If you’re like me, you have at least one bank account or maybe even a handful of them at various different banks. Perhaps you have a checking account, a savings account or even both. You might have direct deposit set up so that your job pays you directly, a debit card to easily spend money from your account and a credit card all from the same bank. These services are just a small portion of what banks are capable of offering.

The overarching theme of banks is that their services revolve around money and for the average person, that mainly involves fiat currency and ways to store it, spend it, and send it to others. Under the hood however, banks have a very important responsibility when it comes to handling money; to verify every transaction carefully and prevent double spending. If our banks can’t be trusted to do this, then there can be no trust in the value of the dollar.

There are a variety of ways in which banks can send money or handle transactions. The most traditional methods to do this are to write a check or to withdraw funds in the form of cash and deposit it elsewhere. In recent years, electronic money transferring strategies have become increasingly common. Some terms you may hear regarding electronic transfers are wire transfers, ACH, or SWIFT. What all of these methods have in common is that they require a way to verify the transaction which takes time, a fee, or both. Despite all the due diligence, the transaction verification process is not infallible and it is possible to send the same digital assets to multiple destinations. This is commonly referred to as double spending. To instill consumer confidence, banks resolve transaction errors by paying with their own capital and are backed by banking insurance (e.g. FDIC) so that in the scenario where they are unable to pay, consumers still receive their money.

As you can imagine, a lot of effort is involved in securing the validity of transactions and even then, additional backup solutions are needed. To offset these costs, banks generate profit through their services. This is where hidden costs come into play.

When money is stored in a bank, it doesn’t simply go into a big vault to be locked away until you go retrieve it. The bank will use this money in a variety of ways to make a profit, such as loaning the money out to customers, investing it in equities, and converting currencies for a fee (forex). To maximize profits, the bank wants people to store as much of their money with them as possible. Banks offer a small interest on savings accounts to further incentivize people to bank with them.

The emergence of blockchain technology is particularly interesting when it comes to solving the traditional problems of banking. Bitcoin is the most famous example of blockchain technology so it will be used as my example . As mentioned earlier, banks must spend a large amount of resources to painstakingly account for their assets and liabilities. This includes getting the math double checked and bringing in auditors to ensure that protocols are being followed. The end result is that the process takes a long time and has a high transaction cost.

Bitcoin solves the double spending problem by using a public ledger to maintain the history of each coin and secures the accuracy of the network with computing power. This means that any transaction made with Bitcoin will go on the ledger automatically once it is confirmed by the network. No double checking or accounting is needed. The ledger can only be changed by having enough computing power to overcome all of the Proof of Work (PoW)  done from the point in which you want to change, which is an extremely difficult, if not near impossible, task.

Bitcoin can be considered a decentralized currency but the same distributed ledger can also be used to bring in other financial services. The umbrella term for these services is Decentralized Finance, or DeFi for short.

This is a new and exciting space in the world of web3 and allows regular people to take finance into their own hands. A popular use case of DeFi is replacing the use of centralized exchanges (CEX) with decentralized exchanges (DEX). Centralized exchanges for cryptocurrencies act similarly to forex, where traditional fiat currencies are converted for a fee. In the case of a centralized cryptocurrency exchange, traders will commonly pay a fee using the coin they are converting or can opt to pay a lesser fee if they pay with the coin used by the CEX. As an example, the most popular exchange by volume, Binance, uses Binance Coin (BNB) as their coin, which can be used to pay a lesser fee.

Whether it is a centralized cryptocurrency exchange or forex services provided by an entity such as a bank, the overall benefits and downsides of using a DEX  are the same. Centralized services are regulated entities in charge of your assets, and are the ones that truly hold your assets while you use their service. The general benefit of such a system is that there is an entity you can reach out to regarding anything related to the service. The platforms also tend to be more mature by the virtue of this system being around comparatively longer. These centralized platforms are kept running by the fees paid during the usage of the service.

A DEX also runs off of trading fees but there are a few key distinctions. First, liquidity can be offered up by anyone rather than all of it coming from a centralized platform, and liquidity providers are also entitled to the fee. A DEX will generally have lower fees, and people can exchange coins on a DEX right from their own wallet rather than handing over their assets to a centralized entity. To provide liquidity to a liquidity pool, one simply needs to exchange a pair of coins they own for liquidity points. These points represent a percentage of ownership of a liquidity pool, which is used to facilitate token swaps on the DEX. An important aspect to understand about providing liquidity  is impermanent loss. When a user provides liquidity to a pool, it entitles them to some portion of the total pool if they want to take back their liquidity. The problem is, the coins being placed in the pool can be volatile, and the pair of coins over time can change in relation to each other in comparison to when they were first placed in the liquidity pool. For instance, if you place 1 coin A and 1 coin B into a liquidity pool, and coin A = coin B, then when you remove your liquidity you will get 1 coin A and 1 coin B back. However, if coin A increases in value such that A = 4B, the ratio of coin A to coin B in the pool will have changed. So, when you remove your liquidity, you may get something more akin to 0.5 coin A and 4 coin B back. Depending on the value of coin A and B, you may have potentially been better off holding the coins instead of offering them up in a liquidity pool.

The DeFi world is new, so it will take a while for the experience to become as broad and as well understood as its centralized counterpart. However, the power to allow people to provide financial services to each other in a manner not dissimilar to a co-op is an incredible innovation.