Cryptocurrency

Decentralized Finance vs. Traditional Finance: What You Need To Know?

Decentralized Finance vs. Traditional Finance: What You Need To Know?

DeFi is an evolving sector in the world of finance and is transforming the way we invest and transact on the new and open web. The one question that new crypto investors keep asking about is ‘’How does crypto investments work? Or How can I earn passive income through crypto investments? Well, Decentralized Finance is the answer. 

What is Decentralized Finance (DeFi)? 

Decentralized finance is an open financial network that runs on software built on top of open source blockchain. DeFi platforms offer crypto lending and borrowing solutions for crypto investors looking to earn passive income on their crypto or any other virtual digital asset holdings. Decentralized finance platforms operate independently, without any third party intervention. A DeFi platform is powered by a pre-programmed software called a ‘Smart Contract’ that outlines the rules of different kinds of transactions. These softwares are self-executing contracts making it a seamless financial  solution. 

Also Read: Top 5 DeFi Tokens 2022 by Market Cap

What are the benefits of Decentralized Finance (DeFi)? 

  • DeFi is permissionless: Anyone with a crypto wallet and an internet connection can access DeFi services. Users can trade and move their assets wherever they want and wherever they want to send it. Borderless payments is one of the most important characteristics of DeFi
  • Transactions happen in real time: The blockchain network is whenever a transaction is completed, and interest rates are updated on a timely basis.
  • Transactions are transparent: Every transaction on the blockchain can be tracked through the blockchain explorer. The level of transaction data transparency ensures any user can view network activity. 
  • Users can retain custody of their assets With non-custodial crypto wallets or via smart contract-based escrow and smart contracts users can customize their investing plan. 
  • Some DeFi protocols are open source. Some projects are present on platforms with an open-source code for developers or users to view and understand.

Also Read: What are DeFi Loans – How does Defi Lending Work?

Use cases of Decentralized Finance

There are several use cases of Decentralized Finance

a) P2P lending and borrowing 

Peer-to-Peer (P2P) borrowing and lending have become popular in the DeFi space. Since the Decentralized finance system removes the need for an escrow or intermediaries, this financial system has been well received by many. Some known DeFi platforms are   Compound and PoolTogether.  These platforms have autonomous protocols for borrowing and lending assets.

b) Payment Solutions

Like traditional finance, decentralized finance too has developed payment solutions for businesses and individuals to send and receive crypto payments. Celer Network, zkSync, xDai Chain are some decentralized payment platforms. 

c) Derivatives and Synthetic Assets

Smart contracts allow the creation of tokenized derivatives and it has become one of the most unique DeFi use cases. Tokenizing a derivative means setting the value of a contract based on an underlying financial asset or a set of assets. This underlying financial asset works like a traditional security, meaning it could include — bonds, fiat currencies, commodities, market indexes, interest rates, or stock prices.

d) Margin Trading 

Like traditional trading platforms, DeFi platforms offer margin trading as an option to obtain funds from a Decentralized Finance platform (like Aave, Compound, Venus) for traders to use as a leverage to earn. A trading method like this is fully collateralized.

Also Read: Borrowing and Lending in Decentralized Finance – DeFI

What is Traditional Finance?

Traditional finance is a centralized authority that manages funds and assets on users behalf. All financial categories like lending, borrowing, trading requires a borrower or receiver, a lender and a financial intermediary that processes all these financial transactions. The key difference between traditional finance and decentralized finance is that in traditional finance the transactions are processed by a central authority while DeFi automates the transaction settlement process with least human intervention.

Also Read: Why TVL Matters in DeFi?

What are the benefits of Traditional Finance? 

Fun fact: peer to peer lending was the first ever system that brought the human race closer. After which, the traditional finance system was established with a central authority. 

Centralized finance is the oldest financial system in the world. Following are the benefits of centralized finance.

  1. Better flexibility: Central financial institutions offer better payment flexibility in comparison to decentralized finance. 
  2. Better returns: Most central financial institutions offer a better interest or ROI on deposits. That is applicable to lending as well as depositing. 
  3. Access to customer service: Centralized financial institutions offer customer service for customers to raise a ticket, seek investment advice and other services in general. 

Also Read: Analysis of DeFi Growth and NFT Hype

Examples of Centralized Finance Institutions   

NBFCs: Non-Banking Financial Companies offer loans to customers based on their CIBIL record. NBFCs offer credit to customers based on their earnings and CIBIL record. 

Gold collateralized loan: In recent years, some institutions offer fiat loans to customers who can offer gold as a collateral. 

Also Read: Ethereum vs Solana vs Polygon

What is centralized finance in crypto?

Centralized finance in crypto refers to institutions and crypto exchanges that are managed by authorities to process buy, sell orders and other crypto investment services. CeFi exchanges are the perfect option for crypto investors who are looking to start their crypto investing journey. 

Also Read: Top Ethereum Projects by Total Value Locked (TVL)

What are the benefits of Centralized Finance in Crypto? 

Centralized exchanges do have authority and control over users funds but there are plenty of benefits of choosing a CeFi.

  1. Easy UI for novice investors: Crypto is still a fairly new domain for a lot of curious investors. A centralized crypto exchange offers a detailed tour of how to get started with investing in crypto. 
  2. Customer support: In moments of crisis, centralized exchanges offer timely customer support to guide customers in case they have queries or need guidance. 
  3. Security of Virtual Digital Assets: Unlike dexs’, centralized exchanges offer 2FA for identification security of customers. In addition, customers don’t have to remember long seed phrases of web3 wallets. 

Also Read: How to Analyze a Crypto Using Fundamental Analysis?

Difference between Decentralized Finance and Centralized Finance 

Decentralized Finance  Centralized Finance 
Has no authority or control over users’ funds or assets. Has control over users’ funds or assets.
Is majorly automated using smart contracts making it an autonomous platform.  Is managed by authorities of the institution.   
Offers low returns on investment  Offers a better interest rate on asset deposits
Offers a seamless experience for obtaining a loan. Requires a user to furnish the platform with complete identification to acquire a loan. 
Is completely autonomous.      The platform is represented by a group of individuals, i.e the management of the platform.   

Which financial system has better potential?

Both financial systems have great potential. The key difference is that users who are adept with crypto investing could invest through a DeFi platform, while crypto novices could gain more experience by opting for a centralized finance platform. 

Also Read: What is Crypto Lending; How Does Crypto Lending Work?

FAQs

How is DeFi better than traditional finance?

DeFi operates as an autonomous institution that offers leverage to users as well as more authority to hold their assets. 

Is Decentralized finance the future?

With individuals joining the financial revolution through investing in VDAs, Decentralized Finance (DeFi) can be envisioned to be the future of finance.

What are the benefits of decentralized finance?

A) Decentralized finance offers transparency of asset movement on the blockchain. B) Transactions on decentralized networks happen in real time. C) Decentralized finance offers users to remain anonymous on the network. D) Decentralized finance minimizes the risk of human error.

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