Intro to Traditional Finance

What is Money?

Money is defined by Oxford Languages as a medium of exchange i.e. anything that can be accepted as an exchange for goods and services. Money has six key characteristics:

1. Durability: The currency does not lose value and is not destroyed or made irredeemable easily.

2. Portability: The currency is easy to transport from place to place.

3. Divisibility: The currency can be easily exchanged in different denominations.

4. Uniformity/Fungibility: All units of the currency are identical in value.

5. Limited supply: The supply of the currency can’t be arbitrarily inflated.

6. Acceptability: The currency must be sufficiently widely accepted.

On the other hand, an asset is something that is owned by households or individuals with an underlying value. An asset is characterized by the following:

• Ownership: Assets represent ownership that can be eventually turned into cash and cash equivalents

• Economic Value: Assets have economic value and can be exchanged or sold

• Resource: Assets are resources that can be used to generate future economic benefits

Different investments are differentiated by their asset class, and each of these classes are subject to different laws and regulations.

There are four asset classes: cash and cash equivalents, fixed income, equities, and alternative investments. Fixed incomes include bonds, treasury notes/bills, etc. Equities can take the form of stocks and dividend payments, and real estate, gold, and cryptocurrencies are usually classified as alternative investments.

1. Liquidity: How fast the asset is able to be turned into cash or cash equivalents. For example, stocks are not very liquid, whereas cash is the most liquid.

2. Risk: Assesses the asset’s potential for financial loss or fluctuation.

3. Profitability: How well the asset is able to generate profit or earnings for the business/individual.

Historically, individuals seeking to take out a loan or deposit assets had to rely on centralized institutions like banks or other intermediaries. This reliance required a significant amount of trust in these entities to manage their assets securely and deliver on financial promises.

However, in 2008, the world witnessed a financial crisis that would redefine modern economic history. The collapse of Lehman Brothers and the subsequent global banking meltdown exposed deep flaws within the financial system. At the heart of the crisis were factors such as the proliferation of subprime mortgage lending, excessive risk-taking by financial institutions, and a lack of regulatory oversight. This crisis not only highlighted the vulnerabilities within the existing financial system, but also contributed to widespread distrust with traditional financial institutions.

As a result, many started to perceive these entities as having contributed to the crisis through irresponsible behavior— as distrust in the conventional financial system grew, so did the awareness of the risks associated with leaving concentrated power in the hands of a few parties.

It was against this backdrop of financial turmoil and growing skepticism towards traditional systems that we begin to delve into the philosophy behind Bitcoin, and eventually the emergence of many other decentralized technologies.

DeFi vs TradFi

The first era of decentralized finance (DeFi) was characterized by Bitcoin in 2009, which utilized a distributed ledger technology to enable peer-to-peer transactions of digital assets, separate from the grasps of a central authority. Bitcoin's creation in 2009 marked a pivotal moment in financial history, establishing the foundation for a new paradigm of decentralized monetary exchange based on two fundamental properties— accessibility and transparency.

Afterwards, new innovations and creations in the DeFi ecosystem started to bloom. The foundation of DeFi revolves around the idea that any individual is able to exchange, borrow, lend and send assets using a digital wallet while maintaining full authority over their assets.

We define decentralized finance as “the movement to build an open, global, and interconnected financial system without the drawbacks of traditional finance.” Often built on blockchain platforms that offer security guarantees, DeFi is still a field that is continuously developing— it continues to have much more room for growth.

Smart contracts are defined by Investopedia as “a self-executing contract with the terms of agreement between buyer and seller being directly written into lines of code.” One of defining characteristics of DeFi is that all content for smart contracts are all open source and publicly accessible— meaning you can go on GitHub and find the real time code that many DeFi projects are using. In addition to this, users are able to participate on many decentralized exchanges (DEXs) at any given moment, and don’t have to operate based off a certain schedule as traditional banks do, which makes everything very accessible.

While DeFi offers a decentralized, peer-to-peer exchanges, intermediaries regulate transactions through centralized institutions such as banks and exchanges in traditional finance (TradFi). In terms of accessibility, DeFi platforms are open and permissionless— allowing anyone with an internet connection to access, whereas TradFi requires user accounts along with KYC requirements, and may also limit access based on specific regulations.

Why is Ethereum the largest platform for DeFi?

Ethereum is a decentralized platform designed to run smart contracts. Ethereum has a native asset called Ether, which acts as the basis of value in the Ethereum ecosystem. In September 2022, Ethereum transitioned from Proof-of-Work (PoW) to Proof-of-Stake (PoS) to address scalability and environmental impact concerns— this was known as The Merge, where stakers replaced miners on Ethereum, helping enhance network efficiency. The Merge allowed for the introduction of sharding and beacon chains, which helped enhance overall network performance and parallel processing for transactions and data on chain.

Ethereum utilizes a Solidity, a robust, turing-complete language (a language which is able to solve all computable problems). Developers can create a wide range of tailored solutions for financial instruments to allow for flexibility and customizability.

A pioneer in the DeFi space, Ethereum’s introduction of smart contract functionality revolutionized finance, attracting early innovators, developers, and projects to the platform. Since then, the space has developed into an expansive ecosystem with a diverse range of DeFi protocols, DApps, and services. Now, Ethereum is recognized as the gold standard for blockchain-based finance.

ERC-20 and ERC-721 serve as the common standards for tokens and non-fungible tokens (NFTs). EIP proposals and upgrades also allow for consensus-driven upgrades to the Ethereum network, which keeps the platform adaptive to changing market needs.

Decentralized technology has a lustrous potential to enhance financial systems. Particularly in underdeveloped regions, where access to traditional banking services are limited or non-existent, Bitcoin and similar cryptocurrencies offer a viable alternative for secure and efficient transactions. Blockchain serves as a blueprint for economic empowerment and financial liberty, and DeFi applications are slowly integrating into our everyday applications.

If you’re interested in learning more about decentralized finance— including exchanges, stablecoins, derivatives, MEV and more… stay tuned for Blockchain at Berkeley’s Fundamentals of DeFi article series!

For the next article in our Fundamentals of DeFi series, we will dive into an introduction on decentralized exchanges (DEX’s)! Subscribe to stay updated with our content!

This series is based off Blockchain at Berkeley’s DeFi lecture series. Credits to Tiffany Liu, Riteka Murugesh, Aditya Bhandari, Nate Pola, Daniela Fajardo, Jaylem Brar, and other previous contributors.