Understanding cryptocurrencies and digital currency as a concept can be complicated and confusing, but it’s much simpler than people think.
For many, the idea of electronic money is hard to grasp, but that’s what we do daily with debit card payments, PayPal, and Venmo.
People don’t bat an eye when it comes to making payments with these services. But, in reality, cryptocurrency will be just as commonplace in the future as these other electronic transactions.
Understanding the difference between centralized and decentralized finance is the difference between using your debit card and crypto.
What Are The Differences Between Central And Decentralized Finance
A central authority controls one payment form of finance, and a decentralized peer-to-peer system controls the other.
With centralized finance (or CeFi), the transactions involve a third party to facilitate the transaction for a fee.
Centralized finance means that a central institution like a Central Bank controls the amount of currency available for all transactions at any given time.
By controlling the total amount of currency in circulation, a central authority helps stabilize the currency’s value and ensure it maintains its value.
Another factor of centralized finance is that electronic transactions require an intermediary, such as a bank, to facilitate the transfer of funds from one party to another, often for a small fee.
The problem with CeFi is the need for more transparency about how funding is approved, to whom, and why.
With lending, consumers often need clarification about what will qualify outside general guidance.
Credit checks and more criteria often leave potential borrowers in the dark about whether their applications will even be considered, much less approved.
Until 2009, which was the year of the invention of Bitcoin, all transactions occurred in this manner.
Since that time, transactions on a digital ledger, or blockchain, have grown in popularity. For example, when two parties agree to purchase terms, they exchange digital coins and tokens as a form of payment.
These transactions are known as decentralized finance since they lack the traditional controls of centralized finance.
The main difference between CeFi and DeFi is that with DeFi, a person directly exchanges with another party to create the transaction rather than operate through an intermediary.
The benefit of decentralized finance is that two parties can make faster agreements and execute transactions easier. Another advantage to peer-to-peer transactions is that eliminating a third party reduces the cost of the transaction, making them more affordable.
The most significant benefit to DeFi is that it allows more people to access funds at more favorable rates.
In traditional lending, people apply and hope that they get approved and funded. Centralized finance is also more costly since the lenders get their money from the Central Bank, which operates with the prime rate, the interest rate that the US Fed sets to loan money to banks and other lending institutions.
The prime rate is added on top of the lender’s fees, so when the prime rate is high, the borrower’s interest rates are also high.
With DeFi lending, the terms to apply are easier, the rates are much more friendly to the borrower, and the process is more transparent through a digital ledger.
Because of the peer-to-peer nature of DeFi lending, a person can apply for financing and get approved by any number of lenders, often at a minimal fee.
This transaction takes place without credit checks or needs for significant collateral, making funding much more accessible for people that otherwise may be excluded in centralized finance.
But be sure, with DeFi, there are added risks that CeFi avoids. Because CeFi is controlled and supported by governmental agencies, there are regulations and safeguards that unregulated finance such as DeFi can’t provide.
The most glaring example of the risk in DeFi was the collapse of the third-largest exchange, FTX, in November 2022, which defrauded millions of people, including some pension plans and individual investors.
The FTX scandal has shown the need for governmental oversight or regulations that fly in the face of the DeFi concept. Still, a move that may be needed as more and more people become invested in cryptocurrencies and the DeFi movement.
Less than 20 years ago, the internet was seen as a non-essential function of society. People still did most of their shopping in traditional shops, went to the grocery store, and engaged with friends and loved ones in person.
Today’s reliance on the internet ranges from entertainment and commerce to social communications in a way that has permeated every aspect of society.
Soon decentralized finance and cryptocurrency will be as commonplace as the internet, and anybody that thinks otherwise has another thing coming to them.