Finance has had a riveting story of evolution and metamorphosis over the centuries. What goes back to trading goats and pebbles in barter to using payment gateways on handheld devices, the way money is moved, and how the transaction is recorded has come a long way. And with the advent of blockchain, the game has just changed completely. 

In the last decade, finance demonstrated an “about face” that on a business level, dismounted the lure of unicorn fintechs in terms of fees in favor of DeFi, which behind powerful memes and anon coders hides the most successful and fluid business models in recent history.  But in this short period of existence, these innovative aspects of finance have created enough stir to challenge the traditional aspect of finance and its institutions. While it may be too early to say, these newer aspects have started showing signs of how the future of finance would look like. And the difference is so significant in the way they work that the world has started to draw a line between and dividing it into two phases, something that you call Traditional Finance or TradFi and Decentralized Finance, also known as DeFI. Let us dive in deeper to understand each of these phases.

TradFi- Traditional Finance 

With the advent of DeFi, the term “TradFi” was also coined, which is the short form of traditional finance. TradFi encompasses conventional financial institutions like banks, asset managers, insurance companies, private equities, real estate funds etc. While banks in various forms had existed for centuries, the first traceable history of how a modern-day bank looked goes back to 1694 when the Bank of England was founded to take care of the Gold of business people that traveled to the country. As carrying gold was complex and had its other cons, keeping gold in secure vaults at the Bank was a better option for business people.  Business people were given a receipt for their gold, which allowed them to redeem their precious metals upon exiting the country. 

While providing security to Gold was paramount, with time, the bank realized that they could profit from the amount of gold passing through their vaults. If businessmen were not returning to claim for their gold for some time, the bank would lend out their gold in return for an interest rate on their deposit. As this was a form of passive income for the businessmen, it made sense for them to be ok with the bank doing this.

This continued over time and soon businessmen became comfortable in transacting with banks and soon the physical gold was replaced with receipts of gold that the bank distributed against the gold it had in its vaults. The bank-distributed paper allowed the recipient to claim the amount of gold stated on the receipt. This was the beginning of gold-backed paper currency, distributed in correlation to the amount of gold a government is holding.

But soon, the cracks began to appear in this system as greed and deceit crept in, debasing the nation’s currency as banks started printing more receipts (currencies) compared to the gold they held in the vaults calling for a change in the system.

It was the year 1971- a significant milestone in TradFi when money changed forever.  Many countries realized what banks were doing, and they started to demand their gold back. Again in the center of the controversy was one of the powerful fiats called the US dollar. Unable to fulfill every demand of returning gold, President Nixon famously unpegged the backing of the US dollar to gold.

The debt ceiling was removed, and the government could print as much money as they liked giving these centralized financial institutions unlimited power. Each time these institutions printed more money, the currency was devalued. And the actual holders of wealth, the ordinary citizens, started losing the value of money they held thanks to inflation that the centralized system had created by having more money into circulation in the economy.

This same system has continued for over 50 years, and more and more money has entered the system devaluing the fiat currency more and more every day. A decision of few has made the citizenry more vulnerable. While TradFi has its share of pros and cons (cons overpowering the pros), the non-availability of an alternative has forced most people to stick with the system. Weighing in the pros and cons should give us a better insight. 

Pros of TradFi

• TradFi is currently the largest and the most familiar financial infrastructure and has the most number of users. 
• TradFi has a well-established history, and the systems are tried and tested. 

Cons of TradFi

• The user or the ordinary citizen has negligible control over the decision that is taken over their money.

• The banks loan out the actual funds, and the visible account balance is IOU from the bank.

• The banks’ transactions are extremely slow and expensive both in terms of time and money. The opportunity cost that a user bears while the transaction is being processed is pretty significant.

• Fiat currency is mostly inflationary  

• Recent times have shown as an aspect of the economy where banks haven’t hesitated in implementing negative interest rates. This means customers have to start paying the banks to keep their monies. 
• Requires various laws to be abided by, and consistent paperwork is also needed, especially in large transactions.

DeFI- Decentralized Finance 

With so many cons that come with TradFi and a couple of malpractice incidents carried out by the oligarchs in power that led to the collapse of the whole system, the ordinary citizens have started questioning the system as a whole. 

This led to forming a system that was independent of these centralized financial institutions that had unlimited powers. This was the start of the innovation called blockchain, which has shown a roadmap on how financial systems could work in a decentralized, trustless, and permissionless manner, giving ordinary citizens an alternative over TradFi called the Decentralized Finance or DeFI.

DeFi is an open financial sector that runs on software built on top of a public blockchain at its core. It involves building financial products and services on top of a blockchain to promote an open financial system that promises to end the over-reliance on centralized institutions that are submerged in rules, regulations, and compliance protocols.

DeFi leverages and uses advanced, agile tools to give control to users of what happens with their monies. The new trend offers extra functionality and reduces operational risks, making it an ideal replacement for the current financial system.

Since the steam is catching up, DeFi, many projects have already taken the TradFi functions to blockchain and have begun showing signs of growth, offering an alternative. But while these systems have their pros over TradFi, they are not entirely free of cons. Time to look at those aspects of DeFi

Pros of DeFi

• DeFi is permissionless, trustless and censorship-resistant

• It is fast and has borderless operations 

• Available all the time 24x7x365

• Cheaper transaction cost than TradFI

• Stablecoins, a critical component of DeFI, act as a hedge against local currency debasement.

• DeFI provides higher yields as compared to TradFi
• Less regulatory scrutiny

Cons of DeFi

• There is an initial learning curve to understand DeFi, which is predominantly due to its nascency.
• The user is responsible for his private keys, which, if lost, could lead to financial loss forever as there is no customer service and no way to recover the lost keys
• The risk by user errors is far higher in DeFi 
• Lack of clarity on regulation can be a deterrent and hinder the adoption

The Final verdict 

While blockchain in the global financial system is still in the early days, one cannot dispute this technology’s ultimate potential and the problem-solving capabilities that TradFi lacks. Decentralized finance has what it takes to revolutionize the financial sector in a time of growing concerns about data and privacy security.DeFi could be the ultimate winner here because so many people are gaining access to banking services in areas where traditional finance has failed its massive potential.