Investing in cryptocurrencies comes with significant risk. You could lose all the money you invest. Please read our risk warning here.
The financial system has advanced over the years. New technologies have emerged, making financial services more secure, reliable, and trustworthy.
Decentralized finance (DeFi) is one of the newest innovations in this space. Some believe it is long-awaited financial liberation. Many others fear it might interfere with the traditional financial system.
Some people don’t even know what "decentralized finance" means. Despite where you fall, you are in the right place. This article will help you learn about decentralized and traditional finance. It will also help you understand how they work and their differences. Read on.
What Is Decentralized Finance?
Decentralized finance (DeFi) is a new financial technology built on blockchain technology. It consists of digital assets, protocols, and smart contracts. DeFi uses these technologies to transfer money and verify transactions.
How Does Decentralized Finance Work?
Decentralized finance facilitates the building of global financial services on the blockchain. Using this system, DeFi helps deliver a less restrictive financial system.
Since DeFi operates on the blockchain, third parties are less likely to interrupt. Thus, DeFi aims to give users total control of their money. DeFi users don’t have to worry about intermediaries.
DeFi started gaining popularity after Ethereum’s 2015 launch. Since then, developers have built many decentralized finance apps (dApps). These decentralized applications function using smart contracts.
DeFi protocols have attracted a lot of money since they began. Ethereum and Bitcoin are among the most popular cryptocurrencies in the DeFi space. Due to its features, DeFi helps many people who can’t access banking services globally.
Currently, about 1.7 billion people don't have access to banking services. Most often, this is due to a lack of the necessary documents for opening a bank account. In some cases, the banks are usually miles away from their location.
Decentralized finance is trying to replace today’s financial system, which involves intermediaries. It also has complex security systems to ensure secure transactions.
Today, the main use cases for DeFi are lending and borrowing. Here are some of the most popular decentralized finance apps today:
- MakerDAO
- Dharma
- Bancor Network
How Can You Use Decentralized Finance?
Below are the major use cases of decentralized finance:
Banking
Financial institutions still struggle to reach remote areas. This factor means that many people won't be able to access essential banking services. Decentralized finance uses digital ledger technologies.
These technologies allow users to manage money with ease. DeFi makes it easier to access financial services, even in the most remote areas. Yet, users must have access to internet service to leverage the DeFi space.
Safe Haven from Global Financial Problems
Many banks failed during the 2008 financial crisis, causing people to lose money. Luckily, you don’t have to worry about such issues in decentralized finance. DeFi doesn’t involve third parties. Thus, the DeFi space is free from problems common to traditional financial institutions.
Helps Avoid Restrictions
Most financial institutions have restrictions that dictate how you transact. In contrast, decentralized finance lets users transact across borders. Users can carry out their transactions without worrying about any violations.
Thus, DeFi makes it easier to handle cross-border business without regulations. This feature helps attract many investors to the space.
Promotes Financial Creativity
Decentralized finance offers plenty of freedom. This factor helps create the best environment for developing new financial products.
It also encourages developers to keep improving existing financial products. These developers aim to create services that are 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 hacking. Smart contracts are pieces of code used to execute specific operations quickly.
When certain conditions occur, smart contracts trigger the execution of specific operations. A hacker can find a vulnerability in these programs and hack into the system. Such actions put a DeFi user's 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. The sector has attracted many people globally. Most DeFi users are looking for an anonymous but secure financial system.
DeFi has already started interrupting the traditional finance system. Major traditional financial institutions have developed an interest in the crypto industry.
Also, governments are trying to regulate DeFi before it causes major interruptions. Currently, governments haven’t created clear regulations for DeFi yet. So, it’s still uncertain how regulatory control will affect DeFi in the future.
Pros and Cons of the Decentralized Finance System
Decentralized finance offers many advantages. Yet, there are some disadvantages to keep in mind. Below are DeFi’s major pros and cons.
Pros
- Decentralized finance has no geographical barriers, making it easy to access.
- Transactions are cheaper due to fewer intermediaries.
- Encourages financial innovations.
- Gives complete control over finances.
- Offers better interest rates than traditional finance systems.
Cons
- Decentralized finance can be pretty tricky to understand for most people.
- You are responsible for protecting your private keys.
- Involves some risks, such as smart contract hacks.
- It is 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 for transactions. This includes banks and other regular financial institutions. If you have a bank account, you have used the traditional financial system.
Traditional finance has been around for a long time, meaning it serves most people. All transactions go through a system. Users 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. As a result, it is easy to trust.
- It offers different financial products under one roof.
- It uses tested and verified systems, which help reduce inconveniences.
- It’s easy to understand.
Disadvantages
- Traditional finance involves expensive transaction fees.
- Transactions are usually slow, especially when international clients send or receive money. This makes traditional finance less efficient for international transactions.
- To receive services, you may need to provide some documentation.
What Are the Differences Between DeFi and Traditional Finance?
Traditional finance involves intermediaries, such as financial institutions, but DeFi does not. Computer programs run most DeFi operations. These operations function without direct human input.
DeFi offers more transparency by allowing users to audit its code. With this feature, users can understand how smart contracts function. The system becomes more trustworthy as a result.
Traditional financial institutions hold licenses from central authorities. Thus, they follow set laws for their operations. They also don’t reveal much about how they manage or protect your money.
Most banks are not available in every rural area. As a result, they are unable to provide financial services to a large number of people. 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. Thus, users can access its services regardless of their 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. In contrast, decentralized finance offers high-interest earning opportunities. These include lending or staking opportunities.
Creating new financial products for users is usually easier and faster with DeFi. The traditional financial system forces institutions to follow strict procedures. As a result, introducing new products might take some time.
Which One Stands Out Between DeFi and Traditional Finance?
Traditional finance is an excellent and well-organized system. Currently, it serves a large part of the world's population daily. Yet, things are changing fast. People are now looking for ways to control and manage their finances better. Decentralized finance is among the most efficient alternatives to traditional finance today.
Decentralized finance has introduced digital ledger technologies. This invention allows 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 upgrade financial products easily. Their goal is 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. Thus, decentralized finance stands out more than traditional finance.
Conclusion
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.
Traditional finance is regulated and has decades of established rules and processes. This can make it less risky and less prone to significant change. It's likely that a combination of both systems will prevail. Ideally, a lot of the best ideas from DeFi will slowly appear in the traditional finance industry. It could be a difficult transition, though it's difficult to argue that there aren't innovations worth taking note of in this new financial paradigm.
Disclosures
Content is given solely for informative reasons, does not constitute tax or financial advice, and does not endorse any particular investment plan. Every investment has risk, including the possibility of a cash loss. Past performance does not guarantee future results.
Bitcompare does not guarantee good investment outcomes. The previous performance of a security or financial instrument is not indicative of its future performance. Before investing in options, clients should carefully assess their financial goals and risk tolerance. Due to the significance of tax concerns in all option transactions, a customer contemplating options should consult a tax professional to see how taxes impact the outcome of any option strategy.
