How DeFi Address the Weaknesses of Traditional Finance

June 24, 2024

The financial sector has long been dominated by traditional finance systems, which, despite their widespread use, harbor fundamental issues that affect everyday consumers and investors. This article introduces Decentralised Finance (DeFi) as a revolutionary model poised to fix these enduring problems.

What Are TradFi and DeFi?

Traditional Finance, or TradFi, encompasses the established systems and institutions—like banks, investment funds, and brokerage firms—that have long been the pillars of the financial world. These institutions act as intermediaries in almost every type of financial transaction, from simple banking services to complex trading and asset management. The reliance on these intermediaries often introduces inefficiencies, including slower transaction times and higher costs for consumers. For example, when sending money overseas, fees can be exorbitant, and processing may take days due to the involvement of multiple banks.

Moreover, the complexity of products and the opaque nature of TradFi can deter the average consumer from fully engaging with their finances. Products such as mortgage-backed securities and derivative contracts are often difficult to understand without specialised knowledge, creating a barrier to entry for the average person.

In contrast, Decentralised Finance, or DeFi, eliminates these traditional intermediaries by leveraging blockchain technology. DeFi platforms operate using smart contracts—self-executing contracts with the terms directly written into code—which are deployed on blockchains like Ethereum. This setup allows DeFi to operate globally, transparently, and without the need for middlemen. Transactions on DeFi platforms can occur faster and at a lower cost compared to traditional methods.

An exemplary DeFi platform is CVEX, a decentralised derivatives exchange. CVEX enables users to trade derivatives directly from their digital wallets, eliminating the need for traditional brokerage or clearinghouse intermediaries. This reduces the fees associated with trading and gives traders full control over their funds at all times. The use of smart contracts on CVEX ensures that all trades are executed transparently and that the terms of the contracts are automatically enforced, further enhancing the security and efficiency of trading.

Additionally, because DeFi platforms are typically open source, they allow for high levels of innovation and rapid development of new financial products and services that can meet the diverse needs of a global user base. This openness also helps in fostering a community of developers who continuously work to improve the platforms and address user needs in real-time, something that is less feasible in the closed ecosystems of traditional finance.

5 Problems of TradFi

  1. High Fees and Middlemen Costs. Traditional finance systems are notorious for the excessive fees charged at multiple levels of financial transactions. For example, investment management fees, brokerage fees, and bank charges can significantly erode investment returns. Studies suggest that investment management fees alone can consume up to 40% of total returns over 25 years. These costs act as a major drain on wealth accumulation for individual investors.

  1. Regulatory Burdens. While regulations are crucial for maintaining system integrity and protecting consumers, they can also create unintended consequences. The regulatory frameworks often increase operational costs for financial institutions, which, in turn, pass these costs onto consumers through higher service fees. Moreover, these regulations can erect barriers that prevent new entrants from joining the market, thus stifling innovation and competition.

  1. Inefficiencies in Transaction Processing. TradFi is often hampered by outdated systems that lead to inefficiencies in processing transactions. For example, cross-border payments can be slow and entail numerous steps involving several intermediaries, each adding their own fees and time delays. Such inefficiencies are particularly disadvantageous in a global economy where speed and efficiency are paramount.

  1. Economic Disparity and Lack of Social Mobility. The traditional financial system has played a role in widening the economic gap. Wealth and power are increasingly consolidated within the finance sector, predominantly among the top 1% of the population. This consolidation has contributed to stagnation in social mobility and growing economic disparities across different societal segments.

  1. Opaque Practices and Lack of Transparency. TradFi is often criticised for its opaque practices where the true costs, risks, and returns are unclear to consumers. This lack of transparency can lead to misinformed financial decisions and perpetuates a system where only the well-informed or well-connected can navigate successfully.

How DeFi Can Help

DeFi, or Decentralised Finance, acts as a potent transformative force within the financial sector, tackling many inefficiencies and inequalities found in traditional finance. By leveraging blockchain technology, DeFi eliminates the need for intermediaries such as banks and brokers. This reduction lowers transaction costs and accelerates financial exchanges globally, enhancing both the speed and accessibility of financial services.

The use of blockchain ensures that every transaction is recorded on a public ledger, making every process visible and reducing the possibility of fraud. This level of transparency fosters trust among users, who can rely on the integrity of financial activities without traditional audits. Moreover, the public nature of blockchain democratises access to financial services, bringing them within reach of the unbanked and underbanked populations around the world. This is particularly transformative for global financial inclusion, allowing individuals who were previously excluded from the financial system to engage in economic activities and manage their financial futures.

Furthermore, DeFi promotes a competitive financial ecosystem by reducing barriers to entry, encouraging innovation, and facilitating a broader range of participants. This enriches the market and ensures financial services evolve to meet the needs of today’s digitally-oriented and globally connected population. Unlike traditional finance, where decisions are often centralised, DeFi platforms frequently use governance models that allow users to vote on key issues, empowering them with a direct stake in the platform's development.

By these means, DeFi challenges the traditional financial model with its advanced, inclusive technologies and promises a more equitable and transparent future for financial markets worldwide.

Bottom Line

DeFi represents a significant step forward in creating a more equitable, efficient, and transparent financial system. As this sector matures, it will require continuous innovation, active community engagement, and adaptive regulatory approaches to ensure that its growth aligns with the broader objectives of financial equity and accessibility. The transformative potential of DeFi could redefine the global financial landscape, making it more inclusive and fair for all participants.