In today’s world, a decentralized financial system is on the rise as a more transparent, secure, efficient substitute to a conventional centralized banking system. Decentralized financial systems seamlessly mitigate the need for centralized banking systems to create a better, more transparent, and dependable financial system – a financial system that is much more accessible.

Decentralized Financial System

Decentralized finance, or DeFi for short, is a financial structure that does not rely on conventional, centralized institutions. We’re accustomed to everything passing via a bank or other financial institutions, such as a worldwide exchange, but DeFi establishes a system that can work independently.

Although digital transactions using DeFi cryptocurrency are maybe the most well-known implementation of decentralized finance, a decentralized financial system allows us to manage various financial applications – such as investing, insurance, swapping, lending, borrowing, and lending – in a much more open and transparent manner.

Decentralized finance, backed by blockchain tech, reduces the dangers of crime, abuse, and misuse of your assets. It will also make financial management significantly more cost-effective and practical since there will be no overdraft charges, no wire transfer fees, and no need to wait during business hours to validate a financial movement.

The Mechanics Behind

DeFi, instead of a bank, employs technology to facilitate activities and operations amongst parties. Along with public blockchains, various open-source protocols are being created, establishing a foundation for decentralized finance to function upon.

A financial system requires two significant elements to function: an architecture to operate on and a commodity to work with. Financial institutions and banks serve under a centralized banking structure, while fiat currencies, such as the US dollar, serve as fiat money. Decentral finance aims to substitute these elements to provide a comprehensive range of financial services.

Architecture

Ethereum is a framework for developing decentralized applications. For example, we can create smart contracts — autonomous codes that can handle financial services – using Ethereum. You can use smart contracts to generate a series of rules for how a financial service will operate and then deploy those rules on Ethereum. A smart contract cannot be changed after it has been executed.

Currency

To generate a reliable and secure decentralized financial system, you need a stable and dependable currency. A stable currency can be defined as any cryptocurrency that corresponds to its value in terms of fiat currency. An example of a stable coin is DAI. Instead of being resourced directly from US dollar reserves, DAI is backed by crypto collateral. DAI is synonymous with the US dollar and 1 DAI=$1. DAI is the stable coin that’s best for decentralized financial systems.

Centralized Banking System

A centralized banking system is a financial system in which all orders are channeled to a single central exchange, and there is no other competitive market. As a result, the listed values of the different assets quoted on the exchange are the only prices accessible to buyers looking to buy or sell a particular asset.

A critical feature of a centralized banking system is that the pricing is entirely open and visible to everyone. Prospective buyers may view all quotations and transactions and examine how those trades move while formulating plans.

Another essential feature of a centralized banking system is the presence of a clearinghouse, which stands amid buyers and sellers and ensures the legitimacy of the transactions since both buyers and sellers, in fact, interact with the exchange rather than with each other. Finally, a fundamental feature of a centralized market is the associated advantage of decreased risk from not interacting with changeable counterparties.

Centralized Vs. Decentralized Banking

Here are the critical differences between decentralized financial systems and centralized banking systems:

  • People or corporations control asset classes and processes in centralized banking systems. In contrast, they are handled by smart contracts in decentralized financial systems.
  • In DeFi, you don’t have to stress over whether or not the system will function appropriately since you can validate the DeFi offerings by inspecting the coding. Furthermore, you can utilize other tools to determine whether or not a deal was successfully conducted. However, to use the services on centralized platforms, you must always do a Know Your Client (KYC) check.
  • One of the drawbacks of DeFi, which is intended to be freely available to all participants without prejudice or constraints, is that unauthorized individuals might abuse it to perform unlawful operations and scams, including funding terrorism-related operations. This is not possible with centralized banking systems.

Bottom Line

All in all, the differences between decentralized financial systems and centralized banking systems are trivial. However, the momentum both of them are gaining will define how we perceive regular currencies and cryptocurrencies in the future.