As the use cases for virtual currencies have grown in the previous decade, two distinct phenomena arising from the same notion have piqued the interest of both crypto enthusiasts and institutional investors: centralized finance (CeFi) and decentralized finance (DeFi).
While both crypto market conceptions aim to achieve the same goal (allowing ordinary people to utilize digital currency for monetary transactions), their approaches are fundamentally different.
Let's go into these two concepts, uncover similarities and distinctions between CeFi and DeFi, highlight the benefits and drawbacks of both, and investigate where the two worlds intersect.
What is DeFi?
DeFi (or "decentralized finance") refers to financial services provided on public blockchains, especially Ethereum. You can earn interest, borrow, lend, purchase insurance, trade derivatives, exchange assets, and more with DeFi, but it's faster and doesn't involve paperwork or a third party. DeFi, like crypto in general, is worldwide, peer-to-peer (meaning it is sent directly between two people rather than being routed through a centralized system), pseudonymous, and open to everybody.
Decentralized finance (DeFi) is a new financial system that is built on secure distributed ledgers, similar to the ones used by cryptocurrencies.
In the United States, the Federal Reserve and the Securities and Exchange Commission (SEC) set the rules for centralized financial institutions such as banks and brokerages, which customers rely on to gain direct access to capital and financial services. DeFi disrupts the centralized banking system by enabling users to conduct peer-to-peer digital transactions. DeFi reduces the fees charged by banks and other financial institutions for using their services. Individuals keep their money in a secure digital wallet, can transfer funds in minutes, and can use DeFi from anywhere with an internet connection.
Decentralized finance uses the same blockchain technology as cryptocurrencies. A blockchain is a distributed and secure ledger or database. Apps are applications that manage transactions and run the blockchain. Transactions are recorded in blocks on the blockchain and subsequently validated by other users. If these verifiers agree on a transaction, the block is closed and encrypted, and a new block with information about the preceding block is created.
The blocks are "chained" together by the information in each subsequent block, hence the name blockchain. Because information in prior blocks cannot be modified without impacting subsequent blocks, there is no way to edit a blockchain. This approach, along with other security procedures, contributes to the blockchain's secure nature.
Also Read | Exploring the Intersection of NFTs and DeFi: Opportunities and Challenges
What do you understand about CeFi?
Interestingly, when comparing CeFi and DeFi metrics and statistics, CeFi platforms outperform the DeFi environment by a wide margin. This is because, in comparison to DeFi platforms, CeFi systems are significantly more sophisticated and user-friendly, owing to the time it took to polish centralized cryptocurrency exchanges and loan platforms. Centralized cryptocurrency exchanges have created user-friendly interfaces that provide incredible services on a safe platform that DeFi platforms are still attempting to match.
As a result, CeFi presents options for earning interest through crypto-based accounts that are functionally equivalent to saving accounts in regular banks, but return substantially greater returns. However, unlike savings accounts, crypto deposits are not covered by government-backed FDIC or SPIC insurance; consequently, it is critical that you understand the hazards associated with this field. Earning yield with CeFi is just storing some of your cryptocurrency on one of the numerous various platforms that offer such a product. It is equivalent to providing liquidity or staking in DeFi.
Also Read | Introduction to Centralized Finance (CeFi)
Difference between CeFi and DeFi
Decentralized finance's prospects have clearly presented a new and productive alternative to established financial institutions. As a result, the debate over DeFi vs CeFi or centralized financing has taken on new life in recent years. Decentralized finance has emerged as a significant contributor to the resolution of various flaws in traditional financial services.
However, it is reasonable to learn the distinction between DeFi and CeFi in order to determine the viability of pursuing DeFi as an alternative to financial systems that have been operational for an inexplicably long time. Is it fair to abandon the financial systems that are trusted by everyone who uses financial services around the world? The following discussion compares CeFi with DeFi in order to gain a better understanding of the CeFi DeFi argument.
Bitcoin introduced the world to a flood of innovative blockchain-based financial applications. CeFi (Centralized Finance) appears to have entered troubled seas since the creation of Bitcoin. However, a new movement known as DeFi (Decentralized Finance) has emerged. It has gotten a lot of attention since its inception.
Because of the underlying integrity-protected blockchain and higher financial asset yields than CeFi systems, Decentralized Finance (DeFi) is establishing a reputation as an ecosystem that provides transparency and control. Furthermore, the broad spectrum that blockchain technology may provide has piqued the interest of learners to understand blockchain technology. Listed below are some of the major key differences between the both-
While the DeFi application code is not necessarily open-source, the execution and bytecode must be publicly verifiable on a blockchain to be classified as non-custodial DeFi. As a result, unlike CeFi, each DeFi user may monitor and confirm that DeFi status changes are carried out on time. Because of its openness, the new DeFi technology has an unrivaled ability to transmit trust.
As previously stated, CeFi initiatives are managed by a single firm or collection of businesses that oversee all aspects of the business. Similarly, while most DeFi projects are developed by distinct groups of people and organizations, the resulting platforms are administered by communities through various procedures. In terms of decentralization, any DeFi project would attempt to mirror Bitcoin or any other public blockchain, albeit the consensus methods would differ from project to project.
Some DeFi initiatives provide governance tokens, which let holders participate in decision-making processes. Compound (COMP) is an example of a governance token that exploded in the summer of 2020.
The DeFi vs CeFi debate also highlights the former's permissionless nature. As a result, consumers do not need to go through a KYC process to use DeFi services, as they do with CeFi services. Users can connect their wallets to the DeFi service, then perform necessary actions such as fund transfers, trading, and so on.
Furthermore, because DeFi services are permissionless, there are no restrictions on access. Furthermore, businesses can use DeFi services to benefit the general public. At the same time, corporations can use DeFi services to grow their business into previously unreachable geographic areas.
CEXs operate on the same principles as their traditional equivalents. CEXs keep limit order books, or off-chain records of outstanding orders placed by traders. DEXs, on the other hand, employ AMM (automated market-maker) protocols to match the counterparties in a transaction, therefore they operate in a fundamentally different way. AMMs use mathematical algorithms to calculate price based on transaction volumes.
CeFi and DeFi services offer different characteristics that are specific to each group. Most CeFi projects, for example, provide custody solutions and have dedicated customer service teams, which are often not available in DeFi.
Trading on DeFi platforms, on the other hand, occurs on blockchain because there is no single authority involved. This accomplishment is made feasible by a number of critical elements, including automated market-making (AMM), liquidity pools and yield farming, and non-custodial swaps. In most cases, there are no KYC requirements in DeFi, and monies are kept in personal wallets until the transaction is completed. The crypto exchanges built on blockchain infrastructures are called decentralized exchanges (DEX).
When the early crypto exchanges enabled fiat transfers, there was no regulation because governments did not fully comprehend Bitcoin and blockchain. Nonetheless, most authorities are now attempting to control crypto activities, either directly or indirectly. As a result, one of the reasons why most CeFi platforms require KYC verification is because of this. Coinbase is registered with the Securities and Exchange Commission (SEC) in the United States, whereas other worldwide platforms have relocated their headquarters to crypto-friendly nations such as Malta or Estonia. Meanwhile, the European Commission is in the process of developing the most complete legal framework for cryptocurrencies. Overall, there are more jurisdictions associated with CeFi services.
CeFi systems are models of traditional banks that have previously proved and continue to showcase their potential. DeFi, on the other hand, is still in its early stages. Many industry observers anticipate a massive transformation in which DeFi services eventually replace traditional ones, posing a danger to the financial system.
Nonetheless, both DeFi and CeFi have a role in the crypto market as of today. They offer speedier transactions, attractive dividends, and good community infrastructure.
Both DeFi and CeFi have a promising medium-term future, as the financial crisis will highlight the need for refuge assets with minimal connection to traditional markets. It will also emphasize the significance of blockchain solutions for all types of financial services that governments should not interfere with.
DeFi will prosper in the long run because it has the ability to make financial services available to everyone. Investors should keep a watch on Ethereum's shift to Proof of Stake as well as legal changes connected to DeFi, since these will have an impact on the developing sector.