When decentralized virtual currencies first came on the scene, they showed little promise. More than a decade later, cryptocurrencies have skyrocketed in value, proving early critics wrong.
This technological development led to the emergence of a new global economic system – decentralized banking. The new system seeks to fix some of the flaws of the current centralized financial system.
When discussing decentralized markets, Sam Patterson of OB1 stated that “Decentralized markets allow people to engage in trade directly with each other. Instead of relying on the centrally-controlled servers of the companies, a decentralized market operates by employing its users’ own computers as the infrastructure.”
Should we then embrace the idea of decentralized financial systems, or is this just another farce? Let’s examine.
What is Decentralized Banking?
To answer the question, “what is decentralized banking?” we first need to define a peer-to-peer (P2P) financial service. Peer-to-peer banking allows two individuals to conduct transactions without the involvement of a third party. For example, in the case of purchases, buyers can transact directly with the sellers and vice versa.
With the above in mind, decentralized Finance (DeFi) is simply a peer-to-peer financial system that uses blockchain technology to allow users to own, issue, and transfer financial instruments. This system runs on decentralized platforms that provide all the services offered by centralized banks.
In centralized systems, intermediaries perform crucial roles, such as loan approvals and maintaining financial data. In DeFi ecosystems, smart contracts and other P2P features perform these functions.
What Technologies Do Decentralized Banking Systems Use
- P2P lending – Decentralized platforms link borrowers directly to lenders once they meet specific criteria. P2P technology eliminates the complex procedures centralized banks usually go through when approving loans.
- Blockchain – Blockchain technology records all financial transactions in real-time. Furthermore, the blockchain is also secure and transparent, giving users safe access to essential financial data. AI algorithms can also make use of blockchain data to connect the right lenders and borrowers.
- Cryptocurrencies – While it is possible to use fiat in decentralized banking, the blockchain was built with cryptocurrencies in mind. These digital currencies are faster, smoother, and allow for enhanced traceability.
- Machine learning – Machine learning and big data automate the lending process and minimizes the red tape associated with traditional banking loans. AI and machine learning also work 24/7 to match borrowers with lenders.
- Smart contracts – Smart contracts are the decision-making mechanism in DeFi systems. Some of the functions of smart contracts include:
- Converting currencies
- Automating transactions between lenders and borrowers, and
- Creating binding contracts between parties.
The Future Impact of Decentralized Finance
With the risks associated with centralized economies, decentralized systems couldn’t have come at a better time. Until now, it was difficult to imagine a new financial market dominated by decentralized technologies, such as blockchain and cryptocurrency.
5 ways DeFi will have a lasting impact on the financial world:
Improved access to financial services
with just a smartphone and an internet connection, anyone can now access financial services. As such, regions that were previously denied by centralized banking systems will now be included in the global economy. DeFi eliminates barriers such as:
- Status – Lack of support documentation, citizenship, and credentials to access financial services
- Geographical location – The current system requires customers to travel to specific physical locations to access banking services
- Wealth – Only top executives with considerable funds were beneficiaries of a centralized banking system.
Inexpensive cross border transactions
While fees vary by country, the estimated global remittance fee is about 7% in the current financial system. By getting rid of intermediaries, DeFi cuts down transaction fees, making payment services affordable for everyone the world over. Remittance fees in decentralized financial systems could reach as low as 3%.
Censorship-resistant transactions
Transactions in decentralized systems are immutable. In other words, once data is written to the blockchain, it cannot be changed by anyone. This feature means that transactions cannot be regulated by institutions like central banks, corporations, or governments.
For instance, DeFi can prove to be valuable for protecting wealth in places with authoritarianism and poor governance. Some Venezuelans, for example, are using Bitcoin to keep their wealth safe from hyperinflation and government manipulation.
Better security and privacy
Centralized systems are inherently unsafe. Your wealth and personal information are always exposed to risk since there is a single point of failure. Decentralized systems built using blockchain technology are naturally resistant to hacking and hardware failure.
Easier borrowing and lending
DeFi ecosystems eliminate the complex process that borrowers and lenders have to deal with in traditional banking. By using a blockchain-based platform,someone in China can receive funds from another person in the United States, and later invest in the U.K. Basically, there is no limit to how or where you can send or receive money.
Could DeFi and Centralized Financial System Work Together?
Unless institutions such as central banks and governments cease to operate, they probably won’t be replaced by DeFi systems. The good news, however, is that they can co-exist. For example, you can perform your financial activities using blockchain technology and exchange your new wealth in a centralized economy.
With the rapid development of the crypto space, there are high expectations for upcoming decentralized banking technology. While the concept is still young, decentralized financial systems are already showing promise. Secure online payments, borderless transactions, and low fees are just some of the features that can help bolster current centralized economies.
