Upgrading a technology that is thousands of years old doesn’t occur very often — yet it’s happening right now. Join us as we explore 6 key improvements.
The problem with Traditional Finance (TradFi)
The traditional financial system is the result of millennia of advancements in dealing with money and other valuables. It is fundamental to everyday life all around the world, and has made possible tremendous leaps forward for humankind. Yet, it suffers from important issues that were not possible to resolve — until the emergence of blockchain technology and smart contracts.
Traditional finance:
- Is heavily centralized
- Requires trust
- Relies on intermediaries for most transactions
- Operates in an opaque manner
- Uses proprietary systems and tools
These issues cause a host of problems, ranging from fraud and discrimination to sluggishness and inefficiency.
How Decentralized Finance (DeFi) improves on TradFi
DeFi fundamentally overcomes (most of) TradFi’s problems, and offers additional benefits. How? Let’s take a look.
1. Lower costs means higher returns
DeFi runs entirely on automated smart contracts. There is no middle man charging hefty fees at every step of the way. Users interact directly with the service provider, which means they enjoy much lower costs.
As a result, DeFi can offer higher real yields than traditional finance.
Consider:
- Derivatives protocols (e.g. futures, perpetuals, options).
- Trading platforms and exchanges.
- Digital asset market places (NFTs).
- Tokenised versions of real world assets such as real estate mortgages or bonds.
All running 24/7 on a blockchain, at a fraction of the costs of their TradFi counterparts. Since they don’t need to recoup significant operating costs nor suffer from downtime, they can charge much lower fees and generate superior yields.
2. Increased speed and efficiency of transactions
Blockchain technology has no downtime, no need for human intervention, no waiting around for payments to settle. It allows users to make fast and secure transactions without the need for manual processing.
Service providers in turn are able to operate without downtime and at drastically reduced expenditure.
3. More efficient capital allocation
DeFi benefits from advanced technologies such as automated market making and price oracles. This has significant advantages even for institutions. An AMM without orderbooks means:
- you get filled instantly
- you always pay spot price
- there is no counterparty for trading
- price discovery mechanism is decentralised versus being the sole bid and ask runner on a centralized exchange
- slippage is reduced
When your size is S I Z E, these benefits can easily result in double digit percentage efficiency gains.
4. Increased liquidity and opportunity due to composability
Decentralized finance is composed of multiple open-source components that work together to create comprehensive infrastructure for financial products and services. This composability allows for the easy creation of novel financial instruments that can quickly capture emerging demand — and liquidity.
Better yet, users can also take advantage of the various financial products and services available to combine them in ways that meet their specific needs.
For example, a user might use a decentralised exchange (DEX) to trade tokens, and then use a decentralized lending platform to borrow against those tokens as collateral If we take it a step further, the user could then use a decentralized prediction market to speculate on the future price of the tokens, and use a decentralized insurance platform to protect against potential losses.
All of these actions could be taken on different DeFi platforms, but because these platforms are designed to be interoperable, projects such as Ithil can bundle these different products into a single service.
5. Greater transparency and trust
One key advantage of tamper-proof blockchain technology is transparency. Due to the public nature of decentralized ledgers, anyone can view and verify virtually everything:
- the underlying processes of any transaction
- amount of tokens held in a wallet or vault
- the permissions of smart contracts (and their multisigners)
This ability to verify completely removes the need for trust, which provides service providers with absolute accountability and users with greater confidence in the system.
6. Permissionless and democratic access to financial services
DeFi opens up access to markets and services that were previously difficult or impossible to access due to high costs, geographical limitations, or restrictions imposed by a central authority or intermediary.
This results in greater inclusion by providing e.g. people in developing countries, or those who are unbanked or underbanked with to access financial tools and services. In turn, the financial system grows and becomes more democratic, which ultimately benefits all of humanity.
It can also spur innovation as it allows anyone, anywhere to build and offer financial services without the need for prior approval. Users in disadvantaged areas of the world might have specific needs that are completely irrelevant to users in wealthy and developed nations, for example microloans to start a new business or pay for tuition accessible via smartphone.
DeFi allows for the rapid, permissionless creation of services and products tailormade to meet these needs.
Why isn’t TradFi rushing to leverage DeFi technology?
Make no mistake — traditional financial players are keenly interested in the technological advantages offered by blockchain technology and smart contracts. At same time, there are quite a few hurdles to overcome.
For starters, public blockchains must be able to provide compliance guarantees for capital flows if they want to accommodate large investment banks. They must also be able to provide absolute breaks between the trading wallet and the authentication. Without a full suite of ZK AML/KYC/KYB infrastructure, this is not possible.
Fragmented liquidity is another significant issue; the resulting inefficiencies can be a show stopper for players that want to allocate with size. Some degree of consolidation will be required.
Finally, consider the current lack of recapture potential. In DeFi, you can currently create $4–5 from $1 through lending + recapture that value through loans. However, no one is interested in sitting with the collaterals typically given in DeFi, for example DAI. Settlement in USD is strongly preferred.
This value can be unlocked by tokenising Real World Assets (RWA) like treasuries and bonds.
Most of these issues are quite technical in nature, whoever, and require a more in-depth examination. So if you don’t already know, stay tuned for more!
