Cryptocurrency vs traditional banking: The future of finance
In the world of finance, two distinct realms have emerged, each with its own set of principles and possibilities. The future of finance is set to be one like never before, revolutionising the way we perceive and engage with financial systems, and harnessing financial freedom, transparency and inclusivity. As the world of decentralised finance ramps up, is it time for traditional protocols to adapt or will they be left behind?
Traditional Finance (TradFi) The foundation of finance:
TradFi refers to the existing financial system that most people use in their daily lives and has been used for decades. The traditional financial encompasses banks, insurance companies, investment firms, and other centralised entities.
Key characteristics of TradFi:
Centralisation
In centralised finance, financial activities are funnelled through a governed, centralised exchange, restricting the flow and control of transactions. Having finance functions centralised allows regulators to have oversight of all business transactions. This can help identify trends in the market whilst also detecting illegal activities.
Regulatory framework
The strong legal framework of traditional finance provides a ground of trust for consumers, a characteristic of which can be disrupted in the realm of DeFi. Hence why most people are still comfortable carrying on using traditional banking and do not feel the need to explore DeFi protocols. However, it can be argued that DeFi, with its decentralised nature and innovative capabilities, offers a compelling alternative that challenges the limitations of centralised finance.
Accessibility
Traditionally, it can be argued that traditional finance holds a great level of accessibility compared to DeFi. Over centuries, traditional banking has established itself as a familiar and inclusive system, catering to a wide range of individuals. Traditional finance’s extensive range of services far surpasses the limited capabilities offered by decentralised finance platforms.
Traditional finance institutions have cultivated strong brand recognition over time, instilling trust and confidence among customers. In terms of user base, DeFi is still in its infancy, with an estimated 4.8 million users worldwide in 2022, presenting a stark contrast to the vast number of users engaged with traditional finance systems, arguing it is more accessible.
However, it is important to note that DeFi’s disruptive potential lies in its ability to evolve rapidly, offering innovative solutions and levelling the playing field for global access to financial services.
DeFi: Unleashing the power of decentralisation
Characteristics of DeFi:
DeFi has unleashed a transformative force that is reshaping the landscape of traditional finance; unlocking new possibilities and allowing individuals to harness the full potential of their financial resources without being bound by centralised intermediaries.
Decentralisation
Decentralisation stands as the fundamental differentiating factor between decentralised finance and traditional finance. This revolutionary concept has disrupted traditional financial systems by presenting fresh products, empowering individuals to take charge of their financial affairs independently, free from dependence on intermediaries like banks and lenders. The use of smart contracts in DeFi eliminates the need for intermediaries and reduces the potential for human error and manipulation.
Transparency and trustlessness
Blockchain technology plays a pivotal role in making cryptocurrencies transparent due to its inherent characteristics. The nature of crypto produces immutable records which means once a transaction is recorded in a blockchain, it cannot be changed after. Having a public address also means that all crypto transactions can be traced to a particular address. However, this doesn’t mean you are able to identify the owner of the wallet.
The transparency of the blockchain can be referred to as trustlessness as users of crypto do not rely on a central authority to make transactions.
Financial inclusion
DeFi can help bridge the gap of traditional finance where individuals might not be able to access traditional banking services. Recent data reveals a significant 20% increase, bringing the number to 28%, of UK citizens feeling excluded from traditional financial services. In this context, DeFi presents a cost-efficient avenue for seamless money transfers. Unlike traditional fiat currencies, digital currencies eliminate exchange fees since they operate without intermediaries, enabling users to exchange funds without incurring additional costs and enhancing accessibility. This statement is also supported by digital currencies such as Bitcoin and Ethereum which do not charge exchange fees as there is no third party involved in transactions along their blockchains.
As a result, digital currencies provide significant savings over traditional fiat currencies, especially for international transactions. The World Bank calculated that in the fourth quarter of 2022, the average cost of sending $200 globally was 6.2%. In contrast, sending an equivalent amount of Bitcoin incurred a mere 1.175% cost (as of 3rd July 2023). This significant reduction in transaction fees contributes to making money transfers more affordable, thereby fostering greater inclusivity.
In addition to the cost efficiency of DeFi, its speed is a significant advantage. Users of DeFi can enjoy swift cryptocurrency transfers and cross-border payments, surpassing the sluggishness of traditional banking systems. A standout example is Ripple (XRP), known for its exceptional speed and cost-effectiveness among cryptocurrencies. With a processing capacity of up to 1,500 transactions per second (TPS), Ripple closely competes with Visa’s 1,700 TPS. However, what truly sets Ripple apart is its ability to settle transactions within a remarkable three to five seconds, in stark contrast to the potential one to three days it may take for Visa transactions to finalise.
Moreover, DeFi offers accessibility to anyone that has access to the internet, further widening its reach. While certain barriers to crypto adoption exist, measures can be taken to enhance accessibility. Companies such as Coincover provide products that safeguard assets and secure access, protecting against theft and loss, thus bolstering the confidence of individuals who are entering the crypto space.
The future of finance: how TradFi and DeFi can work in harmony:
While both traditional finance and decentralised finance offer their own advantages, DeFi’s characteristics can be complemented and address some of the drawbacks of TradFi. Notably, TradFi’s regulated environment fosters a sense of trust among users. As regulation becomes a growing focus in DeFi, it will be interesting to observe its impact on user trust. Increased regulation could enhance security for crypto users, as exemplified by the establishment of rules for key management by the Virtual Asset Regulatory Authority (VARA) in Dubai, which can influence security practices in the digital asset space.
Noteworthy ongoing projects, such as the digital pound, provide a glimpse into the future of digital assets. The Bank of International Settlements (BIS) and the Bank of England recently published a report on project Rosalind, investigating the use of application programming interfaces (APIs) in a central bank digital currency (CBDC) ecosystem. The report emphasises the potential of a CBDC in enabling cost-effective and streamlined payment processes, driving innovation, and serving as a potential deterrent against fraudulent activities.
In the realm of traditional banking, recent collapses of prominent banks like Silicon Valley Bank, Signature Bank, and First Republic Bank due to under-collateralisation underscore the importance of risk management. DeFi could potentially offer a solution to this issue by utilising smart contracts to secure lenders’ funds and mitigate risks.
However, it is crucial to acknowledge the risks associated with DeFi systems. To ensure a secure future for decentralised finance and gain the trust of users, increased security measures and regulatory frameworks will be necessary. Striking a balance between innovation, accessibility, and robust security will be crucial for the continued growth and adoption of DeFi.