Traditional finance, often referred to as TradeFi, encompasses all aspects of the traditional financial system, such as banking, the stock market, the bond market, venture capital, and hedge funds. Decentralized finance (DeFi) emerged as an alternative, allowing people to trade financial instruments, lend, and borrow without relying on centralized intermediaries. Some see these two concepts as entirely separate, and many suggest that one will prevail over the other. However, they can exist alongside one another and even be synergistic.
We’ll look at the key features of TradeFi, how it compares to DeFi, and what the future of TradeFi may hold.
Key features of TradeFi
The traditional financial system is built around central points that enable and regulate the trading, lending, and managing of assets and financial instruments. TradeFi has flourished because it works. Among its many features are robust regulatory requirements that give businesses the security they need to take risks while also providing consumer protection. Still, there are many downsides to these characteristics that have given rise to the alternative DeFi system.
Centralized structure
Centralized entities, such as banks, investment firms, and government agencies, are foundational to the TradeFi infrastructure. These entities develop and market financial products and services. They are also in charge of managing risk by regulating financial markets and providing insurance.
For a centralized structure to be successful, people must trust the entity to manage their funds. Government agencies often partner with non-governmental entities to ensure people’s funds are protected.
Traditional banking services
Traditional banks have a physical presence and domestic banking licenses. Banking licenses issued by financial regulators are required for traditional banks to operate legally. Obtaining a domestic banking license can be a time-consuming, expensive procedure. This ensures that only top-tier entities offer banking services, but it limits the number of providers.
Regulatory compliance
Traditional financial institutions must comply with numerous state, federal, and international laws and regulations. For example, most are required to hold a certain amount of capital to provide a cushion for absorbing losses. They are also required to hold a certain number of liquid assets to ensure they meet their obligations to their customers.
For example, TradeFi institutions must comply with strict know-your-customer (KYC) regulations to verify the identities of those who use their services. KYC regulations help prevent money laundering and fraud. These regulations make traditional institutions an attractive option for institutional investors since their funds are more likely to remain safe. However, this business model isn’t suitable for those hoping to maintain anonymity.
TradeFi and DeFi
The DeFi world emerged to eliminate the need for central authorities when conducting financial transactions. Instead, the DeFi ecosystem relies on smart contracts, distributed ledgers, and community participation.
Decentralized structure
DeFi markets aren’t directly managed by centralized entities. Many rely on automated market maker (AMM) models, which use algorithms and liquidity pools to facilitate trades. In most cases, decentralized applications (dApps) enable anyone to make an asset for others to buy and sell without regulatory hurdles.
Cryptocurrency-based services
Most DeFi services are built around crypto assets rather than fiat currencies used in traditional finance systems. These digital assets can be used to facilitate payments, loans, and speculative investments.
Lack of regulatory compliance
DeFi organizations aren’t required to comply with the same regulations as traditional financial services. This lowers the barrier of entry for those interested in creating or offering financial instruments, but it has several drawbacks.
Due to the lack of consequences, the DeFi ecosystem is rife with financial scams. However, organizations like the Securities Exchange Commission have ramped up their efforts to begin regulating cryptocurrencies, NFTs, and other DeFi assets.
Low barriers of entry
DeFi applications are usually permissionless, meaning anyone can use them anywhere in the world. Many distributed ledger technologies offer low fees and have various low-cost assets, making it easy for anyone to participate, even if they’re generally underserved by the TradeFi ecosystem.
Challenges of TradeFi
TradeFi has many strengths, including security, stability, and an established reputation. However, there are several TradeFi challenges that make DeFi a more attractive option for many.
Resistance to change
The TradeFi ecosystem is managed by various centralized entities that must comply with strict regulations. These regulations make it difficult, if not impossible, for TradeFi institutions to embrace change. Additionally, TradeFi organizations are expensive to operate. Sweeping changes are inherently risky because they come with numerous costs and may not lead to an immediate return on investment.
The legal basis for central banks like the Federal Reserve System goes back decades, if not centuries. Although laws are often amended, they tend to tweak the system rather than make wholesale changes. For example, many of the amendments to the Federal Reserve Act of 1913 are simply aimed at giving the Fed more authority over the United States TradeFi ecosystem.
Limited innovation
TradeFi organizations are often slow to embrace new technologies. They must comply with specific regulations, get approval from board members, and invest large sums of money before using new technologies.
High transaction costs
TradFi transaction costs can be quite high. Banks, brokers, and other entities want to make a profit from transactions. DeFi systems generally automate many of these roles, meaning the overall costs are lower.
Future of TradeFi
The TradeFi ecosystem is well-established and moves at a very deliberate pace. Nonetheless, disruptive innovations like blockchain technology have forced many TradeFi organizations to consider new approaches.
TradeFi institutions are becoming increasingly aware of the many benefits of recent technological innovations. For example, the Federal Reserve has acknowledged that it is looking into a Central Bank Digital Currency (CBDC) similar to a stablecoin.
These institutions are slowly moving toward a financial system that includes DeFi. Traditional FinTech companies like CashApp and Robinhood have already begun offering crypto assets. Major TradeFi banking institutions, such as the Federal Reserve Bank of Boston, have acknowledged that they are looking into the potential for DeFi and TradeFi to co-exist. However, these integrations aren’t likely to happen anytime soon, as the potential risks are still being assessed.
According to Edward Dumas, a lead markets specialist at the Federal Reserve Bank of Boston: “It’s an exciting area, but it’s one that needs to be closely paid attention to, to ensure that we don’t find ourselves creating more harm than good.”
Hedera and TradeFi
Traditional financial systems seeking to use DeFi tools or create a crypto investing platform must use distributed ledger technologies with a track record of security, speed, and scalability.
The Hedera network is among the most secure DLTs and is capable of lightning-fast transaction finality. There is a collection of tools built on the Hedera network that enable TradeFi organizations to incorporate DeFi concepts. ServiceNow, for example, uses distributed ledger technology to improve business efficiency and track internal workflows.
TradFi Sumaary
TradFi (Traditional Finance) refers to the traditional financial system, governed by centralized institutions such as banks and governments. Despite its stability and strict oversight, it is limited in access and has high costs. Decentralized Finance (DeFi), on the other hand, utilizes blockchain and smart contracts to provide decentralized, 24/7 financial services to anyone, at low cost and with high transparency. These two systems do not necessarily compete with each other; they can combine their advantages to create a new financial system that is more flexible, accessible, and secure.
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