- The centralized finance system (CeFi) has also been called the traditional finance system (TradFi).
- The CeFi system is characterized by some crypto enthusiasts as slow, expensive, controlling, biased, opaque, and prone to failure.
- Cryptocurrencies exist in a system of decentralized finance (DeFi) that is designed to overcome the challenges of the CeFi system.
- In DeFi, investors control their assets which can be transferred globally at greater speed and lower cost than in the CeFi system.
- While the CeFi system requires investors to interact with a single counterparty, the DeFi system is globally distributed across thousands of computers worldwide, reducing the risk of failure of a single counterparty.
The Bitcoin white paper was published at the height of the 2008-2009 Global Financial Crisis (GFC), just weeks after the demise of Lehman Brothers. The first block written to the Bitcoin blockchain had data referencing bank bailouts. This shows that the creator(s) of Bitcoin, the world’s most successful cryptocurrency, built the crypto ecosystem at least in part, due to a distrust in the stability of the centralized finance (CeFi) or traditional finance (TradFi) systems. The CeFi system includes today’s legacy financial infrastructure, such as banks, brokerage firms, money transfer agents, stock and futures exchanges, and government-controlled Central Banks. Centralized means that a consumer interacts with a single counterparty who controls the ledger of their transactions.
There are a number of drawbacks to the CeFi system. First, it is slow and expensive, as international wires and money transfers can take up to three days while charging fees of 3% or more. Second, consumers with accounts at a specific bank or brokerage firm may find it difficult and time consuming to transfer assets to another bank or brokerage firm, especially when moving assets into different countries or different currencies. Bankers who believe that their customers face high switching costs may be prone to charging excessive fees for their services. Third, the CeFi system may be prone to failure. Whether it is a war in Ukraine, the GFC, or Central Banks increasing money supply so quickly that inflation erodes the value of fiat currencies like US Dollars, many believe that many fiat currencies and individual banks are likely to fail. Fourth, the CeFi system does not seem fair to all participants, as many global consumers don’t have access to banking services or loans for a variety of reasons including income, location, credit rating, or perhaps even discrimination based on their personal characteristics. Finally, the CeFi system is not transparent, where both banks and bank customers can obscure the risk of their actions.
Cryptocurrencies and digital assets seek to solve these issues by moving to a decentralized finance (DeFi) system. In the global cryptocurrency system, our financial records are not maintained by a single centralized counterparty, but are maintained by a globally decentralized network of thousands of computers in dozens of countries, which reduces the risk of the failure of a specific bank or fiat currency. When a system is decentralized, the power and risk of dealing with a single counterparty is reduced, while the cost of the failure of a single counterparty is minimized.
The decentralized finance system is transparent, where all transactions on most public blockchains are disclosed in real time. Blockchains can process transactions in a faster and cheaper way, making global transfers not in 3 days for 3%, but typically in less than 30 minutes for less than 0.3%.
Cryptocurrencies are not technically native to any specific country or fiat currency, so may be less impacted by the choices of a Central Bank or the regulations of a specific country. Because digital assets are not inherently located in a single country or centralized counterparty, there are no barriers to transferring assets across accounts or countries at any time. Finally, the DeFi world is largely anonymous, where balances are tracked by account number and not personal identities or characteristics. In this anonymous world, everyone is welcome to participate regardless of their gender, age, location, or personal characteristics. Anyone who has crypto or fiat assets will be automatically approved for a collateralized loan as long as they are not terrorists or money launderers. In fact, we find that cryptocurrencies have their greatest use in countries with weak governments, weak banking systems and fiat currencies devastated by inflation, such as Venezuela, Zimbabwe, Ukraine, Argentina, and Turkey.
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