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Traditional Finance and Decentralized Finance

Aug 07, 2021

What is finance?

Finance is defined as the management of money, and it includes activities such as investing, borrowing, lending, budgeting, and saving. Finance originates from the French word "Finer," which means "to end" and "to pay." “To end” in this perspective means to settle a dispute or debt that is due. Adapted into English, finance means the management of money. Finance is the lifeline of all activities; economic, social, and administrative. Finance function can be seen in all activities and processes, from savings to financial institutions and governments taxes. Finance is closely related to money because it’s a means of exchange.

What is Traditional finance/Centralized Finance (CeFi)?

The traditional financial system consists of banks and financial institutions as the main pillars of its operating mechanism. We all have at least one or probably more than one bank account and are using banking services like financial transactions, credit card payments, ATM withdrawals, among others. Banks are quite a powerful constituent of the overall economic scenario, and thanks to globalization, we have today many global banks operating in different parts of the world. The history of traditional finance began in 1694 when the Bank of England was founded to look after the gold of businessmen traveling to the country. Carrying gold around was inconvenient and exposed individuals to the vulnerability of being attacked or mugged. It made a lot of sense to businessmen to store their wealth in a secure vault while carrying out their business. Businessmen were given a receipt for their gold, which allowed them to redeem their precious metals upon exiting the country.

Today, if you want to access financial services such as borrowing, lending out money, earning interest on savings, investing some money, or applying for a mortgage, the first option is to go to your local bank, where you would need to provide proof of identity, address, employment among many other details before an account can be opened for you. Other options could be through a financial advisor or a broker. The current traditional financial system relies heavily on banks and financial institutions to provide these services to its customers. Despite a century of innovations in the traditional financial system, it is still far from perfect; settlement of stocks, bonds, and other financial instruments takes days to clear and requires a massive amount of human capital to be involved in the process.

Criticisms of The Traditional Finance System.

  1. Centralization: Traditionally, financial services are offered in a centralized manner, where central entities such as the government and banks are responsible for governing the way currencies are issued, regulated, and traded. A privileged few make financial decisions affecting billions of people behind closed doors.

  2. Use of 3rd parties: traditional banking makes use of 3rd parties to carry out transactions. To complete a transaction, it will have to pass through middlemen. Typically carrying out a transaction would follow this process; from you(sender) to a middleman like your bank or some payment channels like Interswitch, VISA, or MasterCard, then to you your receiver's bank, and finally to the receiver. The process involves too many parties.

  3. The difficulty associated with international banking: the traditional finance system is inefficient in conducting international transactions. High costs of charges and the slow processing time are the norms for international transactions.

  4. Unequal access to banking services: millions of people are left unbanked across the globe.

  5. Heavy reliance on human capital: banks and financial institutions hire millions of people to maintain an inefficient system while also keeping up with ever-changing banking laws.

  6. A super high barrier for new entries: it's challenging, if not impossible, to create a new financial company without access to tremendous amount of capital hence stifling innovation.

tradition finance

Decentralized finance (Defi) On the other hand, a decentralized financial system is a financial system that is governed by users, and no central entity can control it. Defi (Decentralized Finance) is a new kind of financial ecosystem that is built on the blockchain. Transactions on a blockchain are peer-to-peer, transparent, and encrypted (secure). The idea behind decentralized financial systems is to carry out processes without or at least with little influence from third parties such as banks or financial intermediaries, which saves both time and costs. On the other hand, the control over the respective money and assets lies mainly or even wholly with the individual owners.

Decentralized Finance (Defi) refers to financial products and services that replicate traditional financial offerings by leveraging a blockchain's trustless and transparent platform. 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. It has the potential to disrupt traditional finance because of its ability to be a financial tool outside the government's regulatory control. Decentralized finance is still at its developmental stage, and it is relatively new to many of us.

Decentralized financial systems offer a whole range of advantages that make them more flexible, faster, and less complicated than our traditional centralized system. Until now, we have been dependent on entrusting our money and assets to a third party, usually a bank. On the other hand, the decentralized financial system gives individuals total control over their respective money and assets. In a decentralized financial system, the idea is that each individual has his or her own digital wallet, in which they store their digital assets independent of a third party as an administrator or intermediary; hence transactions between individuals are now directly from each individual to the other.

decentralized finance

In Defi, a smart contract replaces the financial institution in the transaction. A smart contract is a programmable contract that can hold funds and send or refund them based on certain conditions. No one can alter a smart contract when it's live; hence it will always run as programmed.

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.

Advantages Of Decentralized Financial Systems Over Traditional Financial Systems.

Defi may increase the efficiency, transparency, and accessibility of the financial infrastructure.

  • Decentralized finance stands out as an alternative to traditional finance because it can eliminate financial bureaucracy, which is a burden of today’s financial system.

  • Defi was inspired by the aversion to governments and other financial institutions after the real estate bubble of 2008. In the same spirit, Defi essentially eliminates the need for financial institutions and governments when accessing financial products and is therefore also referred to as Open Finance.

  • The decentralized financial system uses a public distributed ledger system through blockchain technology, and it acts as the trusted source governing all operations in the financial sector as opposed to the traditional financial system that entails governments and financial institutions acting as a trusted source governing all operations in the traditional finance.

  • Decentralized finance is also proving to be a reliable method of overcome issues related to hyperinflation resulting from currency manipulation or unexpected devaluations.

  • Decentralized finance doesn't have cumbersome barriers for entry for emerging financial companies as seen in traditional finance. Anybody with programming skills can build financial services and tools on top of the public blockchain.

  • Decentralized finance will be able to provide financial services without geographical barriers and reach places where traditional finance systems have struggled to reach.

  • Decentralized finance offers the possibility of providing uncensored global finances. In a world where people value their privacy, any product that makes it possible to avoid unethical encroachments from any centralized authority will be enticing for people who value their financial privacy.

  • 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 using digital ledger technologies makes it possible to complete transactions without having to worry about privacy violations by governments.

  • Decentralized financial systems don't require heavy human capital as most of the processes are carried out through smart contracts. Smart contracts are self-executing contracts with the terms of the agreement between buyer and seller being written directly into lines of code. It enables transactions and agreements to be carried out among disparate anonymous parties without the need for a central authority, legal system, or external enforcement mechanism. Smart contracts render transactions' traceable, transparent, and irreversible. The use of smart contracts in decentralized finance eliminates the need for human capital and 3rd parties of any sort. While much of the traditional financial system is trust-based and dependent on centralized institutions, Defi replaces some trust requirements with smart contracts. The contracts can assume the roles of custodians, escrow agents, and CounterParties. For example, if two parties want to exchange digital assets in the form of tokens, there is no need for guarantees from a CounterParty.

Despite all these promising possibilities, we also see that a fully decentralized financial world still seems to be a vision of the future.

Criticisms Of Decentralized Finance

Decentralized finance (Defi) is an emerging industry that promises to revolutionize the traditional finance sector. Decentralized finance is still at its developmental stage and still has a few hurdles to overcome before it can topple the traditional financial system.

  1. One of the biggest challenges that could stop decentralized finance from replacing traditional finance systems is the aspect of people being forced to trust unregulated open-source code.

  2. Although some blockchains are virtually impossible to hack, the cryptocurrency world still stands the risk of being vulnerable to hacks, often resulting in large sums of money disappearing.

  3. The most considerable risk of the Defi ecosystem is the same risk that applies to all investments in the world of cryptocurrency. If you get locked out of your wallet, then you have lost your entire investment. This can be avoided by backing up your account information.

  4. Unlike its centralized counterparts, there is no general body to report cases of fraud that occur in decentralized finance.

  5. The Defi space is still developing. Hence it is not user-friendly, and it has proved difficult for non-tech-savvy users to navigate.

  6. The smart contracts that Defi platforms use can have bugs, making them malfunction, resulting in users getting their funds stuck in the smart contract. However, to protect users against such occurrences, there are Defi insurance platforms like etherisc and nexus mutual, giving users the confidence to use Defi platforms.

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. It is important to note that the Defi space is still in a developmental stage, and as such, it is bound to overcome the majority if not all the current hurdles it is currently facing. We are also bound to see a gradual but decisive shift from the traditional finance system to the decentralized financial system. This is due to the continuous failings of centralized bodies such as governments and banks. The financial crisis of 2008, where many people lost their fortunes as a good number of banks went under, is a prime example of the numerous failings of the traditional financial system. Concerned by the threat posed by the current traditional financial systems, many people are looking to emerging technologies to shield themselves, and this is where Defi comes in to shape the future of our financial systems.

Defi is the right step in the evolution of banking and finance. It is clear that the decentralized finance industry undoubtedly has vast potential. Although there is speculation over whether decentralized finance is yet another bubble, I believe it is here to stay. However, its continued existence depends on how quickly Defi can overcome its current criticisms and how rapidly centralized finance institutions incorporate Defi.

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