Differences Between Lending in DeFi and TradFi

By 

David Akilo

 on April 5, 2022. 
Reviewed by 

Romi Hector

A man holding wooden blocks with images and words of peer to peer lending

Decentralized finance (DeFi) services mimic the offerings of traditional finance by providing users with the option to participate in lending, borrowing, and margin trading in an open, trustworthy, and decentralized manner.

Lending in DeFi is a smart contract-based process that facilitates the peer-to-peer lending and borrowing of crypto assets without third parties. DeFi lending allows users to access any loan size they desire without disclosing their identity to a third party. Upon fulfillment of the necessary conditions, the process approval happens within seconds of initiating the transaction.

Lending in traditional finance (TradFi) is more controlled, centralized, and regulated. TradFi lending is one of the oldest forms of accessing loans from regular banks. Borrowers must provide their full identity to the financial institution and undergo rigorous KYC procedures before their loans are approved.

Advantages of DeFi Lending

Proper Management and Record-Keeping

DeFi lending works with smart contracts that monitor and record every transaction within the protocol. This ensures that financial records are properly stored on the blockchain, preventing human error and mismanagement of funds.

Quick Loan Access

A combination of blockchain technology, smart contracts, and cloud-based services ensure that the lending process is seamless and accessible to everyone.

Financial Sovereignty

DeFi lending utilizes non-custodial Web3 wallets that give users complete control over their funds and data.

Financial Inclusion

DeFi lending doesn't discriminate based on status, geography, or history. It is permissionless; the system is open to everyone without any restrictions. Anyone with a crypto wallet and some funds can access and use DeFi lending protocols.

Transparency

DeFi lending depends on blockchain technology; thus, it is transparent, giving all users equal, open, and free access to the data on the network.

Disadvantages of DeFi Lending

Absence of Regulation

The lack of regulation attracts bad actors and discourages the onboarding of traditional institutional investors. It is hard for regular investors to trust a system that is open to everyone and isn't fully regulated.

Steep Learning Curve

Newbies to this space will have to master specific blockchain terminologies and dApps to make the most of DeFi lending. In some cases, learning DeFi concepts and applications can be too cumbersome and complicated for users, making mastering the several protocols an arduous task for investors.

DeFi Lending Risks

Certain risks associated with DeFi lending can be problematic for willing investors. Issues like rug pull scams, impermanent loss, smart contract risks, and flash loan attacks can scare off otherwise interested DeFi participants.

Advantages of TradFi Lending

Trusted Reputation

Traditional finance services are trusted by the general populace because they are run by established banks that have been in business for a long time.

Interest Rates

While TradFi interest rates are less flexible than DeFi's, they may present a low-cost option for small businesses with an excellent credit score and financial history.

Tax Deductible Loans

Another perk of TradFi lending is that small businesses can quickly obtain tax-deductible loans at attractive interest rates.

Additional Services

Provided the client has a relationship with the bank, they may get additional services like loan advice or the provision of a lending advisor to help the client maximize their loans.

Disadvantages of TradFi Lending

Lengthy Approval Process

This entails a prolonged flow of loan documentation from the lending facility to the client. This is a severe drawback for TradFi lending, as most clients are after loans that they can immediately put to use.

Rigidity

TradFi loans are usually inflexible. Most lenders do not allow for partial loan repayment, which means borrowers will be obligated to keep paying for the entire loan period.

Poor Loan Approval Rate

Aside from the slow documentation process, TradFi loans may get rejected most times. The loan approval rate for small businesses from big banks sits at 27%.

DeFi Lending vs. TradFi Lending

There is no doubt that the dependence on blockchain technology gives the edge to DeFi over TradFi lending options. Transparency, trustworthiness, loan approval speed, and attractive interest rates make DeFi the superior lending platform. DeFi participants have more control over their funds, the interest rates, and collateral choice; it's a win-win for all.

However, DeFi lending still has its down side. Obscure regulatory decisions by financial watchdogs like the SEC keep many investors on the sidelines. News of hacks, rug pulls, and code exploits also make many people wary of DeFi and result in them choosing to stick with trusted traditional finance lending options.

Could DeFi Outperform TradFi in Years to Come?

DeFi is growing at a tremendous pace with an ever-rising total locked value, which currently sits around $200 billion. The growing interest in DeFi is due to its many benefits over traditional finance solutions. DeFi offers access to anybody, anywhere, and anytime, without cumbersome restrictions or centralized control.

If innovation in this sector continues, we can expect its growth to triple and eventually surpass TradFi systems. However, some traditional financial institutions are already working to integrate DeFi protocols into their apps, exposing their clients to specific DeFi solutions. This approach may create another outcome, where both DeFi and TradFi exist and operate together.

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