CeFi vs DeFi
The world of finance has become increasingly dynamic with the rise of technological innovation. There are disruptive financial models emerging almost every day putting pressure on the systems we consider normal; to either adapt or get left behind. With the recent rise to the power of blockchain technology and the advancement of the Web 3.0 ecosystem, has opened the door for new alternatives to existing financial services with the benefits of increased transparency and control, whilst decreasing reliance on the systems we know.
Navigating the ecosystem over the past few years has been quite challenging, and centralized financial exchanges within the crypto ecosystem have most certainly dominated asset transfer and trading by quite some margin. However, with the rise in popularity of layer 1s such as Ethereum, as well as dApps, Decentralized Finance (DeFi) activity is on the rise. It’s important to know the benefits and disadvantages of both Centralized Finance (CeFi) and DeFi, and how to optimally navigate the ecosystem with the most control of your assets.
CeFi, and more specifically centralized exchanges (CEXs), are definitely responsible for bridging the initial gap between the traditional world and crypto asset transfer thus far. CEXs are essential for on-ramping and off-ramping fiat, and one cannot add exposure without a middleman at this stage. CEXs are essentially the same as a bank, with the service of providing access to crypto assets and allowing both spot and leverage trading. Their model is a fee-based one. Exchanges may have fees for on-ramping and off-ramping fiat. There are also fees on trades (maker and/or taker fees). All funds on the exchanges are managed by the specific CEX, which ultimately gives meaning to the saying, “not your keys not your coins.” Although this is essentially the same as all traditional banking institutions, crypto assets have the ability to be stored privately, and keeping assets on exchanges adds unnecessary risk to your portfolio. This opens up users to exposure as a result of the exchanges getting hacked, becoming insolvent and other potential mismanaged activities. CEXs also have the power to halt trading and various other functions meaning cutting off access to your funds and services without your input. This being said, when you use a CEX, you need to utilize the exchanges with the best reputations, as well as liquidity in order to best serve your needs.
DeFi is best described as allowing users access to financial and banking services via blockchain technology without the use of a middleman. There is no centralized service involved, and the majority of the services in the various ecosystems run on smart contracts that are built on top of these platforms. The objective of DeFi is to create a fair and transparent financial system that is open-source and permissionless. Most layer 1s have shifted to a proof-of-stake system, meaning the tokens staked on the platform allow for blocks to be generated and to achieve consensus. DeFi allows users to store their assets, borrow, lend, and create liquidity pools and yield farms on various platforms. Decentralized wallets allow users to access these specific features by:
- Storing Native Layer 1 and Layer 1 derivative tokens (Layer 2), NFTs
- Interacting on the blockchain (authorizing use through signing permissions on Dapps, navigating Dapp functions, Liquidity pools, etc)
- Sending tokens to other wallets
- Fee Optimization — otherwise known as gas costs (slow, average, fast, and custom)
The most important concept of DeFi is that it allows you to have full control over your assets and own the keys for your wallet. This is known as “self custody” and the protocols (DEXs, marketplaces, etc.) you interact with are therefore “non-custodial”. This creates the potential for less friction points between the service provider and the end user. This is especially visible in the crypto ethos “not your keys, not your coins” that’s heavily touted especially as a reminder to newcomers when interacting with centralized exchanges, as those services should be seen as a way of swapping and exchanging assets, rather than a long term storage solution.
Differences between CeFi and DeFi
While CeFi and DeFi both aim to increase the adoption of blockchain technology, there are distinguishable, fundamental differences between the two. The main difference between centralized and decentralized finance is the element of control. DeFi gives users complete control over all assets and their related activities. However, this comes with technical challenges that often result in users not being able to navigate the user interface efficiently, as well as giving them sole responsibility for their private keys. Essentially, there is no safety net for users if they lose their keys. Centralized exchanges have years of prioritizing user experience, making navigating their platform more efficient. Centralized platforms will always act as middlemen to user assets and they are seen as easy alternatives for trading and managing cryptocurrencies as long as they are reputable.
Defi users have, for the most part, anonymity with regard to activity on the blockchain. The majority of centralized exchanges have Know-Your-Customer requirements. For most users, this doesn’t pose too much of a problem, but in the spirit of true decentralization and protecting your data, this begets an issue. Privacy of information, especially in the modern era where data is shared and stored by major companies, is a vital and key component of utilizing blockchain technology and should be protected at all costs.
Decentralized finance has ultimate transparency over all transactions due to the nature of blockchain technology. Centralized exchanges operate under a traditional company structure, bound by confidentiality and privilege, and are subject to whichever jurisdiction they report to. However, what this has allowed centralized exchanges to do is secure multiple partnerships, and amass a large number of users that have increased the availability of tradable assets (multi-chain assets) and the liquidity associated. Trading on decentralized exchanges is a bit more tricky as liquidity depends on the liquidity pools provided by other users, and increases asset volatility.
The major advantage of utilizing the services of a centralized exchange is the ability to on and offramp fiat efficiently under regulatory scrutiny. There are currently options in DeFi that require a middleman but are less historically vetted. Needless to say, this may be an option new projects will start pursuing as DeFi becomes more and more popular to cut out the need for Centralized exchange competitors.
Both Centralized and Decentralized Finance aims to achieve the same goal. They plan to make crypto trading popular, improve the trading volume and achieve mass adoption. However, the way these two ecosystems carry out their objectives is different.
CeFi promises security of funds and fair trading on those funds. CeFi exchanges also provide users with various customer support services that DeFi services do not offer. On the other side, DeFi wants to make the crypto space intrusion free. It provides a space for investors to implement their strategies through utilizing smart contract protocols, without having to deal with a middleman.
Both of these models have their pros and cons. It depends on the investor and their needs. If you prefer transparency and privacy, DeFi serves your needs in a better way. CeFi involves trusting the exchange and sharing of risks, but it also allows flexibility and increased options for trading and investing. Being able to utilize the benefits of each financial service area can create an efficient user experience whilst preserving security and privacy components best suited to one’s investment strategy.