Following the 2008 financial crisis, there has been an uptick in data breaches and collapses of many financial institutions, increasing the desire for an alternative financial system. Since its conception, the blockchain community’s original objective was to replace centralization with decentralization and provide an alternative financial system that would address the shortcomings of traditional finance. The notion of decentralized finance (DeFi), although previously an aspirational goal for the blockchain community, is finally becoming a reality with the growing DeFi ecosystem.
What is Centralized Finance (CeFi)?
Centralized financial or CeFi systems involve banks and other third parties for storing and transferring funds to their customers in exchange for a fee. The transaction begins at the store when a customer pays with a credit card. It continues through the acquiring bank, which then submits the information to the appropriate credit card company.
The network only processes and confirms the payment request after charging some fee. Since most retailers charge a fee when customers use credit or debit cards, all participants in the centralized ecosystem are overcharged.
Centralized finance regulates every aspect of the financial sector, from loan applications to the services of local banks.
Decentralized Finance, or DeFi, is an alternative financial system that eliminates the need for third-party institutions such as banks and credit card companies, dramatically reducing transaction times and costs.
What is Decentralized Finance?
The term “DeFi” (short for “decentralized finance”) refers to the broader concept of a financial system that operates only using smart contracts and eliminates the need for centralized institutions like banks, insurance companies, and clearinghouses. Decentralized finance (DeFi) applications aim to deliver financial services like traditional finance (also known as centralized finance or CeFi) but in a completely democratic, global, and transparent manner.
More and more people are demanding the safe storage of personal information, accelerating the development of decentralized, autonomous financial systems. This need for a stable, transparent, and open financial system is the driver behind the growth of the DeFi ecosystem.
Due to its capacity to function as a financial instrument outside of governmental and regulatory oversight, decentralized finance, a blockchain-based paradigm, has the potential to change traditional finance fundamentally.
In its simplest form, decentralized finance refers to a financial system on top of blockchain technology where smart contracts handle and validate all transactions, independent of centralized institutions such as a bank. Its goal is to facilitate or improve the growth of an open financial system by developing economic goods and services on top of blockchain technology. For example, LendeXe P2P Lending enables the lending and borrowing of cryptocurrencies completely independent of a central institution.
Decentralized Finance vs. Traditional Finance:
Both traditional finance (CeFi) and decentralized finance (DeFi) deal with the transfer of funds and various financial services, including access to capital and storage of funds. Loaning money, receiving it, providing liquidity, and other similar activities fall within this category.
Traditional financial systems rely heavily on banking institutions as custodians of funds that they give to other organizations for various reasons. The primary goal of this system is to guarantee a steady flow of capital. However, traditional financial systems still need to provide transparent, global, and fair services due to under-collateralization and taking risks with customer funds.
DeFi is more efficient than the current system and strives to guarantee the seamless administration of financial transactions where users may have direct, peer-to-peer interactions, faster transaction speeds, and dramatically lower transaction fees.
Traditional centralized finance vs. decentralized finance is a wildly controversial subject. There are three key areas where these two differ:
- When dealing with money, a public blockchain is an ultimate authority in a decentralized financial system. In contrast, in conventional finance, the public governance that includes regulations and regulated financial institutions works as the trust source, overseeing all transactions.
- Decentralized finance is gaining popularity because it is more open and transparent than conventional finance. Given the low entry barrier, anybody with programming abilities can help develop financial resources and products on top of public blockchains.
- However, it is doubtful that the established financial system would adopt the new development due to significant entrance hurdles. Regulators’ strict requirements for operating inside their jurisdictions have stifled growth in the DeFi ecosystem.
The Takeaway – Future of Finance
Despite strict regulations, there has been a massive influx of billions of dollars into the DeFi ecosystem, and its popularity is rapidly expanding. Applications (sometimes called protocols) established on the Ethereum blockchain are driving the expansion. If development in the DeFi ecosystem continues to flourish like it is, it will fundamentally transform the traditional financial system and improve many financial services. In addition, protocols like LendeXe show that entirely new products are possible that were unthinkable in the previous financial world. For example, the Ultimate Loan enables anyone a loan 1.5x of their collateral.
