As 2020 comes to a close, it is evident that one particular topic in the finance world has taken the forefront. This is the movement from centralized finance (CeFi) to decentralized finance (DeFi) as the digital asset industry continues to shift towards mass adoption.
The term ‘decentralization’ is not new. This phenomenon can be traced back to ancient human societies when people lived in small, decentralized communities. Having said that, we are born and raised in an age where centralization pervades all aspects of our culture.
The concept of decentralization was reintroduced with blockchain and cryptocurrencies. Bitcoin was the first decentralized digital currency launched in 2009. Since then, many altcoins followed its course, and this has even led to the launch of decentralized applications.
You may wonder, what is centralization, decentralization, and how are they different from each other? Let’s find out.
What is Centralization?
Centralization is a system that represents control and power. It has bred and pioneered bureaucratic institutions – places where decisions are made by a few but ran through a hierarchical structure of mass adoption. It is a system where a single entity could dictate how systems operate and how purposes are served. These became the pillars of evolution to our present day.
Why Do We Have to Dismantle the System That Built Us? Why Is Decentralization the Hope Of Our Future?
As societies evolved, the power controlled by the system became institutionalized and played an important role in creating order, reliability, and trust. However, as the structure of centralized societies evolved, complexity deepened. A reduction in the efficiency level was something we cannot escape as decisions are made at the top with intermediaries.
It is evident that centralization leads to a pyramid structure where those who are at the top call the shots. Just like a pyramid, the larger the base, the more is the power concentrated at the top, and there is a greater risk of anarchy. This challenges the system of checks and balances.
Can we really trust the system?
Security is also a major issue with centralized systems. They are more susceptible to hackers and other malicious activities than decentralized systems. If your bank accounts are hacked, you lose all access to your funds.
Centralized systems also charge fees for various services. These fees vary from provider to provider. These systems are quite popular and easy to regulate, as well.
The unquestioned sense of trust in the system becomes the elephant in the room that we need to address. Could this mean that the system that built us has evolved to become the system that traps us? We must take the lead and look for a better support system for growth.
Our society needs a system that addresses this trust deficit. This gives rise to decentralization. Decentralization is a system whereby no single entity has control over the processing. The same goes for our financial system.
What is CeFi?
Centralized Finance (CeFi) is a system in which all orders are controlled by one central exchange without competing parties. The system aims to conduct fair trade and is built in a way that all orders are channelled through a central exchange. This means that the prices stated on the central exchanges are the only available prices for traders.
Our current financial system is highly centralized. We have government institutions that print and regulate fiat currencies via banks. Banks have total control over your accounts.
A third party has total control over your assets and money, and you need to trust them to secure these assets. But they also charge a hefty fee for their services.
Advantages of Centralized Finance
- Centralized Exchanges: Enables fair trade as buying and selling orders are made via a central exchange.
- Fiat Conversion Flexibility: Turning fiat to cryptocurrency and vice versa is relatively easy.
- Availability of Cross-chain services: This supports coins that are issued on an independent blockchain platform.
- Features: Provides more features to its users compared to DeFi.
- Regulation: It is easier to regulate.
- Popularity: Much more popular than DeFi.
In short, with CeFi, users trust institutions behind the platform to manage their funds and ensure that the operation of the platform remains a going concern. As you might expect, where there is human involvement, there exists a chance for human error. There have been many instances of hacking and other malicious activities.
DeFi eliminates areas where CeFi falls short as it reconstructs the banking system.
What is DeFi?
Decentralized Finance (DeFi) is a system that offers an alternative to the traditional financial system – there is no need for third parties. DeFi allows users to independently manage their funds as they hold their own private keys, confirm their transaction on blockchain technology, and do not require a third-party service.
Cryptocurrencies and decentralized apps (dApps) are the best examples of decentralized finance. No specific organization has total control over them, yet they function smoothly and efficiently. Since it is a peer-to-peer system, users can send, receive and swap cryptocurrencies with anyone in the world with minimal or no fees.
People who have no access to centralized financial systems can easily access DeFi and dApps. DeFi has quickly gained popularity, and its market value has crossed the $1 billion mark.
Advantages of Decentralized Finance
- Accessibility and Privacy: Anyone with a digital wallet can use the platform regardless of their location and without having to give out personal information.
- Autonomy: No centralized authority has the power over your assets and transactions.
- Transparency: Data is publicly available and accessible by anyone.
- Security: It is much more secure than centralized finance due to various cryptography methods. The data is spread over multiple nodes, making it harder for hackers to access them.
- No More Middleman: DeFi eliminates the need for a middle man, thereby connecting users directly without cutting their profits or transactions.
Centralized Finance vs Decentralized Finance
To fathom the impact DeFi can have on our current financial ecosystem, it is crucial to outline the improvements it has on our current system and how DeFi addresses the shortcomings of CeFi. DeFi systems do have the upper hand, but you may wonder how. Let’s find out.
Decentralized distributed ledger technologies are not new. They are at the heart of the system and are an innovative solution for record-keeping. It sets a consensus for machines in a network without the need for a central server to transmit information.
The connected machines work in harmony to store and share information. The information is then stored on a ledger, and even the smallest amendment would require the consensus of all the machines.
Such a mechanism eliminates the shortcomings of centralization – it provides security, stability, and transparency in a trustless system. Blockchain is an example of decentralized ledger technology – it is the vertebra of operation and growth for digital assets like cryptocurrencies. Having immutable digital status is no longer new for digital assets, particularly for cryptocurrencies.
This development also eliminates the issue of double-spending. Cryptocurrencies have a long way to go before they become a universally legal tender. It is without a doubt that this new technology bears a lot of potential for the future – especially with the rise of digital currencies whereby there are many digital currencies in the world right now.
Bitcoin emerged after the great depression of 2008. That year, the stock markets crashed, fiat currencies became less valuable, and the value of assets dropped due to inflation. All this began as the government printed more paper money than required.
Decentralized systems are not affected by real-life factors such as market crashes, inflation and other phenomena.
Despite the challenges and complexities of issuing central bank digital currencies (CBDCs), mass adoption of such a system makes way for more efficient financial activities. This is especially true with the rise of cryptocurrencies, and there are currently around 7,992 coins (as of 15 December 2020).
As the world evolves to become more complex, the system that we built it on becomes the system that we need to disrupt and break away from. It is apparent that decentralization is crucial for the growth of civilization. Technologies that are built on new technologies like blockchain provide transparency and liability in governance, businesses, and communication in terms of both information storage and information sharing.
When decentralized finance emerged, not a lot of people were intrigued, nor did they invest their money in it. But as they saw the shortcomings of centralized financial systems, they started to educate themselves and invest.
The rise of support in decentralization represents an exciting breakthrough to address the shortcomings of centralization. The best example is how the Bitcoin market is soaring this year after an uneventful crash. The price of Bitcoin reached a low of US$ 5,000 but quickly recovered and is currently above US$ 19,000. The market cap was just below US$ 100 billion in the first quarter of the year but is now at over US$ 350 billion.
Such global-scale disruption propels the financial system to grow for the better. Thus, the evolution of a decentralized system is something to watch out for – it has the power to shape the future.