In the traditional financial system, banks and financial institutions act as the main pillars of its operating mechanism. In our lives, most of us must have used banking services in some form or the other including ATM withdrawals, conducting financial transactions, sending money to friends and family, credit card usage, etc. Banks have become an integral part of your economies and globalization has led to several global banks emerging and operating in different parts of the world.
But with the advent of technological growth and the emergence of new digital technologies such as the blockchain, Decentralized Finance or DeFi is redefining the way banking and financial transactions are conducted globally. DeFi can be thought of as conducting transactions using digital fiat whereas, unlike physical money that is deposited and stored in banks, crypto in DeFi is stored and transacted using blockchain technology without the need of an intermediary such as a bank.
In both traditional and DeFi transactions, most of the functions can be performed such as the deposit and withdrawal of money, sending money to someone else, and online shopping. But what differentiates DeFi from traditional financing is that since DeFi is digital in nature and uses blockchain technology, DeFi transactions are processed faster and at lower costs. Elimination of intermediaries or third-party in financial transactions also brings in efficiencies in DeFi. It is especially beneficial when sending money across borders as one can access their funds at any time as DeFi system operates 24/7.
Since DeFi is built on the blockchain, a public blockchain acts as the trust source that governs all the operations in the financial sector and creates transparency in tracing and tracking all the transactions. On the contrary, public governance acts as the trust source in traditional financing which entails laws and licensed financial institutions, governing all the operations.
Unlike traditional financing, DeFi provides numerous opportunities to innovate and provide a range of unique financial services such as staking and yield farming. The DeFi ecosystem uses open-source code and developer tools that allow developers to experiment and innovate and provide innovative financial instruments. Developers can work around the clock without restrictions, upgrading financial products and instruments in the financial sector.
One innovation in the DeFi space is the tokenization of assets where tokenization of loans, collaterals, debt obligations, etc. is becoming a stark reality. Due to the transparency provided by the blockchain, it makes the issuance of loans, repayments, and loan terms easily readable by machines and humans.
DeFi App is a financial application that runs without a central authority governing it. One can access these apps without an intermediary controlling them as the user interfaces directly using smart contracts with a program on top of the protocol. The main categories of DeFi App include decentralized exchanges, stable coins, synthetic assets, lending platforms, insurance, etc.
When compared to traditional financial applications that use core banking systems for recording transactions, DeFi uses blockchain as the underlying ledger for recording and maintaining transactions. The most prominent blockchain that are used to build DeFi apps include Ethereum, Binance Chain, and Solana. These underlying blockchain are used to store the content of the apps, the content of the smart contracts, and the ledger status of all the deposits, withdrawals, and other transactions.
Blockchain handles all the core accounting functions such as matching inputs and outputs and no external systems are needed to reconcile balances as the blockchain nodes are used to validate transactions. Unlike traditional systems, no separate processes are needed for settling and clearing transactions in DeFi. Once the transaction is broadcasted, transaction clearing, processing, and settlement are undertaken at the same time.
DeFi applications are usually fully open-source that are built on top of an open underlying blockchain, unlike traditional financial applications that are closed source and built on top of proprietary systems. And since DeFi App programs are run on a common platform that uses the underlying blockchain, they are usually interoperable with each other and can be programmed to operate with any other DeFi App program in the ecosystem. Unlike DeFi, traditional financial systems are not built on a common infrastructure and hence, cannot communicate with each other and are exclusive to a particular banking institution.
In DeFi if one wishes to secure a loan, a decentralized finance application (dApp) is used to enter the loan requirements, and an algorithm is used to match up with peers that meet the requirements. Once the lender’s terms are agreed upon, the loan origination process begins.
Once the consensus mechanism verifies the transaction, it is recorded on the blockchain and the borrower receives the loan. Smart contracts are encoded for timely payments at agreed-upon intervals as well as for interest payments. The same process is followed on the blockchain at the time of repayment using the dApp and the funds are then transferred to the lender.
In a nutshell, in a centrally planned financial system, the financing terms and conditions are not decided by counterparties in a transaction but directly by a central authority. In contrast, within DeFi, the transactions are conducted without an intermediary more transparently and efficiently and provide more innovative financial instruments.