TradFi vs. DeFi: Decentralized Finance as an evolution of TradFi

It seems like Decentralized Finance is finally the version of finance that has confused everyone. People in finance and outside of the profession included.

Decentralized finance has managed to create both excitement and confusion as individuals seek to maximize the use of this block-chain based ecosystem.

Regardless of your knowledge or background in finance, this article seeks to alleviate some (and hopefully most) of the confusion surrounding Decentralized finance (DeFi) vs. Traditional Finance (TradFi) when it comes to these key questions: What is the traditional financial system? What is a Decentralized Financial system? What do both enable? In what ways does either matter for me, my personal life, or my business?

At our firm 11pm, we feel it’s important to put out engaging content within this new domain. The goal is to not only make you more familiar with the topic but hopefully add to your idea of what DeFi is as an innovation within finance more broadly, so we will be posting content like this from time to time.

To access more articles and learn more about Web3 financial assets, follow us here:

What is Finance and what does it do:

Before we discuss what DeFi is, it’s important to explain traditional finance, or put simply, what is finance and why does it exist. Let’s start first with what problems the field of finance seeks to solve in a society. Finance enables people and institutions to:

  • Move resources between economic actors (pay for stuff)
  • Store surplus resources for future consumption (save/store wealth)
  • Grow the value of resource over time (primarily to make sure the market value of your resources keeps up with your needs of consumption, although it can also be used to purely grow surplus resources — invest)
  • Manage risk (insurance, hedging, or general risk management)
  • Access more resources than you have today (credit)
  • To enable trade (common currency)
  • Enable economic growth (common currency)

You can see that having functionality in order to enable these seven things is important for any economy, regardless of the economic (or in that case political) system under which these things are delivered. So in other words, whether you are practicing delivering these things in a purely market-based economy, planned economy, in a democracy etc, and regardless of the societal consensus achieved on how to organize economic and political life, each of these components serve an important role in enabling an economy to exist in general.

Accomplishing these seven things listed above has traditionally been done through intermediaries (banks, money managers (mutual funds etc), and other financial actors), because until now we have not had the technological capability to settle transactions, enforce them, and track transactions in a secure way without intermediaries; and access to financial services in TradFi (across geographies) is primarily based on identity[1]. Or in other words, we historically have not had the communication technology, IT networks/systems, network architecture, incentive mechanism, enforcement mechanisms, and mediums of exchange that can all operate in interoperable to do things differently until now. More on this in a second.[2]

What is Traditional Finance?

After understanding the role of finance, let’s just put some teeth on a pure definition of finance. Finance is the management and movement of money.[3] It builds products and services around six key areas of financial activity: pay, invest, trade, save, and borrow, and risk management.[4]

Finance is the management and movement of money. It builds products and services around six key areas of financial activity: pay, invest, trade, save, and borrow, and risk management.

As mentioned earlier, we historically have needed intermediaries to deliver these six financial activities in a secure way, because those six financial activities require the following five things underpinning them:

  1. Some way to link resources to individuals (custody)
  2. Way(s) to record transactions and make sure the settlement of money is final (accounting, execution, processing and settlement)
  3. Guarantees that people’s money and information aren’t stolen (security)
  4. Basically agreed upon units of account, mediums of exchange, and stores of value (currency)[5]
  5. Enforcement mechanisms of contracts (legal system).

Now there are all sorts of institutions that exist once you move up the financial stack that layer on top of these five needs, and build more niche products within the six financial activities, but at its most basic level these are the things you need to have a minimally functioning financial system.[6]

Decentralized Finance (DeFi):

What is Decentralized Finance then? Decentralized finance is building products and services around the six key areas of financial activity mentioned above (pay, trade, invest, save, borrow and risk mgmt) using blockchain technology (distributed ledger technology) and decentralized protocols.

Decentralized finance is building products and services around the six key areas of financial activity mentioned above (pay, trade, invest, save, borrow and risk mgmt) using blockchain technology (distributed ledger technology) and decentralized protocols.

A more standard definition is the following:

Decentralized finance is a general term describing a digital financial system where decentralized applications (and protocols) provide financial services on top of a global settlement layer.[7]

So why blockchain Technology? Blockchain & distributed ledger technology can be used interchangeably here.

Distributed ledger technology (or blockchain) is the global settlement layer, or the layer through which transactions are finalized in a secure way. Distributed ledger technology is essentially cryptographically guaranteed record keeping that is done by many different nodes across a globally dispersed network in order to guarantee no central point of failure, instead of record keeping and money settlement being done by central authorities in TradFi.

DeFi vs. TradFi:

With this innovation a few things occur:

  1. Barriers to entry for producing new financial services come down dramatically, as financial services can be produced via code with new rules. (Overcollateralization instead of credit score, depositing money in a smart contract instead of a CD, 24/7 trading hours of tokens instead of M-F, 8:00 am — 5:00pm trading windows)

Producing new financial service with different rules can:

  • Increase the speed at which financial innovation happens since these services are built in an open-source manner
  • Change what financial services interoperability means (all services on a sovereign blockchain can communicate with each other)

This is different from API integrations in TradFi, defi is programmable at its core, meaning any component of a protocol on one sovereign blockchain can interact with another. This means all services on say Ethereum, or Tezos, etc can talk to and interact with each other, and is open source which means they can be forked.[8]

2. Increase accessibility of financial services

Once you separate ownership and secure transaction settlement from identity, this allows for less siloes between financial service providers, and increased interoperability, thus increasing the speed of innovation.[9]

Also as mentioned earlier in footnote 1, defi is permission less, meaning anyone can interact with financial products, regardless of credit score, accredited investor status, or any other TradFi verification mechanisms

This is all generally done in a trust minimized and non-custodial way, meaning:

  • Non-custodial: No third party theoretically can make a decision about your money without your explicit consent, meaning you always maintain full control.[10]
  • Trust Minimized: Basically through tokenomics (or the incentive mechanisms of a sovereign blockchain or a specific defi service/protocol) people spend a lot of time making it very costly to be bad actors. This is not always implemented the best by every DeFi protocol, but for example Bitcoin and Ethereum provide case studies of how large scale projects can solve for getting strangers coordinate to uphold a network and enable free economic activity.[11]

More money more problems:

Let’s be clear, TradFi and DeFi will likely continue to work in tandem, as they have strengths and benefits that enable them to work for different kinds of users and different kinds of transactions, meaning in some ways they have different “target markets.[12]

What I mean by this specifically is I think there will continue to be demand for intermediaries to provide financial services for as long as people want to conduct financial transactions within the six core domains listed earlier. DeFi provides an in short “alterative” financial system that will continue to grow, and potentially outstrip TradFi in size in the long term, but understand there are seven core things finance seeks to accomplish in a society, and to the degree those things will need to be done, there will be space for centralized and decentralized solutions.

For a more specific breakdown of how TradFi seeks to provide infrastructure for the six key financial activities (pay, trade, invest, save, borrow, and risk mgmt) and for how DeFi attempts to provide infrastructure for these six, look below:

[13]

Coming Next…

Since financial services are being replicated from TradFi to DeFi, and new financial services/asset classes are popping up in DeFi, In our next couple of articles we will cove specific examples of DeFi financial services, and provide a breakdown of new/emerging DeFi asset classes.

Additional Notes:

[1] Other things are important here in terms of how DeFi is an innovation which are discussed later, but this identity based constraint is an important point conceptually. Meaning Identity is a core part of how financial services are delivered today, which means there is a lot of focus in TradFi on gatekeeping who has access to what financial services/activities based on the characteristics of who you are. In DeFi, access to a financial service is given by owning a token, regardless of your location in the world, and other personal characteristic typically focused on (such as accredited investor status or credit worthiness). More on this point will be repeated later so keep reading. For simplicity’s sake however I frame it as a technological problem but understand this is a problem also caused by the structure through which TradFi (across geographies) delivers financial services today.

[2] If you want to read more on this also, I’d recommend reading: Nial Ferguson’s The Ascent of Money, Nik Bhatia’s Layered Money: From Gold and Dollars to Bitcoin and Central Bank Digital Currencies, and Ray Dalio’s The Economic Machine in 30 minutes.

[3] https://corporatefinanceinstitute.com/resources/knowledge/finance/what-is-finance-definition/

[4] This is different from a financial system’s purpose, which is channel resources from surplus savers to people who need money. We are saying here functionally how does a financial system do this.

[5] To be clear here, this can be localized as well (i.e barter systems, but this will constrain the size of the flow of money/economic growth in the long term without a common currency)

[6] Understand to address the needs of all users of any given financial system, you need more custom components etc built on top of these five layers (specialized markets that may have more niche rules such as Credit Markets, etc.)

[7] This is our internal definition but is based loosely on the contents of this paper by Wharton: https://wifpr.wharton.upenn.edu/wp-content/uploads/2021/05/DeFi-Beyond-the-Hype.pdf

[8] There are some exceptions here as some services that live on one blockchain cannot communicate with another, but this problem is being worked on. I.e Polkadot, Cosmos, and other inter-blockchain communication (IBC) protocols. And some services are considered quasi centralized like MakerDao etc. Read more here: https://wiki.polkadot.network/docs/learn-comparisons-cosmos

[9] Former CFTC Commissioner Chris Giancarlo makes this case better than I can, listen to his lecture on the topic here: https://youtu.be/11kt7O_Ktr4, go to minute 19:37–24:37 and pay especial attention to 23:14–24:37 for this point specifically

[10] This is different from TradFi, for example if you are an LP, meaning you have a lock up period and basically give a money manager the right to invest your money however they sit fit (within their investment mandate etc.) In DeFi, you always control your money, which means you can remove your money at any point, a DeFi money manager only has the right to invest the cash you have staked at your discretion, no lock up period. There is a similar difference here with bank accounts vs. wallets

[11] Read more here: https://www.sciencedirect.com/science/article/pii/S2096720922000094

[12] This is the best word I could say here but hopefully you can understand what I mean. Not necessarily target markets as financial activities span all components of commerce (any time there is commerce some part of the financial system is engaged with), rather I mean for the time being they do things better for some types of users than others respectively, and will probably maintain those advantages over the near term instead of one totally replacing the other.

[13] This is a graphic I made myself, but is loosely based on the contents of one of the better reports I’ve read on DeFi: Wharton’s DeFi: Beyond the Hype, https://wifpr.wharton.upenn.edu/wp-content/uploads/2021/05/DeFi-Beyond-the-Hype.pdf

--

--

--

Co-Founder and CEO @ 11pm | 11pm here: https://launch11pm.elementor.cloud/

Love podcasts or audiobooks? Learn on the go with our new app.

Recommended from Medium

The Big Problem With Coronavirus Economic Bail-Out Plans: Any Of ‘Em

Capitalization: The Neglected, Misunderstood Step-Child of Modern Finance

Reducing Poverty: How Brazil did it (And any other nation can also)

The Investment Series: Economic Recovery & Inflation

Where Are The Most Popular Investment Areas In Dubai?

Dollar Drops Against Yen on Trade Data

shutterstock_262120577

How much is a ‘shed load’ of money?

Own a car? You won’t believe how much that’s costing you every year

Get the Medium app

A button that says 'Download on the App Store', and if clicked it will lead you to the iOS App store
A button that says 'Get it on, Google Play', and if clicked it will lead you to the Google Play store
Joshua Howard

Joshua Howard

Co-Founder and CEO @ 11pm | 11pm here: https://launch11pm.elementor.cloud/

More from Medium

Ethereum, DAPP, web3 in action

Hong Kong Phooey: Virtual Money Laundering Syndicate Foiled

19% APY — Where Crypto Interest Rates Come From

Many Worlds Founder, Steve Bumbera, on the Way Forward for Crypto

Steve Bumbera, a man in a checked shirt, is in headphones giving a talk on crypto.