Traditional finance (TradFi), as we know it today, involves key activities such as borrowing/lending, payments/transfers, trading, underwriting, investing etc. and is centered around the involvement of financial intermediaries/institutions. Central to its operation is the use of fiat (whether physical or electronic).

Decentralized finance (DeFi) by contrast involves protocols (via the use of blockchain technology), cryptocurrencies and smart contracts to execute activities and is not reliant on an intermediary to facilitate the interaction of multiple users with the protocol. DeFi, facilitates the conduct of similar activities found in TradFi such as lending/borrowing, investing, derivatives and margin trading, etc. It is a trustless open financial services ecosystem.

DeFi has been gaining popularity, but can Defi make TradFi obsolete?

The Debate

Some argue that DeFi may replace TradFi because of the efficiency and accessibility that DeFi facilitates. It allows users to authenticate any transaction conducted through the relevant protocols and recorded on the blockchain. Unlike TradFi services, DeFi services are available 24/7 and users control their own funds.

However, TradFi offers well established systems, stability and regulatory oversight which cannot yet be said of DeFi.

The approach and requirements to conduct financial activities differ in these two ecosystems. This can be illustrated by the following:

Lending/Borrowing

In TradFi, lending and borrowing activities are mainly conducted through banks and non-bank financial institutions. Accessibility to these activities requires persons to be banked, involves various background and credit checks; as well as the application of legal and other fees. 

In DeFi, there are little to no requirements in relation to background/credit checks, etc. before lending/ borrowing can take place. You simply need cryptocurrencies, a wallet and access to the relevant protocol. Protocols allow users to lend/borrow funds using various cryptocurrencies as collateral. Transactions are conducted using smart contracts, are fast and transparent and there is no need to provide private information. 

Payments

In TradFi, payments are conducted through intermediaries, again requiring certain background checks (KYC, etc) and the transfer of value from one person to another can sometimes be delayed (e.g. a bank transfer after hours). In DeFi, payments are transparent, available 24/7 and requires no intermediaries to transfer value from one person to another.

Trading

Trading requires the involvement of a centralized exchange that controls the platform in TradFi but with DeFi, smart contracts automate traditional brokerage activity by allowing users to borrow cryptocurrencies on margin using other cryptocurrencies as collateral.

While DeFi offers speed, transparency, and accessibility it is not clear that this is enough to make TradFi obsolete. There are many shortcomings of DeFi that can inhibit its ability to replace TradFi. Some of these include:

a.   Investor protection- as it currently stands there is no resolution for a user if something goes wrong in a DeFi transaction. There is no one to call if a rug pull occurs or a token’s value has been purposely manipulated. This is in contrast to TradFi where there are intermediaries to address issues that occur or offer some form of protection to consumers. Wrong doers can be identified and pursued (however developing case law on crypto assets shows that unidentified wrongdoers can be pursued).

b.   AML/ Terrorist financing- since KYC due diligence is generally not conducted in the DeFi space, it means that the ecosystem is susceptible to the facilitation of anti-money laundering and other illicit activities. However, strides are being made to conduct sanctions screening of addresses etc, so this issue is likely to be resolved in due course.

c.   Stablecoins- One key aspect of DeFi is the use of stablecoins to conduct transactions, encouraging confidence in the system, like the trust placed in fiat. The BIS has noted that to the extent that DeFi relies on stablecoins, it is dependent on traditional finance[i]. In that regard, it is arguable that TradFi is supporting the DeFi system. DeFi relies on aspects of TradFi since the value of cryptocurrencies is generally recognized in fiat and most stablecoins are backed by fiat or financial instruments based in fiat .

d.   Financial Stability- the BIS notes that there are “no shock absorbers in DeFi that can cut in during stress periods”[ii]. The DeFi ecosystem is interlinked and while it is heavily based on overcollateralization for the conduct of most financial activities, there is no other support if something happens, it could all come crashing down. By contrast, TradFi has various financial institutions that can lend support to each other through interbank lending or a lender of last resort in the Central Bank.

e.   Security issues- malicious actors in the space tend to take advantage of vulnerabilities within protocols and decentralized applications[iii] which means there are areas of the DeFi ecosystem that are vulnerable to attacks and could lead to loss. In this instance, DeFi, like TradFi, faces threats to its security.

f.    Volatility of cryptocurrencies- the volatility of cryptocurrencies suggests that there is a long way to go before DeFi could replace TradFi and the use of fiat. The recent drops in value of Bitcoin and Ether to the collapse of the Terra (Luna) in May 2022 suggests that cryptocurrencies remain very volatile and this volatility is likely to affect mass adoption of the DeFi ecosystem. In times of financial uncertainty, people tend to avoid riskier assets and therefore more reliance and trust is likely to be placed in TradFi than DeFi.

Notwithstanding the above, DeFi has offered many great benefits over the past couple of years including breaking geographical barriers and offering a viable option for the unbanked and underbanked to access financial activities.

While DeFi can disrupt TradFi, and certainly has already done so, making TradFi obsolete would require several concerns to be addressed. What is more likely to occur is a merger of the two ecosystems that would result in a hybrid ecosystem, utilizing the best of both worlds.

References

[i] Aramonte, Huang and Schrimp: ‘DeFi risks and decentralization illusion’, https://www.bis.org/publ/qtrpdf/r_qt2112b.htm

[ii] Ibid.

[iii] EU Blockchain and Observatory Forum: ‘Decentralised Finance (DeFi)’, https://www.eublockchainforum.eu/sites/default/files/reports/DeFi%20Report%20EUBOF%20-%20Final_0.pdf