In the world of cryptocurrency, many would have heard about centralized and decentralized systems and see the two as opposites. Centralized Finance is financial activities that must go through a central point, an institution, while on the other hand, Decentralized Finance is one that functions without a centralized agency, where all information isn’t doesn’t have to go through a single entity.
In this article, we will discuss the way these two systems function, how they are different, and the advantages and disadvantages of each.
A centralized system is one that is dependent on an intermediary which has responsibility and control in overseeing all financial transactions. An example we all know is the bank, which manages all financial transactions. There are entities such as central banks or governments to control monetary policy. This system helps build trust, allowing us to conduct financial transactions with an entity to mitigate risk.
However, Centralized financing has its limitations. If the intermediary is dealing with issues, for example, the bank app crashes or the bank itself is hacked, we would not be able to do anything about it. We have to wait until the bank solves the problem. It also takes a huge amount of money to build an intermediary system, the bank must have a security system as well as many other systems in place that add to the growing expenses of setting up a centralized entity.
Decentralized is a new system that manages financial transactions such as transfers, mortgages, and loans. It does not require an intermediary like a financial institution to certify the occurrence of these transactions. Instead, it utilizes Blockchain technology.
A decentralized system like DeFi (Decentralized Finance) manages financial transactions by using computer systems such as Smart Contracts on the Blockchain instead of working through intermediaries like financial institutions. This is a transparent system where anyone can check the transactions that have occurred and be a part of the system’s development. This system is able to manage anything that a bank can, only it doesn't require the intermediary itself. This cuts costs associated with having an intermediary as well as increases the efficiency and speed of the transactions.
Cryptocurrency works on a decentralized system on blockchain. In order to understand how these two technologies work together, let's take an example. Consider blockchain as a system that stores information on a database, like saving a document on your computer. The difference is that on the blockchain, this information is stored in many places and can be reviewed by anyone.
To illustrate how blockchain allows anyone to review the information, take this example. There are 3 people involved in a centralized system. In this case, only one person would be in charge of the system and manage all the transactions that occur in the group. However, in a decentralized system, all three parties would be involved in verifying data and managing transactions, and all three would be able to view the transactions that have occurred.
The system that blockchain has created is to allow everyone to have and store the information of everything that has occurred on the system. Take Bitcoin, for example, the first to utilize blockchain technology. If person 1 holds Bitcoin, this information is stored on their ledger on the blockchain. Person 2 that has also once traded with Bitcoin has their ledger, as does person 3. Person 1’s ledger not only holds information on their own personal transactions, but this ledger also keeps the information of Person 2 and Person 3’s ledger. Person 2’s ledger will also keep the information of person 1 and person 3’s ledger within their own ledger, and so on…
In this way, everyone on the blockchain keeps their own ledger as well as everyone else’s ledger too. This makes decentralized transactions on the blockchain very safe. Anytime a new transaction occurs, everybody’s ledgers are updated, not only the ledgers of those actually engaging in the transaction. When a transaction is recorded in a multitude of ledgers, rather than in just a few (like in the centralized system), it becomes very difficult for this information to be altered. For example, if a hacker tries to alter information on a transaction, not only will they have to alter it in one ledger, they will have to alter this information in at least half of the ledgers that are on the blockchain in order to successfully hack the system.
The decentralized database on the blockchain is comparable to fingerprints. The chances of you having the exact same fingerprint match as somebody else is one in 64 billion. Similarly, databases in the blockchain world have a very low chance of being duplicated.
The decentralized system has only been in practice for a few years and has limited applications, only functioning in technology and banking. However, the decentralized system is just getting started and has already shown massive potential with it being highly secure, its transparency and connectivity, and its ability to foster fairness among its users.
This is not to say that the centralized system doesn’t have its own benefits. Many of us are far more familiar with the centralized system and find it to be more convenient, easier to use, and trustworthy.
Despite decentralized not being as widely used as the centralized system today, decentralized is still used primarily in the gaming industry such as through NFTs in Play to Earn. Even the fitness industry is getting in on decentralized systems with new schemes like Exercise to Earn. We are confident that in the future, the role of decentralized systems will continue to grow and become an important part of many industries.