update 19 August 2021

Difference between DeFi and Traditional Financial Systems

If you are a cryptocurrency enthusiast, you must have come across DeFi, space’s current pet subject. As of 14 September 2020, it had locked assets with a total value of $14.5 billion. It has grown exponentially from an initial value of $677 million in early January. But what is DeFi? How does it compare to the traditional financial systems? Significantly, where can it find practical usage? This article will attempt to answer these questions. First, though, let us look at how it came to be.

Humans are innate, freedom-seeking beings. This state extends into their financial life. Dissatisfaction with traditional financial systems led to the discovery of cryptocurrencies. They are an escape from centralized regulation. Additionally, they are gaining acceptance as a medium of exchange. However, the financial revolution has not stopped with them. For the crypto purists, cryptocurrencies haven’t achieved full true decentralization. There’s a need for crypto to evolve further. Here’s where DeFi enters.

DeFi An Alternative Financing Platform

DeFi is an acronym for Decentralized Finance. Binance defines it as an ecosystem of financial applications developed on Blockchain. They further explain it as a movement, promoting decentralized networks and open-source software to create multiple financial services and products.

Working of DeFi

DeFi works through DApps and smart contracts; they are decentralized applications built on the Ethereum or other public networks. These create, store, and manage digital assets. They are popular in borrowing and lending platforms and decentralized exchanges (DEX).

Contrasting Defi and Traditional Financial Systems

DeFi contrasts sharply with traditional financial systems. Below is evidence of this.

Management

DeFi is decentralized. In essence, it negates central management. No single institution or person dictates operations. On the contrary, smart contracts manage the engagements allowing little to no human interventions. On the other hand, traditional financial systems have centralized control. The Central bank plays an oversight role in overall financial activities. The organization is hierarchical, with different persons having different abilities to intervene in financial engagements.

Transparency

DeFi deploys on the Ethereum or other public blockchains. Consequently, it is transparent. All transactions are publicly verifiable. However, transactions are pseudonymous. This function helps to mask the real identities of the engaging parties. Contrastingly, traditional financial systems are confidential. You deal one one one with your banker, agent, or broker. Also, your true identity is open.

Hosting

Being a technological invention, DeFi runs on Blockchain. In turn, the internet hosts blockchains. Accordingly, DeFi doesn’t require a physical premise to operate. Alternately, traditional financial systems are brick and mortar models. They need physical premises for function.

Geographic Extent

DeFi defies geography. One can access the services anywhere in the world where there’s internet connectivity. People could be in the extremes of the world yet transact. However, traditional financial systems are bound by space and time. The financial institutions have jurisdictions beyond which they cannot operate. Again, most of their services are obtainable within working hours.

Nature of Assets

DeFi transactions are digital. All the engagements on it utilize cryptocurrencies. The opposite is true for traditional financial services. Here they use fiat currency. Physical notes and coins characterize exchanges.

Gatekeeping

As DeFi transactions are decentralized, they eliminate intermediaries. Transactions are P2P. There’s the direct interaction of the peers via smart contracts. On the other hand, traditional financial systems have many gatekeepers. You have agents and other players that intervene in transactions.

Control

In the DeFi system, you are in full control of your funds. The only requirements are internet access and smart contracts. You determine when to transact, with whom, and in what volumes. That isn’t the case in the traditional financial systems. Here you cede control of your funds to several agents. First is The central Bank that regulates the sector. Second, your bank is the custodian of your funds. Thirdly is the agent/agency that serves you.

Flexibility

In DeFi systems, users have a flexible experience. For instance, one can change the interfaces on their dApps whenever they wish to. They may choose to custom make theirs or source them from third parties. In traditional financial systems, this isn’t the case. The user experience is predetermined. The central authority formulates customer policy. All the customers have a one size fits all service.

Interoperability

DeFi systems allow the interoperability of functions. As the crypto finance sector evolves, so do we see the emergence of new products and services. These can be built on existing DApps allowing greater functionality. On the other hand, traditional finance doesn’t allow interoperability. Each player has a differentiated product. One cannot build on or alter this without permission from the owners.

Advantages Of Defi over Traditional Financial Systems

DeFi offers the following advantages over traditional financial systems.

  • It is fast- Transactions occur over the Blockchain that eliminates intermediaries. Consequently, parties trade directly.
  • It is cheaper- the elimination of intermediaries removes fees payable to them. It makes trading pocket friendly. Traditional financial systems include intermediaries; hence are costly.
  • Inclusive transactions- Anyone with a phone and internet connectivity can transact. It thus enables the participation of those left out by traditional systems.
  • They are secure- smart contracts protect the transactions.
  • They are pseudonymous- The real identity of transacting parties is encrypted.

Final Thoughts

The financial sector is rapidly transforming. Ever so often, innovations that aim at enhancing efficiencies within the system emerge. At the moment, DeFi is one such Innovation. DeFi stands for decentralized finance. Currently, it holds assets worth $6.48 billion and is projected to grow. 

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It is a system of decentralized networks and open source software providing financial services and products. The efficiencies inherent in it make it an alternative financing platform. Users do not have to worry about security breaches, cross-border limitations, privacy, costs, downtime, and others. The dominance of DeFi systems is the future of transactions and economic yields for all users. As they grow, so will the features, options, and advantages they offer.

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