There are two philosophically differing banking systems in the world today—traditional finance (TradFi), consisting of the major banks, credit unions and national financial systems, and decentralized finance (DeFi), consisting of decentralized exchanges, DApps and other institutions lacking middlemen. The two systems are both widely used with nearly 5 million individual DeFi accounts participating in markets estimated to be worth more than $50 billion. In the world of traditional finance, it is estimated that 76% of people globally have at least one bank account, with some striking regional differences. In Japan for example, the number is 98%.
DeFi still lags behind traditional finance but is gaining steam every day. Recent events such as the collapse of Silicon Valley Bank help explain why, and the implications are critical for wealth managers to start planning for now. To understand how DeFi works in comparison to TradFi, and why it has the potential to become a large part of client portfolios, let’s break down the differences and what financial advisors should note.
DeFi Exists to Address the Biggest Issues Inherent in Traditional Finance
Bitcoin was established in the aftermath of the 2008 financial crisis and was detailed in a whitepaper by a person, or perhaps a group of people, going by the name Satoshi Nakamoto. The idea for a peer-to-peer electronic cash system using software code to authenticate and protect transactions without resorting to a centralized bank or government treasury was a breakthrough.
However, the Bitcoin ecosystem itself is not designed to allow for DeFi protocols. While Bitcoin is a critical part of the story, the rise of DeFi can actually be traced back to the launch of Ethereum in 2015. The ability of the Ethereum system to handle smart contracts is what truly makes decentralized apps, and by extension DeFi, possible. ICOs and DeFi exchanges followed later. Today, there are many apps and operations that exist on multiple chains. Some are well-established and handle large amounts of money, while others are newer and innovate on existing ideas.
The use of DeFi has of course not caused the death of TradFi. Banking as we knew it before 2008 continues to this day in largely the same fashion, but with a few new regulations and meaningful changes. Traditional finance continues to have many of the same issues that it had in 2008—for example, banks often charge high fees for simple activities and these fees do not always prevent more failures. The current issues facing banks nowadays highlight this reality.
The collapse of Silicon Valley Bank is the second-largest bank failure in American history and marks the start of a series of issues in the banking sector. In Switzerland, Credit Suisse was purchased by UBS in order to prevent its collapse. According to The New York Times, the Bank Policy Institute considers the SVB collapse “primarily a failure of management and supervision.” In a turn that reminds us why healthy skepticism is important—the executives of SVB gave themselves large bonuses just before their bank failed.
Clearly, the traditional banking sector remains highly flawed. However, DeFi shows that a financial system based on a different set of values with different operating systems is possible. In doing so, it provides a sharp critique of TradFi.
How DeFi and TradFi Differ
Let’s look at the similarities and differences between DeFi and TradFi. TradFi is subject to far more regulations, meaning many elements of DeFi, such as the possibility of total anonymity, are impossible. In traditional finance, networks are overseen by central sources. In DeFi, anonymity is often possible. The customer holds their own money and often directly interacts over a DeFi network with the person they want to send money to or otherwise do business with.
While they offer many of the same services, many of the most common banking services are still comparatively rare in DeFi. For example, cases of DeFi mortgages on homes are difficult to find – though they do exist.
DeFi apps and exchanges allow for financial services to be offered in a radically different way than how TradFi institutions offer them. Typically, DeFi is:
- Decentralized: DeFi typically allows individuals to interact with one another directly. This is made possible through a number of systems, including peer-to-peer networks. This means the many services DeFi offers, such as loans, trading or transfers, are occurring between connected people without a middleman. This often leads to faster transaction times and lower fees.
- Autonomous: DeFi allows for a high level of autonomy. The customer holds their own money, controls what smart contracts they are and are not interacting with, can move their wealth at any time and can review the records of their favored institutions at any time.
- Trustless: As is the case with many blockchain systems, the autonomy the user has combined with the immutability of the records and iron law of smart contracts means that a much lower level of trust is required. Compare this to traditional banks where users have to trust their money is being invested wisely.
- Transparent: Like many other applications based on blockchain technology, a record of all transactions is easily available. While management styles for decentralized institutions vary, many of them are comparatively open.
When this works, individuals have the ability to use a number of financial services at low cost, at any time, and with the full knowledge that a combination of safety features and well-written code prevents theft or misuse of funds. While not all of the same services are as readily available in DeFi as in TradFi, many are, and it is not unreasonable for a DeFi user to expect to be able to take care of many of their financial needs using the DApp or DeFi exchange of their choice.
The Challenges Facing DeFi
To be sure, DeFi does have its faults and faces several challenges that need to be addressed if it is going to achieve mainstream adoption. One significant hurdle is the complex user experience—DeFi platforms are often tricky to navigate, and the terminology can be confusing for those unfamiliar with the space.
While DeFi platforms are built on the principles of decentralization and transparency, they are still vulnerable to manipulation and exploitation by bad actors, as seen with the prevalence of fraudulent activities such as rug pulls and exit scams. There have been several high-profile hacks and exploits in the DeFi space, which has led to significant losses for users. Moreover, the scalability limitations of the Ethereum blockchain on which many DeFi platforms are built can result in network congestion and higher transaction fees as the number of DeFi users rises. This can impact the costs associated with minting, utilizing exchanges and transferring assets, deterring potential users, and necessitating substantial capital from participating fully.
DeFi’s Potential to Outperform Traditional Finance
The values inherent in DeFi tend to lead to certain service options and applications for DeFi systems. As a result, DeFi can offer some advantages, such as:
- It is permissionless – DeFi platforms operate on open protocols, allowing anyone with an internet connection to access and use their services. This removes the need for intermediaries, democratizes finance and empowers people worldwide, particularly those in unbanked or underbanked communities, to access financial services without the usual barriers.
- Often anonymous (or nearly so) – Many DeFi platforms provide a high level of privacy for their users. By leveraging cryptographic techniques and decentralized networks, users can conduct transactions without revealing their personal information.
- Tends to have more flexible and efficient fee structures – Since DeFi platforms are built on decentralized networks and don’t rely on intermediaries, the cost of maintaining and operating these services is significantly reduced. DeFi platforms can offer more competitive rates and services compared to traditional financial institutions.
- Allows for the individual to directly engage with others in the banking system – Aave and Compound enable peer-to-peer lending and borrowing of digital assets, offering interest for lenders and streamlined loan access for borrowers without going through traditional credit checks or application processes. Decentralized exchanges such as Uniswap and SushiSwap facilitate direct asset trading, granting users increased control and typically lower fees compared to centralized alternatives.
Additionally, while TradFi institutions tend to offer low interest rates, even after the series of hikes by the Federal Reserve, DeFi protocols still provide a considerable yield advantage over TradFi institutions. Prominent DeFi protocols like Curve, Yearn and AAVE showcase the potential of decentralized finance. While mainstream coins or stablecoins might not boast high yields, certain new tokens offer remarkable returns that are virtually non-existent in TradFi.
Overall, traditional finance has existed for centuries and will never completely go away. But technology and culture have advanced in a way that opens new doors both for consumers and their financial advisors. More transparent and lower cost banking options, as well as better yield and stronger protection from external forces like interest rate increases and poor management decisions, can be realized in the world of DeFi, making this something to be increasingly fluent in.
Yemu Xu is a serial entrepreneur, investor and early adopter of crypto assets. He is co-founder at Coinbase-listed ARPA Network and Binance-listed Bella Protocol, as well as ZX Squared Capital, an option strategy–focused crypto hedge fund.