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15 Feb 2022

DeFi vs Traditional Finance: What Makes DeFi Special?

Deepan Datta

In this great dance of life, the one thing that keeps everyone moving is money. Over centuries, the form of money has changed and every time for good reasons, offering newer features and greater flexibility to users with each change.

The evolution of money has led to an economic and monetary system that helped economies grow and survive. If you study the history of traditional financial systems, they have mostly been centralized, which means that a single authority figure or body keeps control over an entire region’s financial system.

The traditional financial system offers many strategic benefits like a uniform and resilient monetary system, greater financial control, economies of scale, and so on. But such centralized systems are not foolproof; they are vulnerable to attacks and manipulation, making them highly inefficient and resulting in trust issues.

The global financial crisis of 2008 is one of the finest examples of how centralized economic systems are at the mercy of a select few, and a wrong decision can blow up the whole economy. Similarly, the skyrocketing inflation in many parts of the world showcases how mismanagement in centralized financial institutions can destroy the value of savings.

Problems of this kind require innovative solutions, and Decentralized Finance (DeFi) offers one such. A system devoid of governmental and regulatory control makes the financial system accessible to everyone, creates new possibilities, and provides financial mobility to every person in society.

Key takeaways

  • DeFi uses blockchain technology to eliminate third-party intermediaries.
  • It is easily accessible with none to negligible entry barrier. One needs just an internet connection to access the DeFi ecosystem.
  • Components of DeFi include stablecoins, decentralized exchange, P2P lending and borrowing platforms, crypto synthetic assets, etc.
  • Transactions on DeFi platform are transparent and very affordable. It is a trustless financial system.

What is DeFi?

Decentralized Finance (DeFi) radically changes the way we transact and use financial instruments. Based on blockchain technology, it decentralizes the financial network, so no single entity or person can control public money or resources. In other words, it removes intermediaries from all transactions and gives users greater control over their money and transactions.

The transactions run on smart contracts, which are self-executable contracts that run on automated code. No one can change them once the rules of the smart contracts are set.

Read here: Smart contracts in blockchain and its workings.

By leveraging a set of tools and blockchain technology, DeFi reduces the operational risks in financial transactions and, in our opinion, makes it an ideal replacement for centralized financial systems.

In this discussion piece, we will be looking at the differences between DeFi and traditional finance, in order to understand what makes DeFi unique and sets it apart from centralized financial systems.

How DeFI works

Five Things that Set DeFi Apart from Traditional Finance

Blockchain technology

DeFi is built on blockchain technology, which acts as a single source of truth. Confused?

Let’s try to understand with an example: As you may know, Bitcoin is decentralized digital money based on blockchain technology that enables person-to-person transactions over the internet without relying on intermediaries. Therefore, once the transactions are recorded and stored in the blockchain, they cannot be deleted or manipulated. This makes its blockchain unique and a single source of truth that no one can deny.

The foundation of DeFi is built on the same principle. So by using different DeFi protocols users can conduct various financial transactions without relying on intermediaries. All the transactions, data, and rules are stored on the blockchain and are transparent.

At present, DeFi platforms allow users to borrow funds, earn interest on crypto holdings, exchange crypto assets, and trade crypto synthetic assets.

Low entry barrier

The central financial system has a high entry barrier and doesn’t reach the bottom of the pyramid. The rules and checks in place don’t allow everyone to access it freely. This means that you need to fulfill multiple eligibility criteria prescribed by the banks to open accounts, borrow money, or complete some basic functions. The checks and processes in place make it harder for people to access various financial services.

In DeFi, there is no such barrier, and people with an internet connection can transact on DeFi platforms without approvals. The DeFi ecosystem is permissionless, so anyone with a crypto wallet and stable internet connectionregardless of one’s geographical location and minimum account balancecan transact on DeFi platforms.

Transactions are cheaper

As DeFi cuts out intermediaries from the transaction processes, it saves a lot of time and money. A transaction on a DeFi platform requires you to pay just the blockchain network fees, which is often a fraction of the total transaction value.

For example, In April 2020, a user transferred BTC worth $1.1B (roughly 1,61,500 BTC) for a fee of only 0.00010019 BTC—approximately $0.68.

A transaction of the same value through traditional finance would have cost thousands of dollars. 

DeFi vs traditional finance

Access to global financial markets and liquidity

DeFi is borderless, meaning there are no geographical restrictions on the operation of DeFi platforms, and users can access the platform seamlessly.

For example, through DeFi lending platforms, you can lend money to a person living in the United States or anywhere in the world and earn interest on the money lent.

DeFi opens up the true potential of global financial markets and enhances product developments that were formerly mostly done by only large corporations and licensed institutions.

One strong use case of DeFi is the development of synthetic crypto assets, where traditional financial assets are tokenized and can be traded on crypto exchanges. It enables wide participation in trading traditional financial assets in tokenized form and access to global liquidity, resulting in better price discovery.

Trustlessness

While the literal meaning of ‘trustless’ is not deserving of trust, the word has a new meaning in the blockchain and DeFi space. It means you don’t need to depend on any participant on the network to process the transaction. The trust factor is achieved through consensus, codes, cryptography, and rules of the blockchain protocol of the network.

In other words, transactions on DeFi platforms are processed automatically based on the rules of the blockchain network, without manual interference.

Summing Up

To put DeFi into context, it is a shadow banking system with nobody in charge.

We are currently living through a very early stage of a massive paradigm shift in the financial ecosystem which will bring more transparency, efficiency, and accountability into the financial system.

In the past 12 months alone, the DeFi ecosystem has witnessed surreal growth. Total value locked across various DeFi protocols has crossed over 200 times(refer to the below image). This indicates its popularity and people’s belief in the system.

source: defillama.com

DeFi is slowly moving towards mainstream adoption, and its uniqueness will surely drive more people to join the DeFi movement.

Read here: How DeFi can revolutionize the global financial system. Power and use cases.

Download the CoinSwitch app and start exploring the DeFi ecosystem.

Disclaimer : Crypto products and NFTs are unregulated and can be highly risky. There may be no regulatory recourse for any loss from such transactions. The information provided in this post is not to be considered as investment/financial advice from CoinSwitch. Any action taken upon the information shall be at user's own risk.

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Deepan Datta

Content Writer

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