This financial system consists of digital assets, protocols, decentralized applications (dApps), and smart contracts. It uses these technologies to transfer money and verify transactions.
How Does Decentralized Finance Work?
Decentralized finance facilitates the building of global financial services and products on the blockchain to ensure a less restrictive financial system. Since DeFi operates on the blockchain, third parties are less likely to interrupt. Therefore, DeFi aims to give users total control of their money where they don’t have to worry about intermediaries, such as central banks.
DeFi started gaining popularity after Ethereum’s 2015 launch. Since then, developers have built many decentralized finance apps (dApps) using smart contracts, and the amount of money locked in DeFi also keeps increasing. Ethereum and Bitcoin are among the most popular cryptocurrencies in the decentralized finance world.
One of the main reasons for developing a decentralized finance system was to help the many people who can’t access banking services. Did you know that about 1.7 billion people on the planet don’t access banking services? This is usually because they don’t have the required documents to open bank accounts, and the banks are usually miles away.
Decentralized finance is trying to replace today’s financial system that involves intermediaries. It also has complex security systems to ensure secure transactions.
Today, the main use case of DeFi is lending and borrowing. Here are some of the most popular decentralized finance apps today:
- Bancor Network
How Can You Use Decentralized Finance?
Below are the major use cases of decentralized finance:
Financial institutions still struggle to reach remote areas, denying many people access to essential banking services. Decentralized finance uses digital ledger technologies that allow you to easily manage money without using a bank account. This makes it easier to access financial services even in the most remote areas, provided you have the internet.
Safe Haven from Global Financial Problems
Do you remember the 2008 financial crisis when many banks failed, causing people to lose money? Luckily, you don’t have to worry about such issues in decentralized finance. DeFi doesn’t involve third-parties, which enables it to avoid any crisis in the traditional financial sector.
Helps Avoid Restrictions
Most financial institutions have restrictions that dictate how you transact. Decentralized finance, on the other hand, lets you transact across borders without worrying about any violations. Therefore, DeFi makes it easier to do business internationally, which attracts many investors.
Promotes Financial Creativity
Decentralized finance offers plenty of freedom, creating the best environment to develop new financial products. This encourages developers to keep improving the existing financial products and create new ones to help make transactions faster and more secure.
Is Decentralized Finance Safe?
Although DeFi provides a secure way to transact online, it’s still not risk-free. One of the associated risks is smart contract hacks. Smart contracts are pieces of code used to automatically execute specific operations under certain conditions. A hacker can find a vulnerability in these programs and hack into the system, putting your digital assets at risk.
The Future of DeFi
DeFi’s open financial ecosystem has shown lots of potential during the few years it has been around. Therefore, it has attracted many people globally who are looking for an anonymous but secure financial system. However, DeFi has already started interrupting the traditional finance system as even huge financial institutions are now turning to crypto. So, many governments are trying to stop decentralized finance or at least regulate it before it causes major interruptions.
Governments haven’t created clear regulations for DeFi yet. Therefore, it’s still uncertain how regulatory control will affect decentralized finance in the future.
Pros and Cons of the Decentralized Finance System
Decentralized finance offers many advantages but still has some disadvantages to watch out for. Below are DeFi’s major pros and cons.
- Decentralized finance doesn’t have any geographical barriers, making it easily accessible.
- Transactions are cheaper due to fewer intermediaries.
- Encourages financial innovations.
- Gives full control of finances.
- Offers better interest rates than traditional finance systems.
- Decentralized finance can be quite tricky to understand for most people.
- You are responsible for protecting your private keys.
- Involves some risks, such as smart contract hacks.
- Currently unregulated, making its future unpredictable.
- High fees, especially when dealing with Ethereum.
What Is Traditional Finance (TradFi) and How Does It Work?
Traditional finance (TradFi) refers to the old system of using intermediaries such as banks and other regular financial institutions to handle transactions. If you have a bank account, then you have been using the traditional finance system.
Traditional finance has been around for a long time, meaning it serves the most people. All your transactions go through a system and can be easily tracked. You must also provide lots of personal financial data to access banking services.
Pros and Cons of Traditional Finance
Advantages of Traditional Finance
- It has a longer history than other independent financial systems. So, it’s more established. This also makes it easy to trust.
- It offers different financial products under one roof.
- It uses tested and verified systems, helping minimize inconveniences.
- It’s easy to understand.
- Traditional finance involves expensive transaction fees.
- Transactions are usually slow, especially when sending or receiving money from international clients. This makes traditional finance less efficient for international transactions.
- You might be required to provide some documentation to receive services.
What Are the Differences Between DeFi and Traditional Finance?
You have probably noted some differences between DeFi and TradFi already. However, let’s discuss these differences in detail.
Traditional finance involves intermediaries, such as financial institutions, but DeFi does not. Most DeFi operations are handled by computer programs that can easily function without direct human input.
Unlike traditional finance, DeFi offers more transparency by allowing users to audit its code and understand how its smart contracts function. This enables users to trust the system more. Traditional financial institutions are mostly licensed and regulated, meaning they follow set laws to operate. They also don’t reveal much about how they manage or protect your money.
Most banks are not available in every rural area. This limits the number of people they can provide financial services to. Plus, you must follow a long process to create an account and access other services such as loans. Decentralized finance does not have any geographical barriers meaning you can access its services despite your location. All you have to do is find a good platform, create an account, and deposit money.
DeFi has more opportunities to earn passive income than traditional finance. Most banks have low-interest rates, while decentralized finance has different earning opportunities such as lending or staking that earn you great rewards.
Creating new financial products and introducing them to users is usually easier and faster in decentralized finance than in traditional finance. The traditional financial system forces institutions to follow strict procedures before introducing new products, which might take some time.
Which One Stands Out Between DeFi and Traditional Finance?
Traditional finance is a great and well-organized system that most people and governments rely on daily. However, things are changing fast, and people are now looking for ways to better control and manage their finances. Decentralized finance is among the most efficient alternatives to traditional finance today.
Decentralized finance has introduced digital ledger technologies that allow people to transact more securely, privately, and efficiently. So, if you have been looking for a system that allows you to transact anonymously, then DeFi is a great option.
DeFi uses open-source code that enables developers to easily upgrade financial products to ensure better and more reliable financial services. Getting a loan is also pretty easy since you don’t have to worry about credit checks or hefty fees. Therefore, decentralized finance definitely stands out more than traditional finance.
Change is inevitable. Decentralized finance is among the huge changes in the global financial sector. Although it has shown great potential, it is still quite new. Therefore, traditional finance still has a more intact system. Decentralized finance has the potential to be a fully-packaged financial system, but that will require lots of improvements. Hopefully, you have understood how these two systems work and what differentiates them. Do you think decentralized finance stands a chance of replacing the traditional finance system? Let us know in the comments section.