In 1800 BC Babylon, moneylenders began loaning out coins of various metals and sizes, proportionally signifying their values. This was the first instance of traditional banking, the way we know it. Ever since, banking has evolved, with its traditional version serving humans effectively for numerous centuries, evolving from jingling coins to shining ornaments to glorious green wads of bankrolls we know today.
But as history has repeatedly shown, change is a necessary evil. Traditional banking has grown old and disadvantageous– which renders it incapable of serving a futuristic future of financing. The future of finance will incorporate digital financing technologies, and will no longer need the presence of a centralized authority – such as decentralized finance.
Existing Issues With Traditional Banks
Over time, like almost every product in the world, traditional banks get outdated. Here are 2 reasons why.
Firstly, traditional banks charge a wide range of fees. Especially when compared to their digital counterparts, traditional banks charge a wide range of high fees for their services. Such fees include excessive transactions fees, overdraft fees, and insufficient fund fees. Often when one uses a traditional banking service, they have to go through the hassle of carrying out certain actions with their accounts just to avoid the fees charged by banks.
Bank of America, for example, charges a $35 nonsufficient funds fee, whereas Alliant Credit Union — one of the largest credit unions open to the public — charges just $25 for an NSF fee. With the multitude of fees charged, traditional banks begin to lose more customers due to a lack in customer satisfaction, making traditional banks less appealing when compared to decentralized finance solutions.
Secondly, traditional banks are notorious for offering low to no interest rates on saving accounts. In fact, in a recent survey by GOBankingRates, the best savings accounts were all with online banks: MySavingsDirect, Ally Bank, Barclays, iGObanking and CIT offered the top five highest interest rates. It is to be observed that digital financial services are more lucrative and money efficient for customers, which is due to the ‘surplus’ of savings from not having to maintain a brick-and-mortar branch.
Meanwhile banks set low interest rates to conserve the money lost due to the various costs of maintaining physical branches, deterring customers and adding to a lack of customer trust. This is especially true for retail banks, consumer loyalty can be hard to come by. About 29% of consumers globally said they would completely switch their primary bank if it were easy to do so, according to Bain & Company’s new global survey of 137,034 consumers in 21 countries.
These problems are only the tip of the iceberg, as there are many more issues with traditional banks such as poor customer service, cyber-security, and increasing competition from FinTech start-ups.
DeFi As An Alternative
Decentralized finance (DeFi) is probably the best successor to the traditional banking system. Instead of using a centralized authority like a bank or government, DeFi harnesses the power of peer-to-peer (P2P) lending and alternative lending mechanisms to provide similar moneylending services. DeFi works by the combination of 3 things: cryptography, blockchain and smart contracts.
Cryptography, or cryptology, is the practice and study of techniques for secure communication in the presence of adversarial behavior. It encrypts messages in the P2P network, and hashing is used to secure block information and link blocks in the blockchain.
Blockchains are decentralized, transparent and immutable (i.e. the data in them cannot be changed). The blockchain data is stored across different locations on a myriad of computers worldwide, making the chains decentralized. Finally, cryptography and blockchain technology make each transaction fully immutable. The data cannot be changed, forged, or altered, and the chains cannot be unlinked. Therefore, blockchain can guarantee the fidelity and security of data records and generate the need for a third party.
Smart contracts are simply programs stored on a blockchain that run when predetermined conditions are met. They typically are used to automate the execution of an agreement so that all participants can be immediately certain of the outcome, without any intermediary’s involvement or time loss, playing a key role in the decentralization of the financial system.
Advantages of Decentralized Finance
While there are a slew of benefits to the exciting new technology that is decentralized finance, the two main benefits would be immutability and simpler lending and borrowing applications.
Firstly, DeFi improves data security due to its immutability. As aforementioned, the effective utilization of cryptography along with consensus algorithms such as proof-of-work has helped blockchain in achieving actual immutability. Therefore, the advantages and disadvantages of decentralized finance have enabled the true benefits of immutability in finance.
With the help of immutability, it is practically impossible to manipulate any record on the blockchain network. In addition to the features of decentralization, immutability offers the promising assurance of security, which highly reduces the risks of cyber-attacks for financial data.
Secondly, DeFi offers simpler and hassle-free borrowing applications. Lending and borrowing solutions offer substantially promising benefits for end-users. The pros and cons of decentralized finance would obviously reflect on cryptographic verification mechanisms. At the same time, they also provide the assurance of smart contract integration.
The facility of such functionalities ensures the elimination of intermediaries like banks which are generally responsible for the verification of parties in a transaction. In addition, it also works for verification of the process associated with lending and borrowing transactions. As a result, DeFi enables a faster and easier verification process in lending and borrowing applications.
A Side Note: Financial Inclusion
A rising issue in today’s financial world is financial inclusion, especially in light of the 17 sustainable development goals set by the United Nations. Financial inclusion is defined as the availability and equality of opportunities to access financial services.
It is often observed that it is difficult for traditional banks to contribute to financial inclusion, and they may also sometimes contribute to financial exclusion. This is because of the face-to-face human element of customer interaction, which is open to prejudice and discrimination against certain social groups. This reduces access to financial services, making people more financially excluded.
On the other hand, DeFi can actually increase financial inclusion. The first way would be that it eliminates chances of discrimination, as there is no face-to-face human interaction to harbor prejudice in the first place. Besides that, DeFi also provides financial freedom.
At its most basic level, financial freedom entails having access to financial services that can help one manage their finances. Under traditional finance systems, many people with lower incomes may not qualify to take out loans, invest, or even open accounts in their name.
Seldomly do banks have financial products and services that cater to the low-income populations. Traditional institutions typically have very strict requirements: high credit scores, steep fees, high incomes. Such inaccessibility further hinders those with low incomes from growing their money, creating a loop that stacks the odds against the unbanked with every step.
Unlike traditional finance, which is inherently skewed towards the elite, decentralized finance promotes equal access to financial products in a secure environment. The social consequences of decentralized finance are making themselves apparent, unfolding before our very eyes as cryptocurrency and mainstream finance continue to collide. DeFi seems to be successful in reversing inequality across the board through diversified financial services, transparent transactions and accessibility through a permission-less network.