centralized finance – Forex Academy

The current financial system is centralized. Currency is issued and regulated by governments or central banks. We also entrust our assets to finance firms so that we can get returns on savings. This translates to our financial systems being centralized. And therein lies the problem. Not only do centralized systems have a single point of failure, but they also comprise humans who are prone to making mistakes.

It also means many people are excluded from the financial system. For example, to qualify for a loan, one must have a bank account and a good credit score. And to have a bank account, a person must comply with the bank’s KYC procedures. For someone who doesn’t have the necessary KYC documents, it’s impossible to open a bank account and hence get access to banking services such as a credit card, savings account, loans, etc.

In a centralized system, there is too much power in the hands of institutions, while a big chunk of people is excluded from financial services that would allow them to engage in activities of economic value. Also, entrusting our money in centralized financial institutions means we have very little say in how it is invested and handled – meaning there is no transparency.

So what can we do to solve the centralization problem? The solution is decentralized finance. Decentralized finance is an idea that has caught on, especially in the last couple of years. Crypto ‘purists’ are mainly responsible for pushing the concept into the fore, as they strive to accomplish ‘’Satoshi’s vision.” Bitcoin’s founder – Satoshi, had this as the very first line in the Bitcoin white paper: “A purely peer-to-peer version of electronic cash would allow online payments to be sent directly from one party to another without going through a financial institution.”

In this article, we deconstruct decentralized finance, its inherent features, its defining principles, and the benefits that it could herald for the finance world.

What is Decentralized Finance?

When we take away all the buzz, “decentralized finance” comes down to mean financial access for all, without the middlemen. It’s the idea of handing economic power back to the people.

It’s another application of blockchain technology that aims to expand financial services to more people. Decentralized finance includes digital assets, smart contracts, protocols, and decentralized applications built on public blockchains. After all, blockchains such as Ethereum and Bitcoin are more than the driving technology of cryptocurrencies. They are open sources whose concept could change how the world economy works.

The decentralized financial system movement has three core principles:

☑️Interoperability and Open Source – this means decentralized finance projects should be woven together on a technical level to strengthen their effects as a whole

☑️Accessibility and Financial Inclusion – this means the end goal is to have a financial system that’s accessible to at least everyone with internet connectivity, no matter their geographical location

☑️Financial transparency – this means that the market level of information of services is transparent to all participants while still preserving their privacy

Decentralized finance has six defining characteristics that set it apart from the private networks used by the traditional financial system:

Permissionless – this means anyone can connect to the network regardless of their social status or location
Decentralized – there is no central authority overseeing transactions. Records are kept simultaneously across numerous computers across the world
Trustless – there is no need for a central authority to validate transactions as they are automatically validated
Transparent – all transactions are publicly available and auditable
Censorship resistant – interference by a central authority is not possible
Programmable – developers can code business logic into affordable financial services

Pros of a Decentralized Financial System

A decentralized financial system has a whole host of benefits that could change not only how we interact with money, but also improve the very premise that it originated from – namely cryptocurrency. The following are the advantages of decentralized finance:

Expanded financial access

With decentralized finance, anyone with a smartphone and internet connection has access to financial services. Currently, several barriers prevent a section of the world’s population from accessing financial services:

Status – lack of citizenship, identifying information, etc.
Wealth – high fees required to sign up for access to financial services
Location – long distances from financial service providers

A decentralized financial system equalizes finance such that a top financial trader at a global firm has the same access to financial services as a storekeeper in a remote area of Kazakhstan

Affordable Cross Border Payments

A decentralized financial system removes the need for costly intermediaries, making sending money to loved ones overseas more affordable.

In the current remittance system, there are too many intermediaries involved, making cross border payments too expensive. The current global remittance fee is roughly 7%. In a decentralized financial system, remittance fees could well be below 3%.

Improved Privacy and Security

In decentralized finance, individuals have full control and custody of their wealth. There are no intrusive KYC procedures, and transactions can take place without validation from a third party. This is unlike the current system where users’ wealth and personal information are stored in institutions where it is at risk.

Censorship-resistant

Decentralized finance has censorship-resistant financial products. Transactions are in unchangeable records, and the network cannot be shut off by governments or central banks at a whim. The decentralized finance system is entirely independent of existing legal or regulatory structures.

Simple to Use

A decentralized financial system would feature plug and play applications free of any complexity.

For example, a user in Morocco could receive a loan from India, invest in a business in the US, pay off their debt, etc., – all through interoperable applications.

Improving the Crypto Ecosystem

Decentralized finance solves several problems in the crypto ecosystem. Unlike many cryptocurrencies that grapple with scalability problems, decentralized finance payment products are helping in making micropayments fast, low-cost, and convenient. For example, decentralized exchanges are helping drive liquidity for the crypto market.

Driving Innovation

Decentralized finance helps to drive innovation. People can create financial products whose rules will be coded in a smart contract, and offer them to the world. This leads to not only diversified financial products suitable for different financial needs but also more improved ones as developers compete to unleash the next superior product.

New Forms of Value

Decentralized finance products also contribute to the crypto ecosystem by creating new forms of value and expanding the original idea of cryptocurrencies. Thus, a decentralized financial system helps the crypto ecosystem expand and diversify – all for the benefit of users.

Conclusion

Decentralized finance is an exciting idea and one that could finally equalize financial services. What the internet has done for information could be what decentralized finance does for the global financial system. With rapid developments like digital assets, smart contracts, decentralized exchanges, etc., Satoshi’s vision may very well be an idea whose time has come.

In today’s finance, governments and central banks pretty much control the whole system – from the issuance of currency to setting of interest rates, while big players like regulators, corporations, and international organizations wield so much power over the system. As such, the current global financial order is centralized – with influence and power belonging at the top.

We have worked with centralization since the very invention of banking. That doesn’t mean it is the ideal system – far from it. A centralized system has its own challenges – some of which have contributed to the global problems we face today.

In this article, we break down the cons of centralized finance and what that means for the average person. But first, what exactly is a centralized finance system?

Defining Centralized Finance

Centralized finance, which characterizes today’s global financial system, concentrates authority, control, and decision making at the hands of the top few. Just like other sectors that employ a centralized approach, centralized finance features the following characteristics:

☑️ A clear chain of command – everyone interacting with the system – from employees to consumers, to intermediaries, etc., knows who to turn to for any major decision making.

☑️ Standard operating procedures – financial institutions follow specific standard procedures and methods. As all decisions lie with the managing body, there is little variation between departments and branches.

☑️ Bureaucracy – owing to the central chain of command, the more a financial institution grows, the more the layers of management and hoops that have to be jumped before reaching the front lines

Cons of Centralized Finance

Having all the decision making power and control at the top financial institutions means the entire system has to grapple with these risks and drawbacks:

Billions of People Are Unbanked

In the current centralized system, having a bank account is a prerequisite to accessing financial services. However, over 1.7 billion worldwide do not have a bank account, either due to banks being too far away, not having enough money to open an account or lack of necessary documentation or credentials.

As a result, these people cannot access financial services to enable them to create economic value and improve their standards of living. As the high-economy countries run the global financial system, these people are left behind.

A Centralized System Favors the Financially Literate

To utilize financial services and participate in financial markets, one must have a degree of financial literacy. But currently, only one in three people have an understanding of basic financial concepts, with a majority living in high-income economies. A centralized financial system favors the financially literate while leaving behind the illiterate and semi-illiterate.

Without a basic understanding of financial concepts, it makes it hard for the bigger part of the population to make the right financial decisions and hence create wealth.

Global Inequality

In the centralized financial system, financial markets are usually dominated by those with the best connections to them. These people have access to financial opportunities and asset classes, capital, unhindered access to market information, and access to financial expertise. As a result, wealth is distributed in a top-heavy manner, i.e., the majority of global wealth is concentrated among very few people.

On the other side of the spectrum, the overwhelming majority of people have no access to information or even capital that can help them start building wealth. They may not only be living from hand to mouth, but they may also lack access to investment tools like stocks, bonds, mutual funds, etc.

High Intermediary Fees and Slow Transactions

Centralized finance tends to involve high intermediary fees while sending money across borders. The average cost for sending money overseas is 7% of the total value, and that rises to almost 11% when sending money via a bank.

Even worse, international bank transfers can take several days, leaving many people who are waiting for cash stranded.

Low Trust in the Financial System

Due to the lack of transparency associated with centralized finance systems, many consumers have little or no trust for the model. A report by Edelman shows there is only a 57% level of confidence in the financial sector, with trust in governments – which regulate the financial industry, even lower. Many people report feeling they are not being served in acceptable standards.

Currency Manipulation and Censorship

In a centralized financial system, governments have the power to manipulate fiat currencies. Venezuela and Zimbabwe are two examples of how governments have devalued currencies, causing runaway hyperinflation and a devastating effect of citizens. For instance, currency manipulation in Venezuela caused the price of a cup of coffee to skyrocket by over 772,400% in six months.

Centralized power also means governments and banks can financially censor citizens by freezing their accounts, assets, denying them access to payment systems, emptying their accounts, denying them access to their funds, etc. In short, a centralized system takes away the financial power of citizens.

Systemic Risk

With financial power held by just a few elite institutions, it means one abject failure can send the whole system crashing. This is illustrated only too well by 2008’s US’ subprime mortgages that threw a wrench into banks’ balance sheets, causing a massive downturn that created a ripple economic effect worldwide.

Centralization creates an “all eggs in one basket” scenario, and if that basket breaks, it can spell doom for the world’s wealth on a massive, destructive scale.

Extractive of Value Rather Than Adding Of Value

There are two types of economic activities: those that add value and those that extract value. In today’s centralized financial system, too much economic activity is intended to extract value from other parts of the economy, rather than adding value. To put it another way, much of today’s economic activity is geared at making a profit at the expense of other people and industries.

This state of affairs stifles innovation and advancements that could lead to a better financial system for the betterment of all, as everyone rushes to gain more value while contributing little to nothing in the system.

Complexity

In the centralized financial system, there is too much complexity of terms, concepts, and financial instruments, which increases instability or amplifies shocks in the system. For instance, the average person on the street cannot start to fathom complicated things like CDO-Squared or Commercial Mortgaged-Backed Securities. These complex financial instruments transfer the risks in the finance sector to other countries and industries, with negative consequences for the entire system.

Is There An Alternative?

With such drawbacks for the centralized financial system, is there an alternative? The answer is yes. The proliferation of mobile phones, internet connectivity, and the development of groundbreaking technologies such as blockchain could create never before seen opportunities for a decentralized, accessible-to-all financial system.

This evolution, however, depends on the attitude of governments and the existing financial system. Its willingness, or lack of it thereof, to embrace decentralized financial solutions will very much determine the future of the global financial system.