Comparing Traditional and Decentralized Finance: Understanding the Paradigm Shift in Financial Ecosystems
Tradfi vs. Defi
Tradfi is short for Traditional Finance and focuses on the existing financial system, including central third parties having control of transactions. This encompasses everything from retail banking for the average individual using checking and savings accounts to private banking, private equity, hedge funds, and traditional public equity and fixed-income securities, including those available on stock exchanges like the New York Stock Exchange, Nasdaq, and a number of exchanges in major cities around the world. In the public sector, it can involve Credit Unions, government-backed bonds, and the control of the monetary supply by central banks; in the United States, the Federal Reserve does this. In Tradfi, there is heavy regulation regarding the sale and purchase of securities, including registration of the securities, as well as those who are allowed to participate in these transactions, individuals and entities must be vetted by KYC (Know Your Customer), and AML (Anti-Money Laundering) processes and compliance with these regulations is required by governments. Tradfi uses government fiat currencies like the US dollar, the British Pound, the Japanese Yen, etc. Fiat currencies are legal tender established by governments and are based on the creditworthiness of the originating nation rather than asset-backed (usually commodities like gold).
Defi is short for Decentralized Finance and focuses on community consensus rather than a central authority on finance. Usually, mechanisms such as Automated Market Makers (AAM) and decentralized applications (dApps) are utilized to create assets that people can buy and sell. Defi is based around decentralized cryptocurrencies like Bitcoin, Litecoin, etc.
Centralized Exchanges vs Decentralized Exchanges
Centralized Exchanges are exchanges that utilize KYC mechanisms in order to allow customers to buy and sell cryptocurrencies using fiat like USD. They usually hold crypto assets on behalf of customers as custodians. Due to heavy government oversight, they need to report customer funds to the IRS and have the ability to freeze customer assets, usually on behalf of government entities, on suspicion of money laundering or other illegal activities. Examples of Centralized Exchanges are Coinbase, Robinhood, and Gemini.
Decentralized Exchanges are those that don’t require customers to enter any personal information that allows them to be identifiable and have no KYC requirements. Customers usually have full control of their funds, and nobody can access their accounts other than them. This is done because a random seed phrase is created every time a customer creates an account. Seed phrases are usually a random series of 12 – 24 words that customers must memorize in order in order to access their account. To make things easier, many of these decentralized exchanges allow customers to use a four to six-digit PIN when accessing their account from the same phone or computer and only use the seed phrase when using it from a source.). Examples of decentralized exchanges are Exodus, Uniswap, and King Protocol 4.
Decentralized Loans and Collateral
Loaning on DEXs allows individuals and businesses the ability to apply for loans using digital assets they already own as collateral. Without getting too technical, these function a lot like traditional loans, but instead of the loan originating from a bank or a government-backed institution, you are borrowing from a liquidity pool of cryptocurrencies. These liquidity pools are composed of individuals who voluntarily lend their crypto, a practice called crypto lending, in order to earn more crypto.
Top Defi Cryptos and Use Cases
There are thousands, nearing millions, of cryptocurrencies that focus on Defi space. Let’s focus on the top five at the time of writing, according to CoinMarketCap. (CoinMarketCap or coin market capitalization is similar to the market capitalization of companies and refers to the overall assessed or perceived value of an entity or market.)
3. Wrapped Bitcoin:” WBTC is compliant with ERC-20— the basic compatibility standard of the Ethereum blockchain — allowing it to be fully integrated into the latter’s ecosystem of decentralized exchanges, crypto lending services, prediction markets, and other ERC-20-enabled decentralized finance (DeFi DeFi) applications.
4. Dai: “The price of DAI is soft-pegged to the U.S. dollar and is collateralized by a mix of other cryptocurrencies that are deposited into smart-contract smart-contract vaults every time new DAI is minted.”
Case Study in Banking
JPMorgan Coin is an example of what many private banks and financial institutions are doing, creating and utilizing private blockchains in order to use token systems internally to facilitate cross-border payments within their banking systems. These pilot programs usually fail, but when they succeed, they make cross-border payments much faster and more inexpensively. Imagine sending money to a loved one in another country and them being able to receive it in minutes instead of having to wait one to three days! Another excellent potential use case would be direct deposits: Employees and independent contractors would be able to get paid instantly instead of waiting one to two days!
T-Mobile Changing the Game
Telekom, the German parent company of T-Mobile is beginning to participate in strengthening existing blockchains by allowing their customers to participate in crypto staking programs via their private blockchain systems.
Imagine living a decentralized life in which we live in smaller communities and use cryptocurrencies to transact goods and services with each other without the need for banks or governments. Decentralization aims to make this world a reality by eliminating the double spending problem and establishing a payment system built on community trust. Cryptocurrency will bring us back to a form of governance that is truly for the people and by the people. Long live freedom. Long live liberty.
This article does not serve as financial advice and should not be taken as such.
Mike S. Reyes is the founder and CEO of Pernimed. His experience includes corporate training, and teaching in China; and tech sales and political canvassing/lobbying in the United States. In addition to being a TedX series speaker, he has been invited as a guest to speak on Fox News, CNN podcasts and ABC news; and has been featured in articles in the New York Post, Al Jazeera and NY1. A member of various private clubs, his interests include political activism, following all New England sports teams and playing amateur rugby.
Alexandra Black has spent over ten years in the finance industry working with institutional investors on a wide variety of investment strategies. She has held fundraising and investor relations positions in venture capital, private equity, private debt, real estate, hedge funds and traditional capital markets strategies. She graduated from the Questrom School of Business at Boston University with a B.S./B.A. in Business Management with concentrations in finance and marketing.