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TradFi vs. DeFi: Here’s How They Differ

Zainab Saberi

Aug 1, 2023 • 8 min read

The financial landscape we recognize today, known as Traditional finance (TradFi), has its roots in ancient times. Governed primarily by institutional forces like central banks and financial oversight bodies, its framework is defined by a thick layer of regulations.

Within the sphere of TradFi, entities such as banks, stock exchange platforms, payment service providers, and insurers stand as gatekeepers. The operations and guidelines these intermediaries follow differ based on the region and its specific regulatory norms.

Globally recognized markets, such as commodities, real estate, equities, forex, and derivatives, are all part of the vast TradFi umbrella.

When the average person contemplates finance, they are typically envisioning TradFi. Interactions such as setting up a savings account at a regulated bank, securing mortgages or loans, and utilizing foreign exchange services fall within this category. This system is navigated by various types of banks including retail, investment, and commercial establishments. In the blockchain and cryptocurrency sphere, TradFi is contrasted with its more modern counterpart: DeFi (decentralized finance).

DeFi, or decentralized finance, offers a fresh perspective by facilitating lending, borrowing, and trading financial instruments without the necessity of centralized gatekeepers. While some argue these systems are polar opposites, others believe that they can coexist harmoniously, perhaps even complementing each other.

DeFi stands as a testament to the potential of decentralization. Unique to DeFi are decentralized applications (dApps) which grant users access to cryptocurrency services, bypassing the traditional middlemen. The core ethos behind DeFi lies in constructing financial platforms on blockchain technology, thereby shifting the power from centralized forces to community-driven frameworks.

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How does TradFi Work?

Even with digital advancements, the core of TradFi remains centralized, meaning that elements like balance sheets, transaction histories, and order logs are managed by specific centralized institutions.

Direct peer-to-peer (P2P) interactions are sparse in TradFi. More often, intermediaries handle transactions, necessitating users to place their trust in these entities and relinquishing some degree of control over their resources.

These intermediaries, while operating within the regulatory confines, set the operational benchmarks. A notable instance is the practice adopted by banks known as the fractional reserve system, where they are permitted to loan amounts exceeding their actual deposits.

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Understanding the Mechanics of DeFi

DeFi platforms function through the orchestration of smart contracts. These systems achieve decentralization to such an extent that even decision-making processes are steered by communities using what's known as Decentralized Autonomous Organizations (DAOs).

However, it's not unusual to see a centralized force exerting some influence over a community. For instance, while Uniswap operates under decentralized principles, Uniswap Labs remains a central figure shaping its trajectory. Over the course of their evolution, DeFi platforms aim to transition control to a more decentralized structure, often through the issuance of governance tokens.

Among the leading applications within DeFi are decentralized exchanges (DEXs) and platforms dedicated to lending.

DEXs provide a platform for users to exchange tokens. They do this by allowing them to link their private wallets, thereby bypassing any middlemen. Traditional order books are done away with, and in their place, the Automated Market Maker (AMM) system steps in.

AMMs function using liquidity pools. These pools consist of token pairs, and liquidity providers commit cryptocurrencies to these pools, in return getting a cut from the transaction fees.

On the other hand, lending mechanisms in DeFi permit lenders to accrue interest by committing their cryptocurrencies. Borrowers, conversely, can obtain crypto assets without the necessity of a credit history or KYC checks, albeit they must be prepared for the demands of over-collateralization.

It's noteworthy that Ethereum stands out as the primary blockchain supporting DeFi. Unlike Bitcoin, which only stores transactions, Ethereum has the capability to store both transactions and code. Ethereum's inherent currency is termed Ether (ETH), and any transactions on this blockchain necessitate payment in the form of gas fees.

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Key Features: TradFi vs DeFi

TradFi, or the conventional financial system, centers on central hubs that facilitate and oversee the trade, loan, and administration of assets and financial tools. TradFi's success is evident, offering sturdy regulatory frameworks that enable businesses to venture with a sense of security, while also ensuring the consumer's rights. Yet, certain inherent limitations of this system have paved the way for DeFi as an alternate approach.

Centralized framework

Entities such as banks, investment corporations, and governmental bodies are the bedrock of TradFi. They conceive, promote, and distribute financial goods and services. Moreover, they bear the responsibility of risk management by controlling financial sectors and extending insurance provisions.

The efficacy of a centralized model hinges on the trust people place in these institutions to handle their assets responsibly. To fortify this trust, government bodies often collaborate with external organizations to guarantee the safety of people's assets.

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Traditional banking offerings

Conventional banks are marked by their tangible presence and domestic banking permits. To legally function, these banks need licenses granted by financial overseers. Securing such a license is often a lengthy and pricey affair, ensuring only elite entities can provide banking services. However, this also constrains the diversity of service providers.

Regulation adherence

TradFi establishments are bound by a myriad of regional, national, and global statutes and regulations. Many of them, for instance, need to maintain a specified capital amount as a safeguard against potential losses. Moreover, they must have a certain quota of liquid assets to fulfill their commitments to their clientele.

For instance, entities within TradFi must abide by stringent KYC norms to authenticate user identities. These norms act as deterrents to illegal activities like money laundering. Such stringent measures render traditional platforms appealing to institutional investors due to the enhanced security. But, this model may not resonate with individuals prioritizing anonymity.

In contrast, within the realm of DeFi, its inception aimed to bypass the necessity for central governing bodies in financial dealings. The DeFi landscape leans on smart contracts, shared ledgers, and community involvement.

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Decentralized framework

DeFi markets function without the direct oversight of centralized agencies. Many employ the AMM system, utilizing algorithms and liquidity pools to smoothen trading. Typically, decentralized applications (dApps) empower individuals to list an asset for others to purchase and sell, sidestepping any regulatory red tape.

Crypto-centric services

DeFi predominantly revolves around crypto assets, in stark contrast to the fiat currencies of traditional finance. These virtual currencies facilitate various financial activities, including payments, borrowing, and investment ventures.

Minimal regulatory adherence

DeFi platforms aren't encumbered by the regulatory mandates that traditional financial entities are. This ease of entry attracts those keen on devising or proffering financial instruments, albeit with some inherent risks.

Due to the absence of stringent checks, the DeFi sphere has witnessed its share of financial malpractices. Nonetheless, bodies like the Securities Exchange Commission (SEC) are intensifying their efforts to regulate the landscape of cryptocurrencies, NFTs, and other DeFi assets.

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Accessible participation

DeFi platforms are predominantly open-ended, granting access to users from across the globe. Many shared ledger technologies tout minimal fees and provide a plethora of affordable assets. This inclusivity ensures that even individuals typically overlooked by the TradFi system can actively participate.

Pros of TradFi

TradFi boasts a rich legacy in the financial sphere, making it a seasoned contender. This longstanding history fosters a sense of reliability.
A variety of financial services are available within this singular framework.
The systems it employs have undergone rigorous validation, ensuring fewer hassles for users.
Its structure and operation are user-friendly and straightforward.

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Cons of TradFi

A significant downside is the steep transaction costs associated with it.
Cross-border transactions can be tedious, often taking extended periods, which diminishes their efficiency for global dealings.
Accessing its services typically requires presenting specific documentation.

Pros of DeFi

DeFi eliminates geographic limitations, offering seamless accessibility.
Interactions cost less because it cuts out many middlemen.
It acts as a catalyst for financial creativity and novelty.
Empowers users with full financial autonomy.
It often provides more attractive interest rates compared to its traditional counterparts.

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Cons of DeFi

The DeFi domain can be complex and daunting for the average individual.
Safeguarding your unique private keys falls entirely on you.
Certain vulnerabilities exist, like the threat from smart contract breaches.
Its current lack of regulation makes its trajectory uncertain.
Interacting, especially with platforms like Ethereum, can incur substantial fees.

Future of TradFi vs DeFi

While TradFi is deeply rooted and advances with caution, emerging innovations like blockchain are compelling it to rethink its strategies.

Awareness of modern tech's potential is growing within the TradFi realm. Indicators like the Federal Reserve's interest in creating a Central Bank Digital Currency (CBDC) resembling a stablecoin are noteworthy.

These entities are inching closer to a financial framework that embraces DeFi. Giants in the traditional FinTech sector, such as CashApp and Robinhood, are already diversifying with cryptocurrency offerings. Prominent banking players like the Federal Reserve Bank of Boston have signaled their curiosity about a potential symbiotic relationship between DeFi and TradFi. However, the amalgamation of these systems remains a distant reality, given the ongoing risk evaluation.

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Conclusion

The financial landscape is evolving, with TradFi and DeFi emerging as central players. While TradFi offers stability and a sense of familiarity, DeFi brings innovation, freedom, and often, better rates. As the two systems acknowledge each other's strengths and potential, a future where they work in harmony could reshape the way we perceive and interact with money. Yet, it's essential to stay informed and cautious, given the dynamic nature of the financial sector.

Frequently Asked Questions [FAQs]

Q: Is TradFi going away soon?
A: While TradFi remains dominant in many regions, it's unlikely to disappear completely in the foreseeable future. However, with the rise of new financial technologies, its role may evolve over time.

Q: Can I trust DeFi Web3 applications?
A: DeFi Web3 applications operate on decentralized platforms and, while they offer enhanced transparency and reduced intermediaries, it's essential to do thorough research and understand the risks involved before trusting any platform fully.

Q: What is the biggest difference between TradFi and DeFi?
A: The primary distinction between TradFi and DeFi is their operational approach. TradFi is based on centralized systems managed by institutions, whereas DeFi uses decentralized blockchain technology, eliminating the need for traditional intermediaries.

Q: What is the easiest way to get involved in DeFi?
A: To dive into DeFi, start by setting up a digital wallet compatible with blockchain networks. From there, explore reputed DeFi platforms and services, ensuring you educate yourself about potential risks and rewards.

Q: Why DeFi is better than TradFi?
A: Many argue that DeFi holds an edge over TradFi due to its decentralized nature, which offers more transparency, potentially lower fees, and increased accessibility. However, the "better" choice largely depends on individual preferences and risk tolerance.

Q: What is TradFi?
A: TradFi, short for Traditional Finance, refers to the conventional financial systems, institutions, and practices that have been in place for decades, including banks, stock exchanges, and insurance companies.

Q: Which one stands out between DeFi and Traditional Finance?
A: Both DeFi and Traditional Finance have their merits. DeFi stands out for its innovative approach and potential for democratizing finance, while Traditional Finance is valued for its stability and well-established regulatory framework.

Q: What is an example of a TradFi?
A: An example of a TradFi would be a mainstream commercial bank like JPMorgan Chase or institutions like the New York Stock Exchange.