DEFI TRADITIONAL FINANCE - DeFi stands for decentralized Finance. It is the latest addition to the financial technological (Fintech) revolution. The DeFi is driven by blockchain technology that runs on a decentralized network of independent nodes. These nodes are responsible for verifying transactions and smart contracts and record them on the various blockchain ledgers. DeFi refers to decentralized Finance as no third party controls the user's funds except the decentralized infrastructure. DeFi includes borrowing and lending, farming, staking, flash loans, and stablecoins.
The traditional finance system is currently on the surface system with which we are already familiar. The conventional financial system involves an extensive network of companies that carry out the investing, credit, debit, money markets, lending, insurance, and almost everything that has to do with money management. Unlike DeFi, the traditional finance systems are centralized and usually run by for-profit companies. The conventional financial systems all around the world are running on fiat today.
How Is DeFi Disrupting Traditional Finance?
- DeFi will have a significant impact on how banks operate in the future. It has the potential to convert the overall financial structure to a macroeconomic level.
- In the past couple of years, DeFi is growing exponentially, and billions of dollars have been put in the ecosystem keeping its potentials in view. The main reason behind its growth is the reliable applications built on the Ethereum blockchain (and more recently on second layer chains).
- We all are aware that the conventional business model of commercial banks is to accept deposits and give loans to their clients, and in return, they make profits through interest. Borrowing and lending are the key factors in creating an efficient financial system.
- The difference between DeFi and traditional Finance is the protocols of DeFi that allow the consumers to borrow or lend money on a large scale between unknown participants and without intermediaries, more like a P2P dealing without third-party intervention. Also, it is more efficient as the applications of DeFi bring lenders and borrowers together in one place and automatically set interest rates calculated with the help of current supply and demand. The disruption of traditional Finance by DeFi is because of the recent hype around DeFi applications. It is primarily driven by the advancement of market-making, liquidity-providing protocols, automated market making, borrowing, and lending protocols, such as Uniswap, Compound, MakerDAO, Yearn, Abracadabra.
- An exchange organizes the trading of different assets between two or more market participants, i.e., stocks or foreign currencies. With the emergence of decentralized exchanges, now the holders of cryptocurrencies no longer need to leave the crypto space to swap their tokens.
- For market participants, the primary function of insurance is to reduce the risk factors and bring security as per the traditional financial system. For DeFi, let's explain it with an example of decentralized insurance. Nexus Mutual is decentralized insurance that offers insurances that are responsible for covering the bugs in smart contracts. In DeFi, as everything is based on smart contracts, the main risk for DeFi users is the vulnerabilities in the code of smart contracts. Presently, decentralized insurances are still in the infancy stage due to a lack of awareness. However, it can be expected that a more significant number of more sophisticated insurance models will emerge in the DeFi space in the future that will ensure security and minimize the risks.
- The foundation of the functioning decentralized financial system is because of the introduction of stablecoins. Stablecoins are based on blockchain protocols. They have the principle of price stability inherently encoded. They are the most potential crypto assets that fulfill the function of a reserve currency. They allow participants to engage with each other without the underlying risk of price volatility; that's why they are so-called stable coins.
Benefits Of DeFi Over Traditional Finance
The following are some of the advantages that Defi offers over traditional financial systems,
- The DeFi system is comparatively fast. The transactions take place on the Blockchain that eliminates intermediaries and reduces the transaction time. In this system, both parties trade directly.
- DeFi is a cheaper and more democratic system where all market participants have the same information. The elimination of intermediaries removes additional transaction fees payable to them and unfair asymmetric information advantages of prominent market players. Trading with DeFi becomes very easy; hence it is a pocket-friendly system. Intermediaries are present in traditional financial systems; hence they are costly and often organized in monopoly-like systems.
- Easy accessible. Anyone with a phone and internet can make transactions. This allows unbaked people (currently more than 3 billion people) to participate, reducing poverty and inequality.
- The secure- smart contracts in DeFi protect the transactions making them secure for users.
- The anonymity of users. The real identity of transacting parties is encrypted in DeFi systems. I, however, expect future systems to allow for privacy-based KYC and AML decentralised infrastructure.
It is a fact that DeFi protocols cannot compete with traditional financial systems yet in terms of security, speed, and ease of use. But, there is no doubt that DeFi has produced real, efficient, working applications that have successfully attracted billions of capital. The resources generated from them will be further used to develop more competitive and user-friendly applications in the future.
Traditional Finance is currently looking with anxiety to decentralized systems because of their disruptive potential.
I bet decentralized DeFi will kill traditional Finance and not only integrate it. However, we have a lot of improvements to complete, such as:
- Improve scalability maintaining security by combining proof of stake with and proof of work
- Integrate privacy-based KYC/AML solutions
- Have frontier markets adopting cryptocurrencies as an alternative to USD (El Salvador just started this route)
- Have people learn, study and educate themselves on the natural privacy plan B.
Oliver Camponovo works as an analyst in the financial world and offers advice in both corporate controlling and risk management. He strongly appreciates block chain impact investment & blockchain.