The financial system ensures that different market participants can access their money: Private individuals want to save or invest money. Companies need equity or loan capital to expand their production. The state is also an important market participant, whether as an investor or borrower. Trust is vital to a functioning financial system. It becomes clear just how important it is when trust vanishes. Financial crises can have a severe negative impact on the real economy, for example through a decline in investment. Restoring confidence after such a crisis can take a long time. It often requires additional measures to build confidence in the form of state guarantees and loans, or regulation. Money is allocated in various ways. Banks and stock exchanges are the traditional channels for this. Alongside them, there are now some new alternatives: peer-to-peer platforms and decentralized finance (DeFi).

Banks bring investors (or lenders) and borrowers together. They perform various functions. One of them is maturity transformation: accepting short-term deposits and turning them into long-term loans. Another is lot size transformation: bundling small deposits to fund larger loans, for example. Banks also serve as a risk buffer between borrowers and lenders. This means that if the loan defaults, the bank bears the loss, and not the investor. To make sure that banks can bear these risks, they must have sufficient capital to back their transactions. There are also specific regulations governing banks. Problems arise when investors lose confidence in a bank and want to withdraw their money. As a result, the bank cannot settle all the claims immediately:
Usually, maturity transformation means that claims mature at different times. These bank runs can lead to a chain reaction in the financial system: One bank’s insolvency can have negative consequences for other financial services providers. This can spread to the wider financial sector and affect customers. It is crucial to avoid this domino effect.

Stock exchanges also play an important role in the financial system. You can think of them like a major intersection or central market where borrowers and lenders gather to transfer money. This can be in the form of equity (shares) or loan capital (bonds). Stock exchanges enable investors to invest in companies, for example. This supports the flow of capital in the economy. Stock exchanges do not actually transform maturities or risk. They are usually regu­lated, which gives investors greater confidence. But the investor still bears the risk of the issuer defaulting. Stock exchanges have close links to clearing and settlement infrastructures. Financial professionals and policymak­ers often refer to them colectively as “financial center infrastructure.” Special regulations govern this infra­structure, and supervisory authorities oversee it.

Peer-to-peer platforms offer an alternative to traditional financing channels such as banks and stock exchanges. They connect businesses or organizations that are look­ing for capital directly with investors. For organizations seeking capital, these platforms offer various benefits: They are easier to access than stock exchanges and ideal for raising smaller amounts. Investors on the other hand can invest directly without having to pay a professional broker. The unregulated or less regulated peer-to-peer platforms handle a smaller volume of transactions than the traditional exchanges. They are mainly active in the primary market — less so in the secondary market.

As with banks and stock exchanges, it is essential that investors and borrowers can trust the operators of a peer-to-peer platform. These operators must ensure that transactions are fair and transparent. Most importantly, investors need to know that their money is safe.

Traditional finance is merging with distributed ledger technology, also known as the blockchain. Industry professionals call this “decentralized finance.” Among other things, DeFi aims to offer traditional financial services without centralized intermediaries such as banks, stock exchanges, or peer-to-peer platforms. This means that investors and borrowers transfer their funds directly and independently via a blockchain. The products and services offered in DeFi are based on smart contracts. These contracts are written automatically and enforced autonomously. The rules are stored on the blockchain. This represents a paradigm shift in how we manage trust in financial transactions: In traditional finance, for example with banks or stock exchanges, having trust in how these central institutions operate is crucial. Likewise with peer-to-peer platforms, investors have to be able to trust the operators. In DeFi systems by contrast, it is the security and transparency of the blockchain technology that creates trust.

Banking or financial services are regulated, risk-bearing intermediaries. They perform important functions for the real economy and will probably continue to do so for two reasons:

1. Various banks, central platforms, and markets also coexisted in the past. DeFi is another option for allocating financial resources. It will probably complement existing systems rather than replacing them. It gives investors and borrowers an alternative to traditional channels for certain financial products and services. Investors and borrowers will select the most suitable offering based on their preferences and trust. What’s more, not all products and services are available on all channels.

2. Not all participants want to and are able to make all their financial transactions independently on the blockchain. Some participants still need support. They therefore sometimes turn to banks for assistance. For these participants, banks are trustworthy intermediaries offering both traditional and blockchain-based financial services. In addition, there are hybrid forms such as central exchanges based on the blockchain.

Traditional financial intermediaries will probably continue to enjoy the trust of customers in the future. However, some people value the transparency, efficiency, and autonomy of the blockchain. These individuals have more trust in the technology than in the established, regulated financial system. And this group of customers is growing.