Many have asked, what is the difference between traditional, centralized and decentralized finance? And if DeFi just a fad or here to stay?
In today’s digital age, new technology and innovation have enabled new and more efficient solutions and processes for old existing services. As new systems emerge, it is challenging for users to understand the differences, therefore shunning the inevitable change only to miss out on early adopter benefits.
To clearly see the evolution of the financial system from TradFi to CeFi, and soon, DeFi, we take a journey back through history. Here, we compare the advantages and disadvantages of each system to understand why DeFi provides new irreplaceable value and is here to stay.
What is Traditional Finance (TradFi)?
In ancient markets, people bartered for goods using shells or beads as a medium of exchange, where people come to a mutual agreement for exchange such as tomatoes for meat.
But what if someone wants meat but cannot find anyone who has meat that wants tomatoes? This inefficiency caused the transition to the use of commodity such as widely desired everyday goods like rice, as an early form of “money”.
As needs changed, precious metals such as gold and silver became the mode of exchange before we finally transitioned to fiat money (fun fact: the word fiat derives from Latin which means “let it be done”). Fiat used to be backed by precious metals but it was later decoupled as precious metals were unsustainable to maintain for fast-growing economies. The use of fiat money proved that value is truly created by people’s perceptions and beliefs of its worth.
Since the industrial revolution, the Traditional Finance industry has remained the same, with trust being placed on intermediaries like bank brokers and custodians that handle everything that has got to do with managing money.
While financial technology (FinTech) startups have sprung to solve some of the inefficiencies of the industry, fundamental hurdles caused by heavily centralized and profit-driven systems remain.
TradFi Pros:
- Well-established with a long history
- Trialed and tested systems
- Variety of options in one place
TradFi Cons:
- Unnecessary wide-ranging expensive fees
- Painfully slow transaction times
- Inflationary currencies
What is Centralised Finance (CeFi)?
CeFi is in many ways similar to traditional finance. It allows people to carry out financial transactions such as trading and loaning with their cryptocurrencies. Compared to traditional stock exchanges, CeFi crypto exchanges are open 24/7 365 days a year!
Centralised exchanges require new users to go through Know Your Customer (KYC) and Anti Money Laundering (AML) practices to open an account, this means transactions done on the platforms are not anonymous as the account is tied to a specific person.
To be able to transact, private keys to your funds and holdings are entrusted with your selected third-party entity such as a centralised exchange like Coinbase. The IPO of such centralised exchanges offers a channel for retails and institutional investors to invest in the growth of crypto indirectly through the traditional way of owning their shares.
CeFi Pros:
- Fiat gateway for investors to easily deposit fiat and transact cryptocurrencies
- Cross-chain services – enabling exposure and trading of different independent cryptocurrencies that have done through due diligence before listing
- Customer support team to provide any assistance
- Familiar features and systems like traditional exchanges
- High liquidity and trading volume
CeFi Cons:
- For-profit companies that charge fees to investors
- Not your keys, not your coins! – Users do not directly own their crypto assets
- Vulnerable to hacks if security measures fail.
What is Decentralized Finance (DeFi)?
DeFi is used to signify applications that function without any intermediaries, such as banks & brokerages.
Run by smart contacts (computer codes that automatically execute according to conditions of contact), DeFi applications aim to fulfil everyday financial services of TradFi and CeFi, but in a completely independent and transparent manner.
DeFi and CeFi may be confusing for the uninitiated, can be mistaken as interchangeable terms. The biggest difference between them is the choice between trusting people(CeFi) or solely technology (DeFi) to run financial services.
Another easy-to-identify difference is, in DeFi, there is no need to provide any identification for access, a unique identification code is instead generated for users to use its services.
DeFi pros:
- Accessible by everyone that has an internet connection without barriers or discrimination.
- Trustless service, transactions can be confirmed independently by the user
- Lower fees – through the reduction of intermediaries
- Encouraging innovation through monetary incentives for developing and participating.
DeFi cons:
- Currently complicated and difficult to understand
- High risk due to being in an experimental phrase
- No centralized entity to seek personalized support
- Unregulated – fully responsibility is on the user, no recourse or protection if things go wrong
Ending thoughts
Cryptocurrencies and Decentralized Finance have long been tainted by projects that turned sour, meme coins, and volatility caused by tweets from influencers like Elon Musk.
But if you look beyond the noise, you will find some gems that lay hidden – projects with real use cases and growing active users.
According to Defipulse, the total amount of assets that has been committed by the users and secured by the De-FI ecosystem aka Total Value Locked (TVL) has grown by 25 times from USD 2 Billion last July to USD 55.1 Billion at the time of writing. The reason for the rapid user adoption rate of DeFi is simple: it provides practical solutions to real problems and increases trust in the services.
More than simply facilitating more convenient transactions, DeFi continues to grow at an astonishing pace and it is only a matter of time before it is adopted mainstream.
Stay tuned for upcoming articles focused on deep dives into each segment of the DeFi ecosystem!
Disclaimer:
This is not financial advice. Any action you take is solely your own responsibility. Cryptocurrencies are extremely volatile, only invest with what you can afford to lose. For fundamentals, join Chris and AK in a live webinar.