DeFi vs. Traditional finance: Substitutes or complements?

In a scenario where technology is advancing by leaps and bounds, decentralized finance (DeFi) has emerged as a powerful and disruptive alternative to traditional finance. But are they really there to replace centralized methods or simply to complement them?

Christopher J. Waller, member of the Board of Governors of the United States Federal Reserve (Fed), has put the debate on the table by pointing out the growing importance of DeFi.

During a conference at the Institute for Advanced Studies in Vienna, stated: “In recent years, there has been a lot of attention and a lot of work on DeFi.” This statement reflects the interest surrounding this financial sector.

There has been much debate about whether DeFi will replace centralized finance, while others argue that it will simply extend its reach to traditional ones and blend in with them, without necessarily replacing them.

However, he emphasizes that Advances associated with DeFi could profoundly transform financial markets.

While recognizing the potential efficiency benefits, it also highlights the historical importance of financial intermediarieswhich have been fundamental for centuries.

Addressing the debate over whether DeFi and centralized finance are substitutes or complements, Waller first highlights the economic reasons that gave rise to the traditional financial system.

In most financial transactions, he explains, “peer-to-peer” trading is complicated and expensive, which opened the door for intermediaries, such as banks, to facilitate transactions.

This intermediary role is not without drawbacks. Intermediaries require compensation, which introduces transaction costs, and users must cede control of their assets to third parties, raising concerns about custody and trust in financial records.

The emergence of DeFi and technological innovations

In this context, DeFi emerged as an alternative that eliminates, or at least minimizes, the need for intermediaries. Bitcoin, the first major digital currency, was designed to operate in an environment where trust between parties was not required.

Waller recalls that Bitcoin was founded on privacy, independence from intermediaries, and a transparent and secure registry.

This technological advance, which has allowed tokenization and smart contracts, has allowed DeFi to offer novel solutions.

For example, smart contracts can execute transactions automatically, reducing counterparty risks and settlement costs. However, despite these innovations, Waller argues that DeFi is not necessarily designed to completely replace centralized financebut to complement them.

The technologies behind DeFi, such as distributed ledger (DLT) and smart contracts, can also be used to improve efficiency in traditional finance.

In fact, heavyweight companies such as BlackRock and Franklin Templeton have begun to explore the tokenization of traditional assets, such as US Treasury bonds, using these technologies to accelerate and optimize asset transfers, as reported by CriptoNoticias.

Stablecoins and associated risks

Waller also discusses the importance of stablecoins, a key innovation in the DeFi world. These cryptocurrencies were created to provide an asset of stable value in the cryptocurrency ecosystem, offering an alternative to fiat currencies.

However, stablecoins, particularly algorithmic ones, face considerable challenges. A clear example is the collapse of Terra USD (UST) in 2022, which resulted in huge losses and had a devastating impact on the entire digital asset market.

Algorithmic stablecoins, unlike asset-backed ones, rely on complex arbitrage mechanisms to maintain their peg to the dollar. This system, although innovative, proved unstable in the case of Terra, leading Waller to Warn that these currencies face the same problems as any substitute for genuine dollars.

What does the future hold?

Despite the risks, the technologies that power DeFi, such as smart contracts and tokenization, will continue to generate efficiency gains in the financial system.

Waller concludes that, although some DeFi services cannot be replicated by traditional finance, Technological innovations derived from decentralized finance are, to a large extent, complementary to centralized finance.

In fact, the DeFi sector continues to grow, attracting capital and developers. According to investment firm a16z crypto, more than 170 billion dollars are deposited in DeFi protocolswhich underlines its relevance in the current financial landscape.

In the cryptocurrency ecosystem, DeFi represents a significant portion of innovation, with 34% of active addresses focused on these platforms.

This sector is not only key to the future of cryptocurrencies, but could also redefine the relationship between traditional and decentralized finance.