Decentralized finance (DeFi) and centralized finance (CeFi) are terms that are increasingly attracting global attention for several reasons. In a sense, the terms stem from the rise of cryptocurrencies. The concept of cryptocurrency arose from the introduction of blockchain technology in 2009 when Bitcoin came onto the global scene.
With the cryptocurrency having the potential to rival established financial institutes such as banks, a discussion about the fate of traditional finance took hold. However, the debate has since shifted to CeFi versus DeFi as the niche continues to expand.
Both CeFi and DeFi offer a wide range of crypto-related financial services, but they have specific differences. Additionally, one will quickly notice that CeFi is a broad term whose interpretation could extend to traditional financial services. This article offers a granular explanation of the terms and their principal differences. So, read on to grow your knowledge.
Defining decentralized finance (DeFi)
DeFi, short for Decentralized Finance, is an emerging technology where blockchain-based applications – called decentralized applications or dApps – enable users to save, trade, and even lend funds without any intermediary.
Saving, lending, and other financial services are the preserve of financial institutions and banks, at least that was the case until 2009. According to Satoshi Nakamoto, the person or persons who invented Bitcoin, the cryptocurrency’s objective was to make financial transactions peer-to-peer. They even conveniently titled the Bitcoin whitepaper “A Peer-to-Peer Electronic Cash System.”
As per the whitepaper, the purely peer-to-peer payment system would enable parties in a transaction to exchange value directly, hence taking out intermediaries. The technology would enforce trust using digital signatures and a digital ledger to prevent double-spending.
DeFi takes the idea of peer-to-peer or P2P transactions even further. Software developers and entrepreneurs have built an ecosystem of dApps that could actually decentralize a sector that is traditionally tightly controlled by a few players.
Nonetheless, DeFi is an emerging niche, and for now, the term is best viewed as a broad representation of public blockchain networks. There is a lot of specialization where some blockchains focus on lending and borrowing, while others are solely insurance platforms. All this is possible thanks to the blockchain technology that bitcoin pioneered.
How DeFi works
We stated earlier that DeFi is an emerging niche built on blockchain technology. This is the same technology that underlies cryptocurrencies like Bitcoin and Ethereum. In other words, if one wants to understand the core functionality of DeFi, one must understand how blockchain works.
According to the Bitcoin whitepaper, blockchain is not a new technology. To be sure, Satoshi Nakamoto cited several seminal papers that explained a rudimentary version of the blockchain. Additionally, the Institute of Chartered Accountants in England and Wales (ICAEW) outlined the history of blockchain, in which it credited W Scott Stornetta and Stuart Haber as the originators of the technology.
Nevertheless, blockchain stands for the same concept. It refers to a distributed database (or ledger) shared among different nodes that make up a single network. The distributed ledger keeps a record of transactions by distributing smaller bits to each node on the network. This ensures security and trust in the network, but more importantly, it creates the foundation for P2P transactions.
Each transaction instance is stored in a block. As more transactions occur, the number of blocks increases, creating a blockchain. A typical blockchain network has superusers who must verify each transaction before adding a new block. Additionally, the information in previous blocks is unalterable, making the technology highly secure.
Therefore, DeFi leverages blockchain to provide financial services without the need for intermediaries. Specifically, developers build decentralized applications (dApps) that use smart contracts and cryptocurrencies to deliver stated services.
Banks and other financial institutions are the guarantors of transactions in traditional finance. On the contrary, smart contracts play this role in the DeFi ecosystem. Also, fiat currencies enable parties in traditional finance to exchange value. Cryptocurrencies play this role in the DeFi ecosystem.
A smart contract is a computer program that the creators of the Ethereum blockchain pioneered. It contains instructions and conditions that parties must meet for transactions to succeed. Most importantly, no one can alter the information in the smart contract once it goes live.
To fully grasp how DeFi works, suppose you wish to obtain a loan. First, you will specify your loan needs in a dApp. Then, native algorithms will pair your needs with peers who are willing to fulfill them. The lender will then require you to agree to specific terms, and the blockchain network will record the transaction. If the transaction passes the verification test, you will receive the funds in your wallet.
And what is centralized finance (CeFi)?
Centralized finance (CeFi) refers to the ecosystem where consumers receive financial services through intermediaries. One could argue that traditional finance is an apt demonstration of CeFi. For example, one must have an account with a financial institution (such as a bank) to be able to transfer value.
From the preceding, one might think that CeFi is all about traditional finance, but that is far from the truth. In fact, the idea that bitcoin could revolutionize finance became a reality because of the activities of CeFi businesses, such as Coinbase.
So, what exactly is CeFi in the crypto-sphere? The fundamental idea behind CeFi in the crypto-sphere is to avail crypto investment opportunities based on traditional finance norms. This is to say, users will enjoy the benefits of DeFi but within the constraints of traditional finance.
For example, Coinbase enables users to buy and sell cryptocurrencies, but the process is not peer-to-peer. Suppose you wanted to borrow a loan in the CeFi ecosystem, you’d need to apply to a service provider. Here, you’d also pay services fees to the service provider and interest on the principal sum.
How CeFi works
CeFi works in the same way traditional finance works. The previous paragraph explained that consumers in the CeFi ecosystem could only access services via a service provider. We should add that crypto-focused businesses also require customers to open accounts, much like traditional banks’ savings accounts.
However, one must note that the account does not enjoy similar privileges as those opened with traditional banks. For instance, crypto-related savings accounts do not enjoy the protection of FDIC or SPIC insurance.
How does DeFi differ from CeFi?
From the preceding, it is apparent that DeFi and CeFi are functionally different. However, one needs a granular grasp on the features of each ecosystem to understand the differences better. So, let’s discuss the features and how each ecosystem approaches them.
· Method of exchange
The peers in a DeFi ecosystem exchange value in a way that fundamentally differs from the customers in the CeFi ecosystem – this is, in fact, the primary differentiator.
On the one hand, the exchange of value in DeFi is entirely dependent on technology. The parties communicate via smart contracts, and the verifiers are in charge of enforcing trust. Additionally, DeFi leverages distributed ledger technology to guarantee the security of transactions.
On the other hand, customers in a CeFi ecosystem depend on intermediaries to access needed services. The intermediaries could be cryptocurrency exchanges or crypto-focused financial service providers with the necessary license to offer the stated services. Also, CeFi service providers do not require blockchain networks to facilitate the exchange of value.
In centralized ecosystems, users cannot access services without proper permission. This is the case in CeFi. Specifically, customers in the CeFi ecosystem must sign up for accounts, which requires them to submit to know-your-customer (KYC) regulations. Proponents of permissioned access argue that it enforces fidelity to crypto regulations and prevents criminal activities.
On the contrary, DeFi users do not require permission to partake in the market. All one needs is a non-custodial crypto wallet with proper security measures. Furthermore, the absence of KYC guidelines in DeFi enables users to transact with an elevated form of anonymity.
The subject of custody is an issue that extends from the absence or presence of permission requirements. For DeFi users, one has complete control over their assets. However, this implies that the users shoulder all the risks.
On the other hand, centralized exchanges guarantee safety, security, and trust in a CeFi ecosystem. They also bear the risk of their customers’ funds, much like traditional financial institutions.
· Cross-chain services
Most CeFi services offer investment opportunities in coins created on independent blockchain networks. This is possible because the businesses store funds from several chains. Thus, users can access services from several blockchains.
On the contrary, most DeFi assets and dApps follow the Ethereum token standard, implying that cross-chain exchanges are complex and likely to take longer to complete.
· Fiat currency to crypto conversion
Similar to difficulties in cross-chain interoperability, DeFi faces significant challenges in converting fiat to cryptocurrency. The primary impediment here is that fiat-to-crypto exchange requires an intermediary, counterintuitive for DeFi users.
Contrarily, centralized financing makes fiat-to-crypto conversion or vice versa easy. This is primarily because CeFi services are regulated and have proper systems to tackle any kinks.
Both CeFi and DeFi are fundamental concepts that underly the cryptocurrency ecosystem. However, one cannot help but realize that DeFi is more popular than CeFi in certain aspects. In like manner, CeFi has the upper hand in specific areas.
For example, centralized finance is still a choice for many who want the care of customer relations agents and a high degree of reassurance regarding the safety of their funds. Additionally, CeFi services are necessary if you wish to enjoy the best of both worlds. On the other hand, DeFi is the hot new kid on the block, and many cannot wait to leverage its full potential.