Decentralized finance, the visionary financial system intended to be devoid of intermediaries, has been growing for some years. Contrary to the traditional financial system, centralized finance, it seeks to use the power of smart contracts to get rid of banks, insurance companies, clearinghouses, and other intermediaries within the global financial system – while also ensuring that transparency and security are maintained.
Because of the rapid growth of DeFi in its few years of existence, it has attracted interest from many media and venture capital organizations such as The Washington Post, Bloomberg, Brain Capital Ventures, and AH Capital Management. As of September 2020, Defi accounted for two-thirds of the cryptocurrency market, with collateral levels of at least $9 billion. How do DeFi and banks compare?
Here, you will find out.
An Overview: How Banks Work
So, how do banks work? Banks, whether physical or digital, manage money between individuals and businesses. They use the money they receive from the former to make loans for the latter. For those individuals, they provide security by helping them keep their money safe. For those businesses, they help provide capital for the financing of their activities. In return, they receive interest parts of which are paid to depositors’ accounts. As a result, it is a win-win for all – the banks, depositors, and businesses that they help.
In addition to the interest rates they charge on the loans they provide, banks also make money from their customers via fees such as withdrawal and service fees. In the U.S., the Federal Deposit Insurance Corporation (FDIC) oversees banks and insures deposits with them – up to $250,000.
An Overview: How Blockchain is Decentralized
Blockchain is decentralized because it does not make room for intermediaries on it. It is not subject to the will of any governmental authority: users interact with one another in a trustless environment. Instead of any centralized authority, the control of the system is in the hands of a distributed network. Although decentralization lowers transaction throughput, it helps, among others, to improve data exchange.
Pros and Cons of Both
The biggest flaw with traditional finance is intermediaries. These intermediaries such as the government, although needed for the stability and trustfulness of the system, can also make it inefficient. For example, because it controls money, the government, through its central bank, can print more of it. However, doing so only makes its value drop. Goods also become more expensive. This unrestricted printing of money that the government regularly engages in is the leading cause of most financial crises, as it tends to cause inflation. During financial crises, industries are closed, people lose their jobs, wealth plummets, and bankruptcies are filed.
DeFi, however, circumvents those. By eliminating intermediaries, it ensures quick and permanent access and removes human error and mismanagement to deliver permissionless operations. However, it is not without its inadequacies, too. For example, the greatest problems with DeFi projects are possible uncertainties with hosting blockchains, low interoperability, liquidity, and scalability, and lack of insurance. Also, you and you alone assume responsibility for every transaction you do. Moreover, sometimes, DeFi projects are not as decentralized as they ought to be.
Will Decentralized Finance, “DeFi,” and the traditional banking system work in tandem? Or will it only be the former that will be able to figure its way in the world? It is hard to precisely say. However, one thing is sure: DeFi has come to stay and is set to challenge the very macroeconomic structure on which the traditional banking system is based.
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