Which is the best: Centralized Finance vs Decentralized Finance

The world of cryptography is no longer purely about cryptocurrencies. With the growing awareness of this market segment, the demand for accompanying products and services to support the trading of this asset has begun to grow. We can thus witness the development of a new financial ecosystem almost live. The crypto ecosystem now consists of two parts. The first is centralized finance (CeFi) and the second is decentralized finance (DeFi). These are two different segments that offer financial products and services. Both CeFi and DeFi have specific characteristics that differentiate them from each other and make them more sought after by different users. Below, we will outline at least the basic differences, mentioning the possible advantages of one or the other segment of the financial system and not forgetting to point out the possible risks associated with either CeFi or DeFi.-

Decentralized Finance, Smart Contracts, and Blockchain

Centralized finance (CeFi)

To make it easier to understand what centralized finance is and how it works, it is helpful to compare it to traditional finance (TradFi). In fact, we move into the world of TradFi on a daily basis. Banks are an example of TradFi. Nowadays, almost everyone has a current account with a bank, to which their employer sends their salary or the state sends their pension, and from which they pay their expenses, whether by bank transfer or credit card. CeFi works similarly. Also in its environment, you will find “trusted” intermediaries through which you can make your transactions.

So what is the difference between TradFi and CeFi? TradFi consists of legacy institutions that have been around for centuries and are about to enter the digital asset space by, for example, implementing a blockchain system into their traditional systems. In contrast, the CeFi world consists entirely of companies that offer products and services related to digital assets. The most typical CeFi platforms include centralized crypto exchanges (CEXs), crypto lending companies, and digital currency payment providers.

Users set up a user account on such a platform and use it to process their transactions. Users entrust the operator of such a platform with their funds, both in the form of fiat and cryptocurrency. In return, the operator sets up a so-called hot wallet for each user. However, this means that the user gives up control of their crypto assets, as these platforms actually hold the private keys of their users’ wallets. If the operator of such a platform decides to suspend its clients’ accounts and block their withdrawals, it is hard for the user to do anything about it afterward.

Companies operating in the CeFi market often try to accommodate regulators and central authorities, so the terms of use of a given platform are not very different from the requirements of institutions for a client within the TradFi world. Users of CeFi platforms are thus subject to the rules that CeFi companies set, and such rules are usually created behind closed doors and the user has no influence on their creation. They decide, for example, what rules their customers should follow and which cryptocurrencies will or will not be traded on the exchange.

A not-infrequent condition of institutions that operate under CeFi is that they usually require users to go through a so-called Know Your Customer (KYC) process, or identity verification, for larger transactions. The user thus loses their anonymity. There are also CEX companies that require the user to complete the KYC process upon registration before any trading begins.

On the other hand, the world of CeFi, due to its strong similarity to TradFi, is an easy entry point for aspiring crypto traders. Before the emergence of DeFi, CeFi platforms were the conventional place where users went to trade cryptocurrencies.

The Huge Potentials of Decentralized finance (DEFI)

Decentralized Finance (DeFi)

As described above, under CeFi, users entrust their assets to a central authority through which all transactions take place. DeFi negates such an intermediary and instead uses so-called smart contract protocols for transactions. Decentralized finance, as the name implies, is the opposite of CeFi in that it introduces decentralization to the world of crypto finance.

Transactions are executed through decentralized platforms via decentralized applications (dApps) offering services on the blockchain. These allow users to trade directly with each other, so-called peer-to-peer (P2P). These products and services are provided by applications built on existing blockchains such as Ethereum, BNB Chain, Tron, Avalanche and Solana. The applications are created using smart contracts that specify the rules under which the DeFi protocol operates.

Thus, financial operations in the DeFi environment are based on code that is clearly defined in the smart contract. Smart contracts are computer programs that are hosted and run on a blockchain network, with each smart contract consisting of code specifying predefined conditions that, when met, trigger results. By running on a decentralized blockchain, smart contracts allow multiple parties to arrive at a common outcome accurately, on time, and in a tamper-proof manner. In the TradFi world, the general concept of smart contracts can be likened to the operation of vending machines (coffee, food, etc.) where you put in money and choose what the machine should dispense.

Users can trade in the DeFi environment through their crypto wallets. This allows them to maintain full control over their crypto assets. They also don’t have to register with a central service provider and therefore don’t have to undergo an identity verification process. Thus, users only need to connect their crypto wallet and can get straight to financial transactions within the DeFi world. The latter, like CeFi and TradFi, offers trading, lending and borrowing services.

DeFi, Cryptocurrencies, and the New Banking

Examples of CeFi

CeFi platforms, like TradFi, provide a wide range of crypto-investment services such as spot transactions, derivatives transactions, betting, lending, and asset management.

  • Spot trading: CeFi platforms that provide spot trading services allow their users to buy and sell crypto assets with immediate delivery. Spot trading is available on most CEXs such as Coinbase, Kraken, Binance, KuCoin, Huobi Global, and FTX.
  • Derivatives transactions: derivatives allow users to speculate on the price of the underlying crypto asset. Crypto derivatives such as futures, perpetual contracts and options are provided by several CEXs. For example, Binance, Deribit, Bybit and BitMEX allow users to trade perpetual and futures contracts.
  • Staking: users of cryptocurrencies can stake their coins by locking them on central exchanges for a certain period of time, and users receive a reward for providing their funds to the exchanges. Crypto exchanges such as Gemini, Binance, Coinbase, KuCoin and Kraken offer such a service.
  • Lending: Lending of digital assets is possible on platforms that primarily focus on crypto lending (e.g. CoinRabbit, Nexo and Nebeus). These companies allow users to borrow money (fiat or crypto) against their crypto assets. Users set up a client account with such a company, to which they then transfer their existing crypto assets, which are used as collateral in the loan.
  • Asset management: asset management service providers such as Grayscale Investments, Galaxy Digital, BlockFi or Bitwise manage crypto assets on behalf of their clients.

Examples of DeFi

DeFi platforms do not differ significantly from CeFi and TradFi in the products they provide. The primary difference is the omission of a central authority such as CEX or others. Thus, DeFi offers services such as token exchange, liquid betting, collateralized debt positions, lending, and cross-chain bridges through dApps.

  • Token exchange: Token trading takes place on decentralized exchanges (DEX) such as Curve, Uniswap, PancakeSwap, SushiSwap and Balancer. These platforms use the protocols of one or more blockchains to operate. For example, Curve is available on approximately 11 chains, while Uniswap is available on five.
  • Liquidity Bets: These are protocols in which users lock their cryptocurrency stake and receive a reward in return. Users’ deposits are tokenized, allowing them to exchange them back for the original deposited tokens at a later time. The length of time users must keep their bets/deposits locked up depends on the formulation of smart contracts. These can be time deposits, but can also be deposits with an unlimited time frame. In this case, the user can have his deposit redeemed at any time. The exception so far is the Ethereum blockchain. Again, individual platforms may use one or more blockchains for their operation.
  • Secured debt positions: This is a similar system to liquid betting. The difference is that once the collateral (deposit) is locked in a smart contract, users/investors lose their deposit. But in order not to be detrimental, they will receive in return newly minted stablecoins, which they can dispose of at their discretion. Platforms that offer this service include MakerDAO, JustStables, Kava Mint, Abracadabra and QiDAO. The Collateralized Debt Position (CDP) protocols of these platforms will allow interested parties to mint new stablecoins after locking the collateral. Like previous products, this one can run on one or more blockchains.
  • Lending: using smart apps, users/investors can lend their unused crypto-assets to other interested parties and in return receive a reward in the form of interest. In addition, users can also lend digital assets against their cryptocurrency holdings. This is essentially a system of lending crypto assets from people to people. Perhaps everyone remembers a similar system from the world of TradFi, when this system was used in the Czech Republic by Zonky in its early days. In the DeFi world, you can join such a system on platforms such as Aave, Compound, JustLend, Venus, Solend and Tectonic. These platforms can also operate on one or more blockchains.
  • Cross-chain bridges: This software allows you to send tokens from one blockchain network and receive them on another chain’s blockchain network. When tokens are exchanged from one chain to another, the investor inserts the tokens into a smart contract. These tokens are then “mined” on the new blockchain as a “wrapped token” representing a claim on the original coin. Such a token can then be traded on the new network. Examples of cross-chain bridges are platforms such as WBTC, Multichain, JustCryptos, Poly Network or Portal. Blockchain bridges are gaining popularity as a way for cryptocurrency users to transact. However, by using them, users bypass a centralized exchange and use a system that is largely unprotected and easily attacked by hackers.

DeFi: How decentralized finance works

What’s better?

This question can hardly be answered in a relevant way. Both CeFi and DeFi have their pros and cons. In the end, it will always depend on each individual user on what suits them better and what they prefer. Users who prioritize their privacy and complete control over crypto assets will probably gravitate towards using DeFi. On the other hand, users who, for whatever reason, do not want to study the world of cryptography in detail will probably settle for reviews of centralized exchanges or crypto investment funds and prefer the regulated CeFi platforms. This might explain why CeFi and DeFi have coexisted for several years. In pure theory, the DeFi world is probably better for crypto investors in terms of both options. However, the DeFi market hasn’t yet reached a maturity that is truly safe enough for investors to make a significant impact at the expense of CeFi.

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