Although Decentralized Finance (DeFi) has been disrupting the Traditional Finance (TradFi) sector, TradFi continues to play a massive role in our lives. In this guide, we will explore the traditional finance sphere and discuss its pros and cons.
Understanding Traditional Finance (TradFi)
TradFi is a financial system consisting of various institutions, including credit unions, retail banks, mortgage companies, mutual funds, investment banks, pension funds, and brokerage firms. These institutions have existed for years and are considered intermediaries that facilitate financial transactions between two or more parties.
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If you own a bank account, then you are already a player in traditional finance.
Financial Institutions in Traditional Finance (TradFi) and Their Roles
Central Bank
These institutions are tasked with regulating all banks running their operations in a particular country. Additionally, central banks formulate and implement monetary policies to ensure a country’s financial health is stable. Along with that, these financial organizations regulate fiat currency circulation within a country.
Retail and Commercial Banks
Commercial banks offer direct services to corporate clients. Their services include equipment lending, cash management services, trade finance, and loan products. On the other hand, retail banks serve retail customers, offering personal banking services such as debit cards, credit services, and checking and saving accounts.
Investment Banks
These financial institutions assist governments, individuals, and corporations in raising capital by issuing securities. Moreover, they act as middlemen in processes like company mergers and initial public offerings. Investment banks also identify profitable investment opportunities for their clients.
Credit Unions
These are non-profit organizations, offering clients higher annual percentage yields and lower fees than banks. Credit unions usually serve a certain group of people working within the same geographical area or sharing an employer. Members of such institutions are involved in governing them.
Brokerage Firms
Through a brokerage firm, both institutional and individual investors can buy and sell various financial instruments, including mutual funds, bonds, stocks, and exchange-traded funds.
Savings and Loans Associations
These institutions are customer-owned. They primarily focus on giving their members access to residential mortgages. However, the members can also open checking accounts and obtain personal loans.
Mortgage Companies
Mortgage firms are involved in funding mortgage loans, mostly for commercial property. However, retail customers can also be served.
Insurance Companies
Such institutions help businesses and individuals transfer the financial risk attached to accidents, natural disasters, and property damage. Customers of insurance companies are required to pay a premium to secure insurance policies.
Asset Management Firms
These companies manage funds for individuals. They use the pooled money to invest in multiple investments, including bonds, real estate, and stocks.
Importance of Regulation in Traditional Finance (TradFi)
Most of the popular financial institutions in the TradFi sector are regulated. They adhere to strict regulatory requirements, including anti-money laundering (AML) and know-your-customer (KYC) policies. KYC is the process of identifying and verifying customers’ identities. That means clients must provide their official names, photos, phone numbers, and identification documents when opening bank accounts. AML, on the other hand, are measures put in place to block criminals from making illegal transactions. Financial institutions require clients to show the source of funds to determine if they are legit.
That said, regulations in traditional finance help to maintain the stability of the financial systems as well as protect customers from harm that may be caused by unlicensed companies.
Advantages and Disadvantages of TradFi
Advantages
The TradFi sphere is highly regulated, protecting consumers from bad actors. Moreover, it consists of various players offering numerous services that meet the specific needs of customers.
Disadvantages
Although financial institutions offer a wide range of services, some individuals are not unable to access them since they don’t meet certain requirements. Additionally, transactions processed through traditional financial systems take too long to complete and are considerably expensive.
Conclusion
TradFi offers a regulated way of making financial transactions. However, its downside is that it does not accommodate everyone. Recent data indicates that over 1.3 billion people remain unbanked. All said, businesses in the TradFi space could consider embracing decentralized structures to achieve financial inclusion.