TradFi vs. DeFi - 5 Key Distinctions and Similarities
Table of Contents
- How TradeFi and DeFi Differ
- How TradFi and DeFi Web3 Solutions are Similar
TradFi, or traditional finance, exists completely independent of the DeFi, or, decentralized finance, world. This can be witnessed by watching the overall crypto market cap shrinking from $2.7 trillion to $1.1 trillion, holding almost no effect on the value of TradFi assets. However, the lines are beginning to blur as cryptocurrency is now being used for matters formerly dominated by TradFi.
In recent years, we have seen cryptocurrency facilitate down payments for mortgages, used as assets in retirement plans, and even collateral for loans among many other real life use cases. As we move further into the mass adoption of DeFi, the need for DeFi and TradFi to exist in tandem has never been stronger.
How TradFi and DeFi Differ
In order to open a bank account, apply for a credit card or loan, or do most anything involving a bank, customers must go through a process known as KYC. Know Your Customer, or KYC, are federally enforced regulations requiring banks and financial institutions to verify the identity and income of their customers.
In contrast, DeFi Web3 solutions have zero KYC requirements, as anyone can anonymously create a crypto wallet without submitting any form of identification.
2. Consumer Protection
While there is a lot still to be desired for TradFi consumer protection, it most certainly provides its customers more protection than DeFi. DeFi offers users zero consumer protection in its current form. Since DeFi is decentralized, there is no central authority that can manage payment disputes.
For instance, banks can temporarily pause Zelle transactions, at times reverse Zelle payments, or even recover stolen funds via Zelle scams. For DeFi, the same is not true. If one were to accidentally send their funds to the incorrect address, there is nothing that can be done to recover the funds.
Have you ever forgotten a password? Well, that's fine because most of the time you can simply reset it. Have you ever forgotten a seed phrase? If so, you will understand the frustration that seed phrases can bring.
By design, a seed phrase can never be recovered if forgotten, in order to prevent wallet theft. Therefore, if you forget your seed phrase, then there is quite literally nothing you can do to recover your funds. This phenomenon is unlike a password for a mobile banking app, which can be reset almost instantly in the event of losing a password.
Unlike parking your cash in the bank, holding US dollars in crypto isn’t as easy. To allow users to transact in US Dollars, stablecoins were invented. These stablecoins are pegged to the US dollar (or the national currency of choice). However, this peg is not always secure, simply ask holders of Titan or Terra Luna.
By holding stablecoins, crypto investors are taking a larger risk on holding a US dollar equivalent, as opposed to holding them in an FDIC insured bank. Despite stablecoin’s attempt at pegging the US Dollar, the risk of holding stablecoins makes them more volatile and risky.
5. Restricted Transactions
It is nearly impossible for DeFi protocols to enforce bans on using their platforms for illicit or illegal activity. Since DeFi isn’t tied to a centralized identity, there is truly no way for a cryptocurrency like Ethereum to ban the use of its dApps for, let's say, selling weapons.
On the flip side, traditional financial services, like PayPal or Venmo, actively search through their transaction records to ensure its platforms are not being used for illegal activity. With DeFi, anyone can anonymously send hundreds of thousands of dollars across international borders without the government of either country having a clue.
How TradFi and DeFi Web3 Solutions are Similar
1. Instant Transactions
With services like Zelle, PayPal, and Venmo, customers can send transactions to each other near instantly with little to no transaction fees. Similar to how users can instantly and cheaply send money between each other on chains like Solana, Cardano, or Algorand. Utilizing peer to peer transactions are features users enjoy from both TradFi and DeFi alike.
2. KYC Again
While mentioned that KYC was a differentiating factor between the two, in some cases, they both need KYC. For instance, signing up for a Coinbase, Gemini, or BlockFi account in the United States requires much of the same KYC required documentation that signing up for a bank would.
3. Expensive Transactions
While this isn’t true for all of DeFi, it is true for two of the largest cryptocurrencies by market cap, ETH and BTC. For a variety of reasons, utilizing these networks to transfer money can be cost consuming to the users. Oftentimes, for domestic transactions (within your country) it can be much cheaper and faster to utilize TradFI transfers than DeFi (at least for BTC or ETH).
Reports show that up to 74% of Financial Institutions either own cryptocurrency or plan to add crypto to their ledgers within the near future. Despite holding different roles in the financial markets, TradFi institutions are among some of the largest holders of cryptocurrency in the world. The institutional adoption of cryptocurrency was one of the great catalysts of the 2021 bull run.
The acronym HODL is generally known in the crypto community as "Hold on for Dear Life" and is used by those who capture the long-term vision of the crypto space.
5. Low Accountability
Similar to DeFi, much of traditional finance is unaccountable for their actions. Take for example the 2008 bailouts where institutions deemed “too big to fail” were given financial stimulus to ensure their viability. The same institutions who nearly collapsed our financial system and lost thousands of Americans hard earned money, faced little to no repercussions for their actions.
In fact, many CEOs were offered excellent severance packages on their way out. You can draw quite a few parallels to the 2008 crisis and your average DeFi rug pull. Retail investors put their money in, the money is either stolen or mishandled, funds are lost, and developers or the CEO’s walk away with a handsome check.
DeFi and TradFi both serve their own unique niches within the financial markets. Both products offer amazing services and it is believed that in the future, everyone will be looking at using a hybrid of the two systems.
Is TradFi going away soon?
TradFi is in no danger of being replaced by DeFi, yet.
Can I trust DeFi Web3 applications?
Not entirely. But, with the products being open sourced, you have the ability to manually review the smart contracts to fully understand how the applications work and if it is a safe venture.
What is the biggest difference between TradFi and DeFi?
Regulations. Anyone, anywhere can set up a crypto currency on Pancake Swap. You can open a DEX anonymously. The absence of regulation is how many of the services we know and love on DeFi are possible.
What is the easiest way to get involved in DeFi?
One of the easiest ways would be to transfer ETH from Coinbase to your MetaMask browser wallet and to use platforms like AAVE or UniSwap.
The following video is a comprehensive analysis of TradFi and DeFi that goes into even more detail on the topic.
Thank you for tuning in and as always...
Keep your fingers on the PULSE!
Author: Ken Melendez
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Information in the article does not, nor does it purport to, constitute any form of professional investment advice, recommendation, or independent analysis.