In 2020, decentralized finance really took off. Decentralized finance, or DeFi, has quickly become the most talked-about development in the blockchain technology and cryptocurrency space. Crypto enthusiasts had been experimenting with different use cases for blockchain technology and cryptocurrencies, but the most obvious industry for blockchain technology to disrupt has always been the expansive finance industry, particularly because cryptocurrencies are, in fact, currencies. However, as the focus of conversations quickly turned to decentralized finance, questions arose from skeptics and people who were uninformed of its benefits.
“Why does finance need to be decentralized? Is there really a need for decentralization in finance?”
“What are the benefits of decentralized finance?”
“Centralized finance has existed for a long time and it seems to have worked ok. Why do we need to decentralize it?”
The following highlights the key reasons addressing why decentralization in finance is needed and the improvements that can be made to the financial system by providing a decentralized banking option.
What Is Decentralization And Decentralized Finance?
Decentralization is the distribution of functions or powers from a central authority to regional or local authorities. In blockchain technology, decentralization means that decision-making is distributed across nodes, allowing direct peer-to-peer transactions to take place without a centralized authority such as a bank. Decentralized finance (DeFi) is the decentralization of all of the financial services traditionally offered by a central authority like a bank or financial institution. These financial services are instead provided through the use of blockchain technology and smart contracts.
Here are some of the reasons why decentralization is needed in finance.
1. Cross-Border Payments Are Not Affordable
Decentralization can remove costly intermediaries, ultimately making remittance services more affordable for all. In the current financial system, it is expensive for people to send money across borders. Decentralized financial services can lower remittance fees by more than half. In today’s globalized economy, this is necessary. Many people who wish to send money internationally cannot afford to do so at the current rates. The third-party intermediaries present in centralized remittance systems are paid for through the fees that customers must pay for. By removing third-party intermediaries entirely, Decentralization of these services can eliminate the need for that additional “intermediary” charge, making cross-border payments less expensive.
2. Security Is An Issue
Banks and other traditional financial institutions are quite vulnerable to security breaches due to the fact that they hold users' data in centralized locations. Now that the world has gone digital, not only are they vulnerable to robberies in their physical brick and mortar locations, but they are vulnerable to hacking and digital robbery as well. For hackers, it’s much easier to steal from a large database of information all in one centralized location. It’s not just people’s money that is at risk, it’s also their personal information that can be used to steal their identity, which has numerous long-term implications.
Blockchain is decentralized, which means that transaction data is encrypted and spread across thousands of devices. This means that decentralized finance, which runs on the blockchain, is protected from the vulnerabilities of centralization.
Finally, when you trust a centralized entity such as a bank with your money, you are trusting that the bank will secure it, but at that point you turn over control of your finances to the bank, meaning that you have no control beyond hoping that they can keep your information safe. With decentralization, you continue to have full custody of your wealth and you can complete transactions securely without the centralized authority of the bank. Decentralized finance gives everyone more control over their own finances, while also keeping their money secure.
3. Inequality Is Rising
Decentralization in finance enables anyone with a cell phone and internet access to gain access to lending, borrowing, and other financial services traditionally offered by banks. DeFi protocols enable anyone to earn interest on cryptocurrencies and more. More than 1 billion people currently lack access to financial services globally, as they do not qualify for them under the constraints of an antiquated financial system. Through decentralized finance, these people can finally gain access to financial services and the financial tools that can help them build wealth. With inequality on the rise, decentralized finance is needed to bridge the gap between the rich and poor and to help people escape poverty.
4. Traditional Financial Institutions Are Not Transparent
On the blockchain, every transaction is available to and verified by other users on the network. This not only adds to security, as many eyes are viewing the information and checking for any potential abnormalities, but it also allows for improved data analysis due to more users having access to the data.
The current lack of transparency with regards to transactions in centralized financial institutions leaves them with another potential point of failure.
5. Traditional Finance Does Not Enable Interoperability
DeFi protocols and applications can be built so that they complement each other. This is the true mark of innovation and allows DeFi projects to build off of one another which can speed up the process of technological development. This process is called interoperability, and the lack of interoperability in the centralized financial system has hindered its progress.
6. Global Financial Systems Offer Limited Support For Countries With Destabilized Currencies
Countries with destabilized currencies and inflation and/or authoritarian governments do not provide ways for citizens to protect their wealth. Since the traditional financial systems in those countries are plagued with a number of inefficiencies and problems, people in countries with these monetary problems often watch helplessly as their money becomes worthless.
Thankfully, people can avoid inflation and other financial problems their country may be facing by investing in cryptocurrencies. With developments in decentralized finance, they can easily access the same financial services as they would be able to at a bank but avoid government-controlled financial institutions.
7. Centralized Systems Create Privacy Risks
Banking in its centralized form requires that customers provide the bank with their personal information and access to their money in exchange for the provision of financial services. This means that customers are required to give up their privacy, in exchange for services and the perception of safety/security.
Decentralization has made it possible for people to gain access to financial services without having to provide personal information and legal documents that they may or may not have access to depending on various requirements, such as their immigration status.
There are clear advantages to decentralization, and so it has already been suggested that some systems that are currently centralized be transferred to the blockchain in an effort to decentralize them. Currently, initiatives such as putting credit information on the blockchain and into the decentralized finance ecosystem, are already in progress. In essence, this would bridge the gap between centralization and decentralization.
Decentralization In Finance
It is clear that there is a need for decentralization in finance. In fact, even some banks plan to integrate bitcoin into the financial services they offer, signaling increased awareness and acceptance of the benefits of decentralization in finance. Perhaps they too are starting to realize the impact that decentralization will have on the finance sector.
In most places, however, financial services remain centralized, which leaves much of the world’s population excluded from the financial system and many more people regularly dealing with the limitations of centralized finance. By continuing to inform the population of the benefits of decentralization, the mass adoption of cryptocurrencies, and the real-time cost savings, the decentralized finance industry will continue to grow, and innovation within financial technology will continue at an accelerated speed to support this growth.
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