Decentralised versus centralised finance: Impacting a global market

We currently find ourselves at the dawn of a new era: decentralisation. And from global civic and business leaders to everyday individuals, the world has started to take note writes tech entrepreneur, Kirill Bensonoff.

The decentralisation of finance in particular has become a hot talking point, driven by the public’s growing disillusionment with the centralised financial sector and its shortcomings. More than ever before, individuals are calling for control of their personal data, ownership and money and decentralisation is being marked as a possible solution. The advantages of decentralisation seem almost too good to be true. Lowering the entry requirements of the finance industry, catering to the underbanked and expanding the reach of services and commerce opportunities, to name only a few examples. Needless to say, the decentralised finance (DeFi) options being developed right now are likely to have a significant impact on the financial industry of the future.

Centralised versus decentralised finance

Centralisation refers to a point of central control, which in the case of finance refers to banking institutions. Historically, centralisation in finance was desirable as a measure and maintainer of stability in global financial processes, thought to be more secure and stable than personal management. These systems were particularly necessary for cross-border transactions due to the reach of the infrastructure. But, there’s a catch: the centralised finance sector is only as stable as we pretend it to be. Realistically, centralised financial systems are impacted by a variety of issues such as fraud, forgery, questionable lending processes and more.

As widespread as centralised financial institutions are, there are still big gaps in accessibility. The majority of the world owns a smartphone and has access to the internet, but many countries still struggle with providing reliable banking accessibility and financial stability or accountability.

Comparatively, decentralised finance describes a new type of financial system that is distributed and built on the foundational open source networks of Bitcoin and Ethereum, offering many improvements to current financial systems found across the globe. With no central point of control and no intermediaries, these systems are unlikely to be affected by manipulation, fraud or other issues; yet still powerful and far-reaching enough to maintain the capabilities needed for financial transactions to take place reliably and transparently.

Decentralised finance: The impact

The biggest impact from decentralised finance will be felt by underbanked communities, or communities facing financial upheaval. With an internet connection and smart device being the only requirements (thus far), these individuals can easily gain access to a global financial trading market, and manage their own transactions. More importantly, these systems are also censorship resistant and publicly auditable, suitable for the prevention of corruption and manipulation as an added measure of security.

By the end of 2018, the total amount of internet users reached an estimated 3.9 billion, with digital banking reaching around 2 billion at the same time,  an indicator of the increasingly technological nature of finance and key to the development of DeFi systems. This type of connectivity and accessibility is the game-changer for fintech and DeFi solutions. Combining all these factors with the convenience of these systems, decentralisation is democratising finance.

Decentralising lending

DeFi is also grabbing attention in another area: lending. Using permissionless public blockchains, loans can be granted on decentralised systems, and could even be granted across borders using smart contract technology. Smart contracts are programmable auto-executing digital contracts which execute agreed upon terms and can be applied to assets. Via this method, lenders will soon be able to match with financiers technologically, and have their loan executed on the blockchain.  Multiple examples of this currently exist on the Ethereum blockchain, with no intermediaries needed to conduct the process. At present, the majority of decentralised lending platforms are based on collateralised borrowing, where borrowers must put up collateral of greater value than the value of their borrow before a loan is granted.

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Scaling for success

This potential doesn’t mean that the adoption of decentralised finance systems will be seamless. Centralised finance institutions are capable of processing enormous amounts of transactions per second, which decentralised systems have yet to replicate successfully. In order to keep up with that type of demand, DeFi developers have started creating scaling solutions such as the Lightning Network which adds a second “layer” onto the Bitcoin or Ethereum blockchain that works by minimising the amount of transactions taking place on the blockchain by opening a dedicated private “channel” between two users wanting to transact, until an agreement is met to close the channel. If the technology is implemented, transaction times are set to increase to close to a million transactions per second.

Is it likely that decentralisation will completely replace centralisation in finance? Yes and no. Centralised finance has until now come across as the most trustworthy option, but is also affected by a multitude of issues causing increasing public disenchantment. Decentralisation offers a new promise, but has yet to reach the realm of necessary operating capacity to totally replace existing infrastructure. What is more likely is that a hybrid of both systems will be the future of finance, offering the best of both worlds to end-users.

By Kirill Bensonoff, tech entrepreneur