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Traditional financial services, such as payments and loans, were offered for centuries by established financial institutions. However, this changed when blockchain technology emerged. As crypto became well-known, it became a new issue.
Cryptocurrency is no longer a term that only a few people are aware of. These days many organisations are showing an inclination towards the crypto market, along with a broad number of investors that are open to investing in cryptocurrencies. Since the concept of crypto has expanded in the last few years, the debate has now shifted to a new set of considerations – the distinction between DeFi (decentralised finance) and CeFi (centralised finance).
Even though both of them can be used in the crypto environment, there are major differences between them.
The abbreviation CeFi stands for Centralised Finance. Both CeFi and DeFi are used in the crypto world. The term may sound complex, but it basically refers to centralised financial institutions such as banking services.
Let's take our mind away from crypto for a second to explain the origins of CeFi. Centralised finance has been established way back in ancient Mesopotamia. Since then, humans have used various goods and assets as currency, such as livestock, land, gold, and fiat currency. In this respect, it has been determined that currency may either have its real value when it comes to, for example, land or an imputable value like fiat currency.
Whether fiat money is a crypto nemesis or not, you can find out in this myth-busting article: 'What is fiat money & why is it the enemy of crypto?'.
Typical financial institutions are centralised, meaning a single authority has controls over them. For example, this refers to most banks, brokers, and borrowers. In terms of crypto, centralised finance connects traditional monetary systems with a new asset class – cryptocurrency.
CeFi in crypto refers to online platforms for acquiring and selling cryptocurrency and cryptocurrency-related financial services using a central banking network or a centralised banking system.
Centralised entities run CeFi services such as centralised exchanges. A centralised exchange (CEX) provides a neutral platform to conduct cryptocurrency transactions. CeFi companies as service providers tend to abide by regulations laid down by local authorities. For example, these regulations oblige them to implement ordinary practices for centralised financial institutions such as Know Your Customer (KYC) and Anti-Money Laundering (AML).
If you are a frequent reader, you probably remember that we discussed cryptocurrency exchanges in our 'A beginner's guide to cryptocurrency exchanges'.
Cryptocurrency trading is one of the most common solutions introduced by CeFi at the moment. In addition to cryptocurrency trading, centralised service providers offer customers a bunch of other services such as crypto lending, borrowing, and margin trading.
With the rise of decentralised finance in the crypto industry, many people have turned to it. That is mainly because centralised services can be more easily attacked and corrupted since there is a single point of power. Additionally, CeFi platforms are more exposed to technical malfunctions as there is a single point of failure. On the other hand, it promises security of funds and fair trade on those funds.
To understand CeFi better, we are now going to set out an explanation of its core features.
When users enter a centralised exchange platform (such as Binance, Coinbase or Kraken), they can deposit their assets in an internal account. That means that money is stored on the platform and remains out of the hands of users.
All crypto trading orders are managed through a central exchange. It means that a user doesn't need to worry about managing the seed phrase and private key. Most customers on centralised exchanges consider them trustworthy and do not mind sharing their personal data or putting funds into the provider's custody.
While centralised exchanges include the risk that users could use their money if during an attack their security protocols fail, they contain some beneficial services such as whole departments committed to customer support.
CeFi supports many currencies that are released on other blockchain platforms. This is one significant advantage CeFi has at the moment in comparison with DeFi. Due to the complexity of performing cross-chain swaps, DeFi services cannot support it.
CeFi supports cross-chain services by securing custody of funds across divergent blockchains. It combines a range of financial services with a simple payment system.
Centralised finance platforms provide more flexibility when it comes to converting fiat money to crypto and the other way around. Generally, converting cryptocurrencies to traditional money requires the use of a centralised institution in most cases.
CeFi helps convert fiat currencies into cryptocurrencies more easily and quickly. Easy-to-use tools allow for better user onboarding on a CeFi exchange.
Since CeFi provides the most extensive fiat-to-crypto conversions for cryptocurrencies due to many exchanges and trading volumes, institutional investors are enabled to inject significant amounts of capital into the market. Injecting capital into the crypto market provides ample liquidity for a number of prominent cryptocurrencies.
Generally, a CeFi platform sets its own interest rates. This presents an advantage because interest rates are in that case more stable. In other words, market pressures cannot influence them.
On the other hand, CeFi interest rates are significantly higher than on DeFi platforms. The CeFi business includes legal entities that can be plugged into the conventional currency and payment system, yet handling costs can exceed the cost of similar services in decentralised finance.
CeFi doesn’t equal security. There are many CeFi service providers and each is different. The cryptocurrency invested may be used in multiple manners with varying levels of uncertainty. Therefore, it is always good to DYOR (‘Do Your Own Research’) about how the crypto asset is going to be used and what particular risks and threats could be included.
Centralised finance basically means that there is an intermediary. Because the ‘middleman’ is involved, transaction fees are higher. Big transaction fees made a lot of people think about using DeFi instead.
Having a single point of control attracts cybercrime. Cybercriminals look to capitalize on a CeFi platform’s substantial liquidity. As mentioned above, users’ funds are kept on the platform itself so if security fails, funds and information are at severe risk.
Last but not least, collapses and frauds made many users switch to DeFi. In the aftermath of the bankruptcy of FTX, the second biggest centralised cryptocurrency exchange worldwide, many users decided to take control of their crypto assets and switch to DeFi.
FTX collapsed in November 2022 following a report highlighting potential solvency concerns including FTX-affiliated company Alameda Research. The collapse shook the volatile cryptocurrency market which ended up losing billions. Soon after the report was published, FTX founder and ex-CEO Sam Bankman-Fried was arrested in the Bahamas and extradited to the United States, and the company filed for bankruptcy.
Additionally, the platform then experienced various security attacks in which hundreds of millions worth of tokens were stolen. It seems that due to the collapses of FTX and other CeFi companies, DeFi services gained an advantage in the Cefi vs DeFi debate.
DeFi stands for Decentralised Finance. It is an umbrella term that describes financial products and services based on secure distributed ledgers. Such financial products and services can include anything from asset management, asset storage, yield farming, and insurance to lending and borrowing.
If you are interested in what you can all do in the world of decentralised finance, why not read this article: 'How to earn crypto: Earning from DeFi'.
DeFi challenges the centralised financial system by using peer-to-peer digital exchanges. The main advantage of DeFi is that it removes the need for a central authority or intermediary. That basically means that there is no third party that should verify or approve transactions.
In the text above we discussed mainly centralised exchanges that have been offering crypto financial services for many years now. Decentralised exchanges (DEXs) operate on blockchains such as Ethereum (ETH). The blockchain settlement layer provides unique benefits for decentralised finance and non-custody of digital assets.
One interesting thing about decentralised finance (DeFi) is related to its anonymous development. A majority of DeFi projects are created and handled by unidentified groups of individuals.
DeFi is still in its early stages of development, but many new DeFi services and projects are entering the crypto market. Let's take a look at some of DeFi's main attributes.
Decentralised finance (DeFi), sometimes referred to as ‘open finance’ takes out the intermediary in financial transactions. For example, instead of having your bank, platform or credit card issuer acting as the middleman when you make a purchase, you can trade directly.
DeFi systems do not rely on any centralised financial institutions. Therefore, they are not subjected to corruption or bankruptcy. There is no single institution in control and no single point of failure. The decentralised nature of DeFi protocols mitigates a large portion of this risk.
DeFi is all about code. DeFi applications and platforms are generally built using smart contracts, which are pieces of code that determine the rules of a DeFi protocol.
If you want to learn more about the importance of decentralisation, we suggest taking a look at this article: 'What is decentralisation & why is it important?'.
Contrary to the conventional norms of access followed in traditional finance, DeFi applications are permissionless in nature. Any user can access DeFi just by having an internet connection and a crypto wallet.
If you have a crypto wallet and internet connection, there are no barriers to entry, irrespective of your geographical location or amount of funds. DeFi aims to provide an open financial system that can be accessed by any DeFi user.
Having a crypto wallet brings us right to the next attribute – DeFi is non-custodial. This is one of the most important features of decentralised finance since it enables DeFi users to keep complete control over their crypto assets and personal data.
If you want to know more about storing crypto, crypto wallets, and private keys, why not read this article: ‘How to use crypto’.
Peer-to-peer relationships are based on immutable smart contract software that automates negotiated agreements between persons. Therefore, the system itself eliminates central authorities from storing the data and digital assets.
Using Web3 wallets such as Metamask helps customers to efficiently interact with DeFi protocols and applications. Having more control over assets and personal data presents a new age of financial services that are tailored to the needs of a user.
DeFi provides transparency. In fact, it is one of its most striking and obvious traits. All data, codes and transactions on the blockchain are visible to everyone. Each transaction has to be broadcasted to other users on the network.
A high level of transparency ensures high trust levels among users, auditability, authenticity, and security. Furthermore, transparency regarding transaction data enables comprehensive data analysis. Each user can view and understand the DeFi smart contracts’ code and functionality, along with what kind of transactions are happening.
Immutability basically means that something cannot be changed. Since decentralised finance is built on blockchain technology, all data is immutable. The exchange of financial transactions and personal data requires a certain level of integrity. Therefore, it is significant to have tamper-proof information throughout the decentralised financial system.
Immutability improves auditability and security. It is not only a vital feature of DeFi, yet also a credible trait that could add up to the popularity of blockchain technology in the world of finance. Tamper-proof information makes financial operations very secure and easier to audit. This mechanism is useful when it comes to due diligence research and fraud detection.
Even though DeFi includes higher levels of security and transparency, there are three classes of risks related to decentralised financial services. These are technical risks, financial risks and regulatory risks.
Technical risks generally stem from issues with protocols, software, and hardware. This risk is important since its occurrence could compromise the functionality of an entire decentralised exchange platform. They depend on various factors such as memory safety, race conditions, use cases, and others. Risks in the technical class also depend on smart contracts and the role they play within the system of decentralised finance.
Financial risks are another important category when it comes to DeFi. For example, when using decentralised exchanges, users should be aware of liquidity risks due to the lack of liquidity providers in the crypto market. In other words, it may be difficult for users to exit positions rapidly if the price moves against them or if they need to immediately access their funds.
Financial risks point to the risk of users losing money and withdrawing from the decentralised system. Even though each user should understand that there are financial risks when it comes to any investment, either related to CeFi or DeFi, a lack of regulation within the DeFi environment makes things harder for ordinary users.
The next risk class is linked to a lack of regulation in the area of DeFi services. DeFi is still a new concept and therefore, mainly unregulated. Probably laws and regulations governing DeFi are going to be created in the near future, but for now, it presents an uncertain legal area for both users and creators. In the world of centralised finance such as traditional banking systems, DeFi transactions may be seen as illegal or suspicious activities.
Finding the right regulatory balance is tricky. After all, we are talking about a global permissionless system that could eventually beat DeFi in the Defi vs Cefi match. If the regulators decide to take on a strict approach and eliminate all risks, technology would be stifled.
Many people think that DeFi presents the first glimpse of a future beyond traditional financial services and intermediaries. For some people, it may look like an uncertain trend that cannot sufficiently protect consumers and investments. However, both groups of opinions confirm that DeFi has made an impact on the financial system.
As the technology evolves, decentralised financial products and services will become more compliant and secure in terms of consumer and investor well-being. It is an interesting concept that could transform the financial system totally.
On the other hand, the CeFi vs Defi match doesn’t need to have a winner. The third group of opinions is that the best of both worlds could be attained if CeFi and DeFi cooperated. Even though it seems impossible at first due to their striking differences, CeFi could embrace innovation and a different point of view tailored to the needs of the user.
Next step: DeFi Tax 101: Everything You Need to Know about Tax on DeFiGo to next step
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