🪻For centuries, people have lived in a world of centralized finance. Central banks control the money supply, and the vast majority of financial transactions are completed through intermediaries. People borrow and lend through traditional banking institutions. However, in recent years, another distinctly different model has made significant progress, known as DeFi. In this system, transactions are recorded between traders using a common ledger that is not controlled by any centralized institution. DeFi addresses the following five persistent issues in the traditional financial system: centralized control, narrow channels, inefficiency, fragmentation, and lack of transparency.
1. Centralized Control
🪻Centralization can be divided into many layers. Most consumers and companies only interact with a local bank that controls the interest rates and fees. While switching banks is feasible, it comes at a cost. Moreover, the U.S. banking system is highly centralized, with the four largest banks controlling 44% of the volume of mortgage deposits, a figure that was only 15% in 1984. Interestingly, banking systems in other countries are even more concentrated than in the U.S., such as in the UK and Canada. In a centralized banking system, various layers form a unified entity that attempts to set short-term interest rates and influence inflation rates.
Centralization is not limited to the financial sector; the same phenomenon exists in the technology sector. Amazon, Facebook, and Google each dominate their respective fields of e-commerce, digital advertising, and online search.
2. Narrow Channels
🪻To this day, there are still 1.7 billion people in the world who have never used banking services. These individuals find it difficult to obtain loans from banks and to survive in the online business world. Furthermore, many consumers must resort to payday lending to address liquidity shortages. Even when they do engage with banks, there is no guarantee of securing a loan. Such examples are numerous; for small business loans, most banks are reluctant to proceed due to the small amounts involved. Instead, banks tend to suggest using credit card loans, which can have an annual interest rate exceeding 20%. The financing threshold is so high that it is very difficult for many projects to obtain loans.
3. Inefficiency
🪻The inefficiencies of the traditional financial system are numerous, perhaps the most shocking example being credit card rates. Due to the pricing power of payment processing oligopolies, every time a credit card is swiped, consumers and small businesses lose 3% of the transaction amount in remittance fees, which total 5%-7% in the U.S. Additionally, processing stock transactions (a technical term for ownership transfer) can take up to two days. In the internet age, this is simply unreasonable. Other inefficiencies include high and slow fund transfer fees, the need to pay direct and indirect intermediary fees, a lack of security, an inability to conduct micro-transactions, and many unforeseen inconveniences for users. Under the current banking system, mortgage rates are very low while loan rates are very high because banks must earn fees from transactions to sustain their operations. Similarly, the inefficiencies in the insurance industry are also evident.
4. Fragmentation
🪻Consumers and businesses interact with financial institutions in a context that lacks interconnection. It is well-known that the U.S. financial system is island-like, designed to maintain high transfer costs. Transferring funds from one bank to another not only takes a long time but is also very complex. For example, a wire transfer takes three days to complete.
To address this issue within the traditional financial system, Visa attempted to acquire Plaid in 2019. Plaid's products allow any company to access banking information with user consent. Although this strategic move can buy Visa some time, it does not resolve the fundamental issues of the current financial system.
5. Lack of Transparency
🪻The traditional financial system is opaque. Customers know very little about the financial health of banks and must rely on limited government protections such as the Federal Deposit Insurance Corporation (FDIC). Additionally, customers find it challenging to know whether the loan rates offered by banks are competitive. Although the insurance industry can find the lowest rates through financial technology, the lending market is highly fragmented, and competitive lenders are constrained by inefficient systems. Even the lowest prices are still subject to operational costs and substantial logistical costs.
🪻Impact
The impact caused by the aforementioned five issues is dual. On one hand, the costs brought by these problems lead to slow economic growth. For example, if high loan interest rates are due to inherent costs at banks, high-quality investment projects may fail. Due to high loan costs, project parties may not be able to bear them. An entrepreneur's business plan might only have a 20% return rate, but it could still contribute to economic growth. However, if banks tell entrepreneurs that the loan interest rate is 24%, that entrepreneurial plan may never be realized.
On the other hand, these issues solidify resource flow and worsen inequality. Regardless of political factions, most people agree that opportunities should be equal. Whether a project can receive financial support depends primarily on the quality of the business plan and the rationality of the execution plan, rather than other factors. The key point is that if good projects do not receive funding, inequality restricts growth. Although the United States is known as a land of opportunity, the wealth gap there is significant, making it difficult for funds to flow between the richest and the poorest Americans. Due to the narrow channels of the current banking system, people largely rely on costly fundraising methods (such as payday lending in the U.S.), and cannot freely buy and sell financial products in the e-commerce world, exacerbating unequal opportunities.
The impacts are profound; even if minimized, these constitute a long list of serious issues for the traditional financial system. The current financial system cannot fully adapt to the digital age in which people find themselves. DeFi offers a brand new opportunity. Although it is an innovative technology, the benefits it brings can be transformative.