Decentralized Finance vs. Traditional Finance: What You Need To Know
Decentralized finance (DeFi) is an emerging industry that promises to revolutionize the traditional finance sector. The need for an open, transparent, and secure financial system is the key driver behind the decentralized finance vs. traditional finance debate, so it does not come as a surprise that decentralized finance is slowly emerging as an alternative to today’s financial system.
Decentralized finance, which is a blockchain-based concept, has the potential to disrupt traditional finance because of its ability to be a financial tool that is outside of government and regulatory control. The creation of completely decentralized and independent financial systems has since continued to gather pace amidst growing calls for data and privacy security.
What is Decentralized Finance?
At its simplest, decentralized finance is an open financial sector that runs on software built on top of a public blockchain. It involves the building of financial products and services on top of a blockchain with the aim of promoting or enhancing the development of an open financial system.
DeFi seeks to revolutionize the financial sector by acting as an alternative to centrally-governed institutions, such as banks, that have historically acted as financial intermediaries.
DeFi leverages a set of progressive, agile tools to give control to users. The fact that the new trend offers extra functionality in addition to reducing operational risks makes it an ideal replacement to the current financial system.
Decentralized finance started gaining prominence as a replacement for the traditional finance system in 2018 when 15 Ethereum-based projects came together with the aim of building an independent, secure, and open financial system. Some of the early proponents behind the DeFi movement included MakerDao, Origin Protocol, and Paradigm.
What Are the Differences?
Decentralized finance vs. traditional finance is hotly-debated topic. The two differ primarily on three points.
- In decentralized finance, a public blockchain acts as the trust source, governing all operations in the financial sector. In contrast, public governance, which entails laws and licensed financial institutions, acts as the trust source, governing all operations in the traditional finance.
- Decentralized finance continues to gain traction in part because it is a more open and transparent than traditional finance. The lack of barriers to entry means anybody with programming skills can take part in building financial services and tools on top of public blockchains.
- In contrast, cumbersome barriers to entry have made it improbable for the traditional finance system to embrace the emerging trend. The fact that one must obtain proper licenses and authorization from regulators has limited innovation around the traditional finance systems.
Decentralized Finance vs. Traditional Finance: Which One Stands Out?
Decentralized finance stands out as an alternative to traditional finance because it can do away with today’s financial bureaucracy, which is a burden of today’s financial system. The use of digital ledger technologies such as Ripple’s XRapid has made it possible for people to gain full control of their assets and their personal financial data when transacting in the global financial sector.
The use of open source code and developer tools presents a unique opportunity, as developers would now be able to experiment with more financial instruments as decentralized finance continues to gather pace. Developers will be able to work around the clock without restrictions, upgrading financial products and instruments in the financial sector.
Decentralized finance makes it possible for developers to come up with financial instruments capable of operating digital assets without limitations. Tokenization of pretty much everything from loans to collateral or debt obligations could also become a reality. The fact that blockchain technologies are accessible and transparent can make the issuance of loans, repayments, and loan terms easily readable by machines and humans.
DeFi Use Cases
1. Baking services
Decentralized finance threatens to phase out traditional finance because of its ability to provide financial services without geographical barriers. Traditional finance has struggled to reach some remote parts of the world, leaving billions without access to banking services.
Thanks to the integration of digital ledger technologies in applications, people in remote parts of the world can now access banking services through their mobile devices. For that reason, DeFi promises to succeed in areas where traditional finance has failed.
2. Addressing global financial issues
Following the 2008 Financial Crisis, many people lost their fortunes as a good number of banks went under. Concerned by the threat posed by the current global financial systems, many people are looking to emerging technologies to shield themselves.
Decentralized finance is also proving to be a reliable method of circumventing issues related to hyperinflation resulting from currency manipulation or unexpected devaluations, as is the case in China.
3. Circumventing Censorship and Restrictions
The popularity of decentralized finance continues to grow because it could make it possible for people to circumvent bans or restrictions imposed by oppressive governments. The traditional financial sector comes with a lot of regulations and requirements that, at times, make it difficult for people across borders to transact business.
The integration of blockchain technology into a number of financial products, such as Ripple, makes it possible for people to send and receive money without having to worry about bans or restrictions. The fact that people cannot track transactions with the use of digital ledger technologies makes it possible to complete transactions without having to worry about privacy violations by governments.
The ability to provide uncensored access to global financial services is one of the reasons why decentralized finance will continue to stand out from traditional finance. In a world where people value their privacy, any product that makes it possible to avoid unethical privacy encroachments from authorities stands to be a successful one.
The idea of building censorship-resistant products in the financial sector will continue to fuel decentralized finance popularity.
4. Financial Creativity
Decentralized finance is also proving to be a reliable tool for enhancing the development of financial products that in the past were the domain of large, licensed institutions. Financial derivatives, as well as futures and swaps products powered by digital ledger technology, could soon become a reality, given the amount of innovation around digital ledger technologies.
Even though decentralized finance is still in the early stages of development as an alternative to the traditional finance system, a number of apps have already been developed. The apps are giving people a taste of what the financial future could look like.
- DAI, with a userbase of 21,000 people, is ranked as the largest decentralized finance app. As the creator of the MakerDAO stablecoin, the app makes it possible for people to receive loans by depositing Ethereum. The app is completely decentralized.
- Dharma is another decentralized finance app that operates as a lending platform. The app makes it possible for people to lend and borrow Ethereum, regardless of their credit score.
- Bancor Network is slightly different from the other two decentralized finance apps, as it allows users trade cryptocurrencies without an intermediary, such as a broker.
What are the Challenges?
Any good technology is always prone to challenges that may derail its adoption, and decentralized finance is no exception.
One of the biggest challenges that could stop decentralized finance from replacing traditional finance system is the aspect of people being forced to trust unregulated open-source code. The fact that anyone can access a source code powering a decentralized finance system means anyone can hack smart contracts and steal all the keys, which could result in people losing substantial amounts of money.
The technology behind the decentralized finance application is still underdeveloped and unfriendly, and it will always be prone to vulnerabilities that would damage the technology’s reputation.
The Bottom Line
While the use of digital ledger technologies in the global financial system is still in the early days, one cannot dispute this technology’s ultimate potential. Decentralized finance has what it takes to revolutionize the financial sector in a time of growing concerns about data and privacy security.
The fact that DeFi could result in so many people gaining access to banking services in areas where traditional finance has failed underscores its massive potential.
Decentralized finance will first have to address a number of issues pertaining to scalability, security, liquidity, and regulations if it is to replace today’s financial system.
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