If you’re an investor or even just the money manager for your household, understanding the ins and outs of finance is a core component of your everyday life.
From budgeting for groceries to bolstering your 401(k) retirement account, personal financial aspects are a vital consideration for most. Outside of personal finance, the world revolves around public and corporate finance — equity investments, credit arrangements, and much more.
Up until the last few years, virtually all forms of finance that you know and use fall into the bucket of traditional finance. But with the growth and spread of crypto, a new type is on the horizon: decentralized finance.
Read along as we break down the differences between decentralized finance (DeFi) and traditional finance (TradFi).
What Is Traditional Finance?
According to historians, finance has been around since 3000 BC, stemming from the ancient Babylonian empire and Mesopotamia.
From financial lending to charging interest, ancient civilizations set the stage for our modern-day practice of traditional finance. Overall, traditional finance describes the study and discipline of money and assets.
Examples of traditional finance are your 401(k) savings account (personal), sourcing capital from investors (corporate), and central banks (public). Whether investing in stocks and bonds or stashing money under your pillow, any interaction with capital assets or currency is an act of finance.
The most important aspect to understand regarding traditional finance is that it’s centralized.
From fund managers to local banks and everything in between — everything is organized and governed by the few. Third parties and board of directors are notable traits across all traditional finance forms.
What Is Decentralized Finance?
Decentralized finance, better known as DeFi, breaks away from many vital tenets of traditional finance with the help of blockchain technology.
DeFi removes the need for intermediaries (centralized banks or third parties) during financial transactions. Instead of intermediaries, decentralized finance leverages smart contracts to execute agreements once predetermined conditions are met.
Although this may sound complicated, we’ll provide a brief example below.
You want to take a loan, but your credit is far below optimal. Instead of ruining your current credit situation, you can head to one of the most popular DeFi protocols available: Compound.
Compound is a DeFi protocol that enables anyone to lend or borrow cryptocurrencies. For the sake of the example, let’s say you deposit 10 ETH into the Compound protocol. You can use the 10 ETH as collateral to take out a loan in the form of stablecoins, such as USDT or USDC.
Although you retain custody of your collateralized ETH — you cannot remove it until you repay the loan. Once repaid, the smart contract releases your collateral, and you can withdraw it from the platform.
As you can see, there isn’t a single moment where you deal with an intermediary or third party. The smart contract within Compound automates every transaction.
Compare that to traditional finance, where hours, days, or weeks pass until a bank or lending agency hands over a loan (after checking your credit score, of course).
The Differences Between DeFi and Traditional Finance
Now, let’s dive into the differences between DeFi and traditional finance.
In many respects, DeFi is viewed as an evolved form of traditional finance to meet the needs of the modern day. As the world is consumed by technology, the need for countless intermediaries crumbles, and the desire to streamline financial freedom comes to the forefront.
Even if you’re heavily invested in traditional finance, such as stocks, bonds, and other financial instruments, it’s worth the time and effort to understand how decentralized finance offers a dramatic improvement to traditional finance.
DeFi May Be More Transparent Than Traditional Finance
Transparency is one of the starkest differences between DeFi and traditional finance.
In the world of traditional finance, a lot of the details go on behind the scenes. Order books are only viewable by exchanges, and sometimes lax lending standards can exacerbate financial repercussions (i.e., the 2008 Financial Crisis).
In other words, transparency is often restricted to the top players in traditional finance.
Compare that with DeFi, which is naturally transparent because it operates on the blockchain. Every transaction on DeFi protocols can be found — making it more difficult to hide a money trail.
Furthermore, you don’t know how your money is being put to work when you deposit it into a financial institution. With DeFi, the crypto is generally viewable and at your fingertips as long as you meet the predetermined conditions set by the smart contract.
DeFi Has Different Lending Requirements vs. Traditional Finance
With DeFi protocols, such as Compound or Aave, the amount you borrow is limited to the collateral factor.
Depending on the deposited crypto assets, you’ll be able to borrow roughly 70-80% of your collateral. Although this may seem overly conservative, it forces borrowers only to take what they can afford.
Compare this with traditional finance, where borrowers do not have to show that they can repay the debt promptly. Thus, predatory lending practices and overambitious traders create a precarious financial situation.
Once again, DeFi paves the way in a trustless manner that only requires a smart contract. In the event of liquidation, the smart contract automatically removes the crypto collateral from your wallet to repay the debt.
DeFi Is More Accessible Than Traditional Finance
Traditional finance has a high barrier to entry compared to decentralized finance.
Whether signing up for a credit card or setting up an employer-sponsored Roth 401(k), you must meet specific criteria. On the other hand, DeFi allows you to borrow and lend cryptocurrencies regardless of your financial situation.
As long as you have an internet connection and crypto in your digital wallet — you’re free to use DeFi.
DeFi Doesn’t Charge Sky-High Rates on Loans
As it stands, a $300,000 (30-yr fixed) mortgage loan can be as much as 7.7% APR.
Rates on loans fluctuate depending on your credit score, making traditional finance increasingly challenging for many. Whether you invest in real estate or not, DeFi offers a unique rate proposition compared to traditional finance.
Compound borrow rates are variable yet are often much lower than traditional borrow rates. For example, borrowing ETH on Compound currently has an APR of 2.7% (rates may vary). Additionally, borrowers can decide to pay back any amount of the interest owed at any point as long as they are not liquidated.
DeFi Enables Multiple Yield-Bearing Options
The primary goal of traditional finance is to put your money to work.
Traditional finance lets investors speculate on stock prices and compound gains through dividend payouts. Although these strategies have worked for many decades, new opportunities are on the horizon.
Decentralized finance allows you to lend crypto and earn a modest interest rate. In addition, lenders can collateralize their crypto to take out a loan. This loan can be deposited and loaned out on Compound or Aave for additional earnings.
This practice is called yield farming because it puts your crypto to work across different DeFi platforms.
Self-Custody Is a Core Tenet of DeFi
When using DeFi protocols such as Aave or Compound — you own your crypto even if it’s staked as collateral.
In other words, a third party or financial institution cannot access your funds. Instead, the smart contract dictates where your crypto collateral goes, such as back to your wallet once you repay your loan.
With traditional finance, your money is never in your wallet. The stocks and bonds you own through a broker are not physically yours. The platform might freeze your funds, lock your account, put withdrawals on hold, and much more. If something like that happens, there is nothing you can do about it other than wait.
DeFi, on the other hand, does not have third parties and cannot freeze your account because you control your account.
Investing in DeFi Cryptocurrencies
DeFi platforms open an entirely new world of finance that blends aspects of the old while implementing new and exciting changes.
Although you can use DeFi platforms to put crypto to work, investing in DeFi cryptocurrencies, such as Aave (AAVE) or Compound (COMP), is also possible. DeFi-based cryptocurrencies can be bought on exchanges or through crypto investment advisers like Shrimpy.
The world of decentralized finance is an emergent force that has intrigued even the largest financial institutions like J.P. Morgan, Goldman Sachs, and more. As always, it’s essential to research each DeFi-based cryptocurrency thoroughly before making any decision.
Shrimpy is providing an endorsement of Shrimpy Advisory. Shrimpy and Shrimpy Advisory are affiliated companies. A conflict of interest exists because Shrimpy Advisory will be compensated if a client utilizes Shrimpy Advisory’s services.