In a short period, cryptocurrency has developed more drastically than the traditional finance world. This niche is governed by its own set of rules and models, with no ties to the rest of the conventional financial models which makes it exceptional in the first place.
Basically, cryptocurrency investors have had limited tools and knowledge in the area of traditional finance. However, these two worlds have begun to merge – a collision of individual concepts and strategies. Thus, more economic concepts found in traditional finance will become applicable in cryptocurrency as well.
That said, cryptocurrency investors must understand these traditional concepts and how they can be applied to crypto. This article explores the role of traditional finance in cryptocurrency, the difference between the CeFi and DeFi, and what it may mean for the world of cryptocurrency.
What is traditional finance?
Traditional finance simply refers to the methods used over the years. It includes financial methods such as getting loans, overdrafts, and creating accounts in brick and mortar banking institutions. An example of traditional finance is walking into a bank to get a loan or using a cheque to withdraw cash from a bank.
Traditional finance often has investors who take rational, deliberate decisions which operate under risk and uncertainty. Also, traditional finance can be defined as ‘normative’ because the established rules and regulations are followed by everyone universally. These rules, however, are not influenced by personal opinion or feeling, rather they are based solely on facts, which is why many people refer to this type of finance as objective
Centralised finance versus decentralised finance
The key difference between centralised finance and decentralised finance is the exchange model. With centralised finance, the system is governed by centralised authority which makes the rules and enforce them.
On the other hand, decentralised finance is governed by technology – a computer algorithm, for example. DeFi users access financial services via decentralised applications (dApps), a platform that leverages smart contracts and DAOs for self-automation.
Because of this difference, an intermediate body becomes the biggest differentiator, this intermediate body is responsible for exchanges in CeFi. This means CeFi transactions, users can transfer risk to these exchanges and this makes them responsible for keeping the users funds safe.
However, in DeFi, these intermediaries do not exist. What replaces it are known as smart contract protocols which serve as the intermediary which self-executes transactions based on predetermined criteria.
There are other differences between the two. For example, CeFi aids fiat to crypto conversions and cross-chain solutions. This means, where necessary, a CeFi body can transfer funds to aid its users in cases like requesting a loan or an overdraft, or block all transactions in an emergency such as a hack.
While with DeFi, it is incredibly more transparent and private because the systems are set up not to ask for personal details of the user and unlike CeFi, are non-custodial. More so, with DeFi, transaction restrictions do not exist and block trading is not possible.
What is the role of traditional finance in cryptocurrency?
The biggest role traditional finance can perform in cryptocurrency is providing maturity and security. With cryptocurrency, it is important to consider the immaturity of the ecosystem and how it is still at a budding stage.
Bitcoin, being the oldest cryptocurrency, has been around for at least 13 years. In comparison, the oldest surviving bank – Banca Monte Dei Paschi di Siena – was founded in 1472. This further implies that current traditional finance institutions have been around for several centuries and, as such, possess a few tricks up their sleeves compared to the cryptocurrency space, which is relatively new.
Also, with new projects and trends like NFTs, DeFi, IDOs and others, plans are on the way to making them long-term and incorporating them into today’s economic world. However, the issue still remains that there’s a severe lack of insurance, protection or even the experience to create a new financial paradigm.
This is where traditional finance specialists come in. With their understanding and experience of concepts that have been applied to decades-old institutions, cryptocurrency is bound to thrive. Think of cryptocurrency as the young student who needs to learn from the master, traditional finance.
In fact, Jack Tao, the CEO of Phemex, a cryptocurrency derivatives trading platform, when acknowledging the need for better solutions stated that: “With over a decade of experience at Morgan Stanley, I’ve seen what centralised financial institutions are capable of doing to protect themselves and was disappointed to see the same tactics in an ecosystem that was supposed to embody principles of distributed control and equality.”
“We started Phemex because investors deserve better. The cryptocurrency industry is small but burgeoning, and we want to drive the change towards a better monetary system.”
Also, it is undeniable that traditional finance possesses the knowledge to address some of the biggest problems in the cryptocurrency industry. For instance, an average crypto investor may not see the holes in the armour of cryptocurrency, but experts in the traditional finance sector can catch on to such matters early enough.
Finally, although cryptocurrency is all the rage in the financial world at the moment, it does not make traditional finance useless or obsolete. In fact, traditional finance may have yet another important role to play in grooming the cryptocurrency industry.