Bridging Gaps Between Traditional Finance And Decentralised Finance
Since the first Decentralised Finance project in 2017, many DeFi projects have sprung forth. The number of assets using DeFi protocols is currently ranging between US$ 160-190 billion, according to the estimations by DeFiLama.
This article will draw comparisons between Decentralised Finance and Traditional Finance. We will also highlight use cases of Decentralised Finance and how institutions have bridged the gap between both finance systems.
What Is Decentralised Finance?
Decentralised Finance is a new digital financial infrastructure that eliminates the need for a central bank or government agency to authorise transactions. Instead of a single server like traditional finance, this system relies on decentralised networks.
DeFi’s financial services are based on a protocol powered by Blockchain and run on a decentralised infrastructure, mainly the Ethereum network. As a result, programmers can create customisable, economical, and secure financial systems that anybody with a computer and an internet connection can use.
Use Cases Of Decentralised Finance
Management of Assets
The most important use of DeFi is that users now have more control over their assets. This includes purchasing, selling, and transferring digital currency within an app or online platform that provides them with interest.
In addition, DeFi applications are built to keep your financial data private. Private keys and passwords can be disclosed only when necessary, which is helpful for consumers who want control over sensitive information.
KYT Implementation and Compliance
KYC protocols are essential in traditional finance systems. It’s the traditional finance compliance instrument for implementing anti-money laundering measures and thwarting the funding of terrorists. However, the problem with KYC is that it stands against the foundations of decentralised finance.
DeFi solves the problem using a more recent notion known as KYT or Know Your Transaction. This idea implies that instead of focusing on users' identities, it is somewhat concerned with transaction behaviours and digital addresses.
Decentralised Autonomous Organisations
A DAO is a collection of individuals who come together without any choices dictated by a central leader. They're based on smart contracts and implemented on a blockchain.
Each DAO has an objective and may be linked to various sectors. It could range from a community like Mantra DAO that lets individuals stake, lend, and borrow their crypto assets or buying a collective product like a landed property or the original copies of a constitution at an auction.
The present insurance system of traditional finance is clogged by mountains of paperwork, antiquated auditing systems, and cumbersome insurance claim procedures. These concerns with the existing system could be resolved with the proper adoption of smart contracts. Many DeFi startups, such as Nexus Mutual and VouchForMe, use blockchain to insure against DeFi or smart contract risks.
Peer-to-Peer Lending and Borrowing
Open lending platforms are among the most common DeFi applications. These are often basic DApps that allow you to lend your digital assets to other users in exchange for earning interest or borrow digital assets from other users to pay interest on top. Two well-known names doing P2P lending and borrowing are Compound and PoolTogether.
The core traits of DeFi make it well-suited for solving global payment bottlenecks. With Blockchain technology, users can exchange cryptocurrency directly and securely, without intermediaries. DeFi payment systems enable big financial institutions to simplify market infrastructure resulting in a more open economic system for the underbanked and unbanked.
What Is Traditional Finance?
Traditional financial institutions (TradFi) are primarily concerned with conventional banking. It is based on a centralised platform managed by government agencies and several intermediaries — traditional finance cuts across services such as loans, overdrafts, and opening accounts with traditional banks.
What Decentralised Finance Does Differently From Traditional Finance?
The fundamental difference between Decentralised Finance and Traditional Finance is how they exchange information.
- Traditional Finance is governed by a single authority that makes rules and enforces them. Decentralised Finance is typically more fluid because this system isn’t controlled by a single individual but by technology.
- Decentralised Applications use smart contracts to run all DeFi services and automate transactions for users. In contrast, traditional finance requires intermediaries, signatures and paperwork.
- Unlike traditional finance, where licenses and authorisation from authorities are required, decentralised finance has fewer hurdles and restrictions. Due to the lack of entry hurdles in DeFi, anybody with programming skills can contribute to developing financial services and tools on top of public blockchains.
Risks Associated With Decentralised Finance Versus Traditional Finance
Employing new technology to disrupt a well-established organisation like a centralised bank comes with risks. A common saying in DeFi is to “invest what you can afford to lose.” It is much riskier for newcomers drawn in by the promise of yield farming and passive income.
Here are common risks associated with decentralised finance versus those in traditional finance:
DeFi’s foundation is based on anonymity. As such, creators and developers can make their projects look attractive, gather lots of followers, raise millions of dollars, and pull the plugs on the projects. A famous rug pull in decentralised finance was OneCoin, where the creators fled with over US$ 4 billion. The creators would have been easily found and arrested in a traditional finance system with their known identities.
Social Media Scam
Scammers pretend to be crypto celebrities and influencers. They persuade crypto enthusiasts to hop on a project and promise to hold giveaways when they send crypto to specific addresses.
Scammers in DeFi pose as legitimate businesses and target customers who unwittingly provide personal information or facts that fraudsters might use for nefarious purposes. It's usually done by setting up a fake website, sending an email asking for a wallet address and password, or sending a text message to change your password that looks to be from a trustworthy organisation.
On the other hand, the prevalent risks in traditional finance compared to decentralised finance are:
- People who transact in the traditional finance system risk confiscating their assets if the bank suspects an unusual transaction. DeFi wallets can transact millions of dollars without any raised eyebrow.
- A bankrupt government can turn to desperate means and seize her citizens' accounts and savings to offset the debt.
- Significant transactions in traditional finance can take days or even weeks to process. In contrast, decentralised systems can meet the increasing demand for processing transactions.
Bridging Gaps Between Traditional Finance And Decentralised Finance
The core idea behind DeFi is to revolutionise the traditional finance system entirely, and this is by making it more transparent and resilient. Here are three main ways companies in the DeFi space bridge the gap with traditional finance:
Use Of Verifiable Credentials To Assess Creditworthiness
Users can get collateralised loans through decentralised platforms like Compound and BlockFi, while others, like Aave, offer flash loans for short-term cash without selling assets or via an intermediary.
However, despite its promise, decentralised platforms have struggled to provide unsecured loans to customers. Instead, they require collateral of more significant value than the loan to safeguard against credit risk because they lack a core layer for assessing creditworthiness.
An overcollaterised loan is pointless and makes it difficult to get the full benefits of decentralised financing. A possible solution for users is to continuously create credit history on each platform by taking out smaller loans, but this is time-consuming and ineffective.
A more viable approach uses verifiable credentials to allow users to bring current credit information into the DeFi ecosystem. These credentials can be used for KYC screening, citizenship verification, reputation score, and credit history. As a result, users can obtain unsecured loans at low-interest rates and without the requirement for crypto collateral.
Licensing And Regulation
One of the most significant challenges that DeFi have faced is a lack of regulation and authorisation. This has resulted in the present state of cryptocurrency instability and price volatility, which has pushed institutional and individual investors away. The potential to include institutional participants inside the DeFi ecosystem, and retail customers who wish to use a dependable and secure platform, is provided by constructing a regulated and licensed exchange like Uniswap.
Education Of Users
The core idea behind DeFi is to revolutionise the traditional finance system entirely, and this is by making it more transparent and resilient. However, the fear for most adopters of Traditional Finance is the high-risk potential. More platforms explaining the decentralised ecosystem like the BitPrime Blog, Binance Academy, and Alexandria are needed to create a bridge between both finance systems and quell these fears.
Valuing Decentralised Finance Versus Traditional Finance
The goal of valuation is to determine an asset's underlying worth regardless of market pricing. As a result, you can determine if your assets are underpriced or overvalued.
Two techniques are used to value a traditional finance asset — absolute and relative valuation models.
Absolute valuation methods determine an asset's total fundamental worth, often known as the intrinsic value. It is mainly determined by the investor's anticipation of future returns on the asset. In comparison, relative value is a way of estimating the worth of an asset by considering the value of similar assets.
DeFi assets, on the other hand, are distinct from traditional assets, and the only method to determine their monetary worth is to use newly established procedures.
Determining reliable valuation procedures for newly issued DeFi assets is complicated. DeFi protocols are similar to early-stage fintech start-ups in that their total addressable market is unknown but potentially significant. Another critical question is how much rent these protocols can extract and route back to governance token holders in the long term. It would be fascinating to see as DeFi evolves as it becomes mainstream.
Conclusion – Will Defi Spell The End Of Financial Institutions As We Know Them?
DeFi appears to offer all traditional finance offers and more. Therefore, whether it will end the existing financial system as we know it will continue to be debated.
Although there have been simple, operational DeFi apps that have already attracted billions of dollars, DeFi applications cannot currently compete with traditional banking solutions regarding adoption, and ease of use. Hopefully, those resources will be used to create more competitive and user-friendly applications
About the author:
Olaniyi is a freelance finance & business writer experienced in writing about cryptocurrencies & NFTs, personal finance, entrepreneurship & small businesses, the stock market & investing. You'll find him on LinkedIn.
The above references an opinion and is for informational purposes only. Do not take this as personalised financial advice or investment advice. The views expressed by the author do not necessarily represent the opinion of BitPrime.
Last updated: 10/05/2022