Chapter 1: Traditional Financial Institutions
In order to introduce DeFi (Decentralized Finance) to readers lacking background knowledge, we will first review the basic workings of traditional financial institutions. For simplicity, we will focus on the most influential institution in the traditional financial system—banks—and discuss their core areas to understand the potential risks involved.
Banks
Banks are giants in the financial industry, providing convenient payment, savings, and credit services to individuals, businesses, other financial institutions, and even governments. In fact, their scale is so large that the total market capitalization of the world's top ten banks reaches $2 trillion. In contrast, as of December 21, 2019, the total market capitalization of the entire cryptocurrency market was only about $200 billion.
Source: Top 1000 World Banks 2019
Banks are a key component of the circulation machine. The circulation machine refers to the financial industry—they facilitate the free flow of funds around the world by providing value transfer (deposits, withdrawals, transfers), increasing credit limits (loans), and other services. However, banks are managed by people and are subject to regulatory oversight, making them susceptible to human-related risks such as mismanagement and corruption.
The 2008 global financial crisis was a manifestation of banks' excessive risk appetite, forcing governments to provide massive bailouts to banks. This crisis exposed the flaws in the traditional financial system and highlighted the need for improvement.
DeFi aims to create a better financial environment by leveraging emerging internet and blockchain technologies, particularly optimizing three key components of the banking system:
Payment & Settlement Systems (Remittances)
Accessibility
Centralization & Transparency
1. Payment and Settlement Systems
If you have ever tried to remit money to someone or a business in another country, you should have felt the pain points involved—remittances involving banks around the world typically take several business days to complete^1^, and they come with a variety of fees. Worse still, there may be issues related to the documentation required for remittances, compliance with anti-money laundering laws, and privacy.
For example, if you live in the United States and want to send $1,000 from your U.S. bank account to your friend's account in Australia, this usually incurs three types of fees: your bank's exchange rate, the outgoing international wire transfer fee, and the incoming international wire transfer fee. Additionally, the recipient may take several business days to receive the money, depending on the location of the receiving bank.
Cryptocurrencies driving the DeFi movement allow you to bypass intermediaries that take a large share of profits during the transfer process. Transfers are also likely to be faster—your transfer transaction will be processed unconditionally and will only incur relatively lower fees compared to banks. For instance, transferring cryptocurrency to any account globally takes only 15 seconds to 5 minutes (depending on various factors^2^) and incurs a small fee (for example, around $0.02 on Ethereum).
2. Accessibility
If you are reading this book, you likely have a bank account and can access financial services provided by banks, such as opening accounts, loans, and investments. However, there are many who are less fortunate, lacking even the most basic savings accounts.
Distribution map of unbanked populations (Source: Global Findex, World Bank, 2017)
The World Bank estimates that as of 2017, 1.7 billion people did not have an account at a financial institution, with more than half coming from developing countries^3^. They primarily come from impoverished families, and the main reasons for not having a bank account include poverty, geographical location, and trust issues.
For the 1.7 billion unbanked individuals, accessing banking services is extremely difficult—but DeFi has the potential to simplify this. Accessing DeFi Dapps (decentralized applications) only requires users to have a smartphone with internet access, without going through lengthy verification processes. The World Bank estimates that among the 1.7 billion unbanked individuals, two-thirds own mobile phones^4^. Therefore, unlike traditional banks, DeFi Dapps can serve as a gateway for these individuals to access financial products.
DeFi represents a movement aimed at promoting borderless, uncensored, and barrier-free financial products. DeFi protocols do not discriminate against anyone and create an equitable environment for participation.
3. Centralization & Transparency
Undeniably, traditional financial institutions like banks, which are regulated and comply with government laws and regulations, are among the safest places to store funds. However, they are not without flaws—even large banks can fail. In 2008, Washington Mutual, with deposits exceeding $188 billion^5^, and Lehman Brothers, with assets over $639 billion^6^, both went bankrupt. In the United States alone, there are records of over 500 bank failures^7^.
Banks are one of the central nodes that led to the collapse of the financial system—the failure of Lehman Brothers triggered the 2008 financial crisis. Concentrating power and funds in banks is very dangerous. Historical events have proven this point to be entirely correct.
Transparency is also closely related—ordinary investors cannot fully understand how financial institutions operate. A series of events leading to the 2008 financial crisis included credit rating agencies giving AAA ratings (the best and safest investments) to high-risk mortgage securities^8^.
DeFi will be different in this regard. DeFi protocols built on public blockchains (like Ethereum) are mostly open-source, facilitating audits and enhancing transparency. These protocols typically have decentralized governance organizations to ensure that everyone is aware of what is happening and that no malicious actors can make harmful decisions unilaterally.
DeFi protocols are written as lines of code—you cannot deceive the code because it treats every participant equally without discrimination. These codes operate exactly as they are written. Since the code is open-source for public scrutiny, any vulnerabilities will quickly become apparent. Ultimately, the greatest advantage of DeFi lies in its ability to eliminate intermediaries and operate in a zero-censorship environment.
Decentralized Finance vs Traditional Finance
Market friction, inaccessibility, and regulatory uncertainty are some of the major issues plaguing the current banking system. Unfortunately, not everyone can enjoy the services available in the current banking system—those unable to access banking services find it difficult to participate fairly.
The DeFi movement aims to bridge these gaps, allowing everyone to access financial services without undergoing any form of censorship. In short, DeFi opens a vast window of opportunity and allows users to utilize various financial tools without restrictions based on race, religion, age, nationality, or geography.
Comparing traditional financial products and decentralized financial products, we find that both have their pros and cons. In this book, we will gradually introduce you to the concepts and possibilities of decentralized finance, so you will know how to leverage its best features to solve real-world problems.
In Chapter 2, we will provide an overview of DeFi and some DeFi applications to help readers understand the basic concepts of how DeFi operates.
Recommended Reading
Decentralized Finance vs Traditional Finance: What You Need To Know (Stably) https://medium.com/stably-blog/decentralized-finance-vs-traditional-finance-what-you-need-to-know-3b57aed7a0c2
The 7 Major Flaws of the Global Financial System (Jeff Desjardins)
https://www.visualcapitalist.com/7-major-flaws-global-financial-system
- Decentralized Finance: An Emerging Alternative to the Global Financial System (Frank Cardona)
https://www.visualcapitalist.com/decentralized-finance/
- How Decentralized Finance Could Make Investing More Accessible (Jeff Desjardins)
https://www.visualcapitalist.com/how-decentralized-finance-could-make-investing-more-accessible/
