DeFi vs CeFi: What is the difference between decentralized and centralized finance?



There are some similarities between DeFi and CeFi, but they are not the same. In this guide, you'll learn about the differences between DeFi and CeFi.

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Decentralized vs centralized finance


Customers are frequently unaware of the underlying rules or agreements that govern financial assets and goods, so the traditional centralized finance (CeFi) ecosystem may appear mysterious to non-experts.


Decentralized Finance (DeFi), on the other hand, is making a name for itself as an ecosystem that promises transparency and control, thanks in part to the underlying integrity-protected blockchain, as well as higher financial asset yields than CeFi platforms. However, the distinction between CeFi and DeFi is not always clear.


This article discusses how DeFi differs from CeFi in terms of legality, security, economics, privacy, and market manipulation.


What is CeFi and how does it work?


Centralized finance was invented several thousand years ago in ancient Mesopotamia. Since then, humans have used livestock, land, and cowrie shells as currency, as well as precious metals (such as gold, which has near-universal cultural acceptance as a store of value) and, more recently, fiat currencies.


As a result, it has been demonstrated that a currency can have intrinsic value (such as land) or an imputed value (fiat currency). All known attempts to build an everlasting, stable currency and finance system were based on the concept of a centralized institution, such as a government supporting a currency's financial worth and commanding a military force. But what does CeFi mean in the context of cryptocurrency?


Under centralized finance, the primary principle underlying centralized exchanges (CEXs) in crypto is that all crypto trading orders are routed through a central exchange. Binance, Coinbase, and Kraken are examples of CeFi companies. Users register with these exchanges and use the same platform to send and receive tokens. But that's not all. In addition to cryptocurrency trading, these exchanges provide lending, borrowing, and margin trading.


Despite the fact that funds are housed on the exchange, they are kept outside of users' control and are vulnerable to threats if the exchange's security procedures fail. As a result, various security attacks have targeted centralized exchanges. Customers on centralized exchanges feel safe disclosing personal information and entrusting funds to these organizations because they believe central exchanges are trustworthy.


Furthermore, large exchanges have entire departments staffed with customer service representatives to assist customers. Customers are given a sense of security when they receive excellent customer service, assuring them that their finances are in good hands.


What is DeFi and how does it work?


New imputed currencies have emerged as a result of the introduction of blockchains and their decentralized, permissionless features. One of the blockchain's most powerful features is the ability to transfer and trade financial assets without the use of trusted intermediaries. Furthermore, decentralized finance, a new blockchain subfield, focuses on developing financial technology and services on top of ledgers using smart contracts.


DeFi uses cryptocurrencies and smart contracts to provide services without the use of intermediaries. In today's financial world, financial institutions act as transaction guarantors. Because your money is routed through these institutions, they wield enormous power. Nonetheless, in DeFi, the financial institution is replaced in the transaction by a smart contract.


Most CeFi products, including asset exchanges, loans, leveraged trading, decentralized governance voting, and stablecoins, are compatible with DeFi. However, the number of goods available is constantly increasing, and some of the most complex products, such as options and derivatives, are also evolving at a rapid pace.


DeFi also has three distinguishing features: transparency, control, and accessibility. A user can examine the specific rules that govern the operation of financial assets and goods in DeFi. DeFi, for example, strives to eliminate private agreements, back-deals, and centralization, all of which are significant barriers to CeFi transparency.


DeFi empowers its users by allowing them to remain the custodians of their assets, which means that no one should be able to censor, move, or destroy their assets without their consent. DeFi goods can be designed and deployed by anyone with a good computer, an internet connection, and a little know-how. At the same time, the blockchain and its distributed network of miners handle the DeFi software's actual operation.


DeFi vs. CeFi: Various properties compared


The following section discusses the most common DeFi vs CeFi properties.


Public verifiability


While DeFi application code is not always open source, its execution and bytecode must be publicly verifiable on a blockchain in order to be classified as non-custodial DeFi. As a result, unlike CeFi, any DeFi user can witness and confirm the orderly execution of DeFi state changes. Because of this transparency, the new DeFi technology has an unrivaled ability to transmit trust.


Atomicity


A blockchain transaction allows for the execution of sequential actions, which may include several financial transactions. This combination can be made atomic, which means that the transaction will either complete all of its activities or fail as a whole. While CeFi lacks this programmable atomicity attribute, expensive and time-consuming legal agreements could be used to enforce atomicity.


Anonymous development and deployment


Centralized finance transactions are less anonymous than DeFi transactions. Many DeFi projects are created and managed by anonymous teams, and the founder of Bitcoin is still unknown to this day. Once installed, the DeFi smart contracts are operated implicitly by the miners. Anonymous DeFi applications can operate without a front-end, forcing users to interact with the smart contract directly.


Custody


Unlike CeFi, DeFi enables customers to directly control their assets at any time (there is no need to wait for the bank to open). However, great power comes with great responsibility. Users bear the majority of technological risks unless such insurance is purchased. As a result, centralized exchanges, which are essentially the same as traditional custodians, are becoming increasingly popular for storing cryptocurrency assets.


Trading of crypto assets


CEXs are based on the same principles as their traditional counterparts. Limit order books are off-chain records kept by CEXs of outstanding orders posted by traders. DEXs, on the other hand, operate in a very different manner, matching the counterparties in a transaction using automated market-maker (AMM) protocols. AMMs use mathematical algorithms to determine prices based on transaction volumes.


Execution order malleability


Users of permissionless blockchains frequently openly share the transactions they intend to complete through a peer-to-peer network. Because there is no persistent centralized entity ordering transaction execution, peers can engage in transaction fee bidding contests to steer the transaction execution order. Many market manipulation tactics have been demonstrated as a result of this order malleability, and are now commonly used on blockchains.


On the contrary, CeFi regulatory bodies impose stringent requirements on financial institutions and services, such as how transaction ordering must be implemented. This is possible, however, due to the centralized nature of CeFi's financial intermediaries.


Transaction costs


Transaction fees in DeFi, and blockchains in general, are critical for preventing spam. However, because financial institutions in CeFi can rely on Anti-Money Laundering (AML) verifications of their clients, they can choose to provide transaction services at no cost (or are compelled by governments to offer some services for free).


Non-stop market hours


Outages are a common occurrence in CeFi markets. The New York Stock Exchange and the Nasdaq Stock Exchange, for example, are the two main trading venues in the United States, with hours of operation ranging from 9:30 a.m. to 4:00 p.m. Eastern Time, Monday through Friday.


Because blockchains are nonstop, most, if not all, DeFi markets are open 24 hours a day, seven days a week. As a result, DeFi lacks pre- and post-market trading, whereas CeFi has generally thin liquidity on a variety of goods during these times.


Privacy


DeFi is only available on blockchains that use non-privacy-preserving smart contracts. As a result, rather than true anonymity, these blockchains provide pseudo-anonymity. Because centralized exchanges with AML policies are frequently the only viable option for converting money to cryptocurrency assets, these exchanges have the authority to reveal address ownership to law enforcement.


Arbitrage risks


To avoid the risk of price swings, an arbitrage should ideally operate atomically. Arbitrage on centralized and hybrid exchanges is inherently vulnerable to market price swings unless arbitrageurs collaborate with exchanges to ensure execution atomicity.


Arbitrage between two decentralized exchanges on the same blockchain can be considered risk-free when transaction fees are ignored. This is due to the atomicity of the blockchain, which allows traders to write a smart contract that performs the arbitrage and reverts if the arbitrage does not yield a profit. Arbitrage risk is comparable to that of a CEX and hybrid exchange when two DEXs on separate blockchains are arbitraged.


Inflation


Inflation is the depreciation of an existing currency supply as a result of the addition of new supply. While inflation is defined as the loss of purchasing power of a currency, the relationship between supply and inflation is not always clear; sometimes, the money supply increases without causing inflation.


In CeFi, central banks retain the ability to create fiat money, and inflation is frequently measured against the value of a representative basket of consumer goods, also known as a consumer price index.


In the DeFi world, the asset supply of several cryptocurrencies is subject to change. Bitcoin (BTC) eventually is likely to run into the dilemma where supply has a hard cap — while the economic activity it has to sustain does not have a cap — leading to a scarcity of currency. Moreover, Bitcoin, or blockchains in general, without a block reward and thus no inflation, may be vulnerable to security instabilities.


It remains to be seen whether BTC and other cryptocurrencies suffer from severe income disparity due to the fiat system's inflation. There is no solid evidence that cryptocurrencies fix this problem.


Cross-chain services


CeFi services are frequently used to trade BTC and other major coins generated on independent blockchains. Due to the complexity and time required to complete atomic cross-chain exchanges, DeFi services typically do not support these tokens.


CeFi services address this issue by storing funds from multiple chains (whereas decentralized services require that tokens follow Ethereum token standards to achieve interoperability).


Because many of the most valuable and frequently traded coins exist on separate blockchains and do not follow interoperability rules, CeFi has a significant advantage.


Fiat conversion flexibility


Centralized services are typically more flexible than decentralized services when it comes to converting money to Bitcoin and vice versa. Because converting fiat to cryptocurrency requires a centralized institution, most DeFi providers do not provide fiat on-ramps. Furthermore, customers can be onboarded significantly faster in CeFi, contributing to a better customer experience.


The table below summarizes the differences between DeFi and CeFi:

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Synergies between CeFi and DeFi


DeFi is still in its early stages. Because of the blockchain settlement layer, DeFi, like CeFi, has unique characteristics such as transparency, non-custody, and decentralization. The blockchain, on the other hand, limits DeFi's transaction throughput, confirmation latency, and privacy.


DeFi continues to rely heavily on the established financial system. Notably, the value of crypto-assets on DeFi is still determined and recognized primarily in fiat currency. Because their value is linked to fiat currency, stablecoins are among the most widely used crypto-assets. Only central banks are permitted to issue central bank money, as stated at the outset of this article.


As a result of DeFi's reliance on fiat currency, central banks are rendered obsolete, at least for the time being.


CeFi lending platforms serve as a conduit between the traditional monetary system and the cryptocurrency market. Users can use these services to borrow fiat money (rather than fiat-pegged stablecoins) and use their crypto holdings as collateral.


These platforms are run by well-known companies that act as counterparties for both depositing and borrowing customers. As a result, these companies are frequently referred to as crypto banks.


Furthermore, DeFi and CeFi share the same goal: to provide customers with high-quality financial goods and services while also powering the economy. To summarize, both DeFi and CeFi have advantages and disadvantages, and there is no simple way to combine the best of both systems.


As a result, we believe that these two distinct but intertwined financial systems will coexist and mutually benefit. A few synergy prospects are highlighted in the section below.


Bridges


Financial institutions are connecting DeFi and CeFi to improve their efficiency. Oracles such as Chainlink transport CeFi data to DeFi; Synthetix enables users to trade CeFi financial instruments as DeFi derivatives; and the Grayscale Bitcoin Trust enables users to trade Bitcoin on the CeFi OTC market.


DeFi as an innovative addition to CeFi


DeFi protocols do more than just mimic basic CeFi services; they also optimize them for the unique properties of blockchains. In DeFi, for example, a new exchange mechanism known as AMM has replaced CeFi's well-known order-book architecture.


A smart contract that accepts assets from liquidity providers is known as AMM. As a result, rather than dealing with liquidity providers directly, traders trade against the AMM smart contract. Transaction costs are reduced because the AMM design involves fewer contacts with market makers than a CeFi order book.


CeFi, for its part, is following suit. As a result of the AMM concept, centralized exchanges (such as Binance) began to offer market-making services. Certain CeFi markets, such as foreign exchanges, have used a combination of the AMM model and human interaction and are well-positioned to enter the DeFi market-making industry, whereas existing DeFi markets are not. AMM providers may use some CeFi approaches to reduce their clients' exposure to arbitrageurs.


Lesson for CeFi: DeFi collapse


On March 12th, 2020, the cryptocurrency market crashed, with the price of ETH falling by more than 30% in less than 24 hours. On May 19th, 2021, the price of ETH dropped by more than 40%. In CeFi markets, the Dow Jones Industrial Average fell by 9.99 percent, earning the moniker "Black Thursday" (but with less dramatic daily moves).


CeFi and DeFi were both extremely stressed during the crashes. Centralized exchange systems were disrupted as a result of unusually high trading activity (for example, Coinbase paused trading for almost an hour, and exchanges were momentarily shut down after exceeding pre-determined daily movement limitations). Similarly, the price of gas on Ethereum (ETH) has skyrocketed, with a standard ETH transfer now costing more than a hundred dollars.


As a result of the increased network load, the MakerDAO liquidation bots failed in February 2020, delaying the confirmation of users' transactions. DeFi services, unlike CeFi, are technically always available due to the distributed nature of blockchains. In the aforementioned extreme scenarios, DeFi systems become prohibitively expensive for the majority of users. Since then, there has been a greater focus on the resilience of DeFi protocols.


Despite the fact that CeFi and DeFi have different settlement processes and user behaviors, CeFi could benefit greatly from DeFi's stress tests. While CeFi relies on circuit breakers to mitigate excessive asset volatility (markets stop trading when volatility exceeds specified levels), DeFi appears to have avoided such disruptions thus far, which may help CeFi better understand its boundaries.












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