Over the past century, the operations of money and financing have been largely centralized functions, overseen by banks, regulators and governments. In the wider economy, the ability to provide funds and facilitate transactions is under the supervision of central agencies and regulatory entities.
With the emergence of cryptocurrencies, the practices and operations of finance are being re-evaluated and disrupted by innovative and emerging approaches. Unlike fiat currencies, cryptocurrencies are typically not created by a central government, nor are the ongoing operations of cryptocurrency systems controlled by a government.
There are currently two popular methods of managing cryptocurrency transactions: centralized finance (CeFi) and decentralized finance (DeFi). CeFi is similar to traditional forms of centralized finance, with banks and exchanges managing currency and transaction flows. DeFi enables peer-to-peer trading without the need for a central exchange. CeFi and DeFi have some similarities and have their own pros and cons.
What is centralized finance?
CeFi is a method in the cryptocurrency market that handles the purchase, sale, and trading of cryptocurrency tokens through a centralized exchange.
CeFi is the cryptocurrency marketplace’s equivalent of how traditional stockbrokers and investment firms handle fiat currency and stock trading on public stock markets. Unlike fiat currency stock trading, CeFi is not strictly regulated globally, but Western economies including the United States and Europe have relevant regulations1.
CeFi often requires “know your customer” (KYC) compliance, i.e. confirmation of a user’s identity before they can start using a centralized exchange. By verifying user identity, KYC attempts to help prevent tax evasion, money laundering and terrorist financing2.
In the CeFi model, asset custody is handled by a central exchange that executes transactions. As part of asset management, CeFi exchanges hold the private keys to cryptocurrency wallets and have access to cryptocurrency tokens on the blockchain. Central exchanges are partly responsible for the safety, security, and timely execution of transactions, and for properly reporting this to users. Central exchanges in the CeFi model may charge fees and transaction fees for executing transactions, including buying, selling, trading, and converting tokens3.
CeFi exchanges are also often active in cross-chain bridging operations, enabling users to switch from one cryptocurrency token to another4. For many users, a CeFi-based approach is also the first entry point into the cryptocurrency market, as CeFi exchanges enable users to purchase cryptocurrency tokens with fiat currencies5.
The ability to perform margin trading and provide loans directly is also relevant to the CeFi model.
Advantages of CeFi
Customer Service: Customer service is part of the support many CeFi cryptocurrency exchanges offer their users.
Fiat Currency Conversion: CeFi exchanges can convert fiat currencies into cryptocurrencies.
Cross-chain support: CeFi provides a cross-chain exchange mechanism for multiple cryptographic tokens.
Margin trading: Some CeFi exchanges allow users to trade using margin accounts, where a portion of the value is loaned to the user with interest.
Income: CeFi offers the possibility of interest income on assets.
Disadvantages of CeFi
Escrow: Funds are held outside of the user and may be at risk of being stolen, frozen or confiscated.
Regulatory Risk: There are potential risks of regulatory compliance, which could result in service interruptions, fines or closures.
Accounting: Accounting and reconciliation are all handled by CeFi, rather than entirely implemented through code in smart contracts, which can be subject to errors, delays, or opacity.
Examples of CeFi
Examples of CeFi companies include:
Binance: One of the world’s largest cryptocurrency exchanges, offering trading, lending, savings, and other services in multiple cryptocurrencies and fiat currencies.
Coinbase: One of the largest cryptocurrency exchanges in the United States, offering trading, custody, wallets and other services for multiple cryptocurrencies and fiat currencies.
Gemini: A U.S.-based cryptocurrency exchange that provides trading, custody, wallets, and other services for multiple cryptocurrencies and fiat currencies, featuring security and compliance.
Kraken: A U.S.-based cryptocurrency exchange that offers trading, margin trading, options trading, and other services in multiple cryptocurrencies and fiat currencies.
Nexo: A cryptocurrency lending platform that provides instant loans and interest income based on crypto asset collateral.
What is decentralized finance?
With DeFi, cryptocurrency transactions—including buying, selling, lending, and payments—can take place peer-to-peer.
DeFi takes a different approach to cryptocurrency trading than its cousin CeFi. In DeFi, there is no central exchange that holds custody of assets. Instead, individual traders secure assets by controlling private keys. Users do not need to rely on a central authority to execute transactions, but instead adopt a smart contract-based approach, which generally runs on the Ethereum blockchain.
While DeFi strives to eliminate any form of centralized control, it does use decentralized exchanges (DEX) to help facilitate the operation of cryptocurrencies. The purpose of a decentralized exchange is not to act as an institution for executing trades, but to help enable the flow of trades. A related concept is decentralized applications (dApps), which can also be used to help smart contract-based applications implement DeFi use cases.
In DeFi, model fees typically associated with financial services transactions are eliminated because the model is decentralized and there is no central authority charging service fees.
Advantages of DeFi
Trustless transactions: DeFi automatically executes transactions through smart contracts without relying on third-party institutions or intermediaries. This reduces transaction costs, improves transaction efficiency, and avoids fraud and censorship.
Asset control: DeFi allows users to fully control their assets instead of being stored in centralized financial institutions. Users can access and use their assets anytime, anywhere without restrictions or risks.
Inclusiveness of financial services: DeFi breaks the geographical and identity restrictions of traditional finance, allowing anyone to participate in and enjoy financial services. DeFi provides greater opportunity and choice to the billions of unbanked people around the world.
Innovation of financial products: DeFi uses the programmability of blockchain and smart contracts to create a variety of financial products and services, such as stable coins, lending platforms, exchanges, derivatives, insurance, oracles, etc. DeFi makes financial markets richer and more diverse.
Openness of the financial ecosystem: DeFi is built on open source and transparency, and anyone can participate and contribute. The various components of DeFi can collaborate and combine with each other to form a decentralized financial network. DeFi promotes collaboration and competition in finance.
Disadvantages of DeFi
Complexity: DeFi models rely on complex algorithms and smart contracts, which may contain loopholes, errors, or incompatibilities.
Security: DeFi systems have become a priority target for attackers, which can result in funds being lost, stolen, or locked.
Volatility: Since there is no central authority, volatility can be an issue, potentially leading to wild price swings, illiquidity, or failed trades.
Customer Service: Since the technology is primarily driven by algorithms rather than humans, there is no customer service and users are left to resolve issues on their own.
Examples of DeFi
Examples of DeFi companies include:
1inch Network: A decentralized trading aggregator offering the best trading prices and liquidity across multiple cryptocurrencies and fiat currencies.
MakerDAO: A decentralized stablecoin platform that provides decentralized USD (DAI) and interest income based on crypto asset collateral.
PancakeSwap: A decentralized exchange based on Binance Smart Chain that provides trading, liquidity mining and other services in multiple cryptocurrencies and fiat currencies.
Stargate Finance: A decentralized lending platform that provides instant loans and interest income based on crypto-asset collateral.
Uniswap: An Ethereum-based decentralized exchange that provides trading, liquidity mining, and other services for multiple cryptocurrencies and fiat currencies.
Similarities between Centralized Finance and Decentralized Finance
Although CeFi and DeFi differ in their approach to cryptocurrencies, the two models also share considerable similarities.
Both DeFi and CeFi rely on blockchain technology as the fundamental foundation for their operations. With blockchain at its core, both methods are commonly used to provide a variety of cryptocurrency-related financial services. At their core, both DeFi and CeFi enable individuals to perform a series of common basic operations, including the ability to buy, sell, and trade cryptocurrencies.
DeFi runs on Ethereum smart contracts, which are also available in CeFi use cases and come with permissions to help build, manage, and run the contracts. While it may be easier for regulators to impose different types of financial compliance measures on CeFi, it is also likely that CeFi profits will not escape the eyes of government tax authorities.
In addition, both CeFi and DeFi have considerable security risks. While DeFi is an easier target for attackers, attacks against CeFi also continue to occur. However, with CeFi, central authorities can and should do more to help ensure operational security.
Of course, there are some important differences between CeFi and DeFi, but they both share the same core underlying goal, which is to promote and facilitate the use of cryptocurrencies.
Summarize
CeFi and DeFi are two different but related trading models in the cryptocurrency market. They all utilize blockchain technology to provide various financial services and functions. The main difference between them is whether there is a central authority to manage and execute transactions. CeFi is closer to traditional centralized finance and offers advantages such as customer service, fiat currency conversion, cross-chain support, margin trading and income, but it also has disadvantages such as custody, regulatory risk and accounting. DeFi leans more toward decentralized finance, offering advantages such as custody, permissionless, anonymity, DApps, and fees, but also has disadvantages such as complexity, security, volatility, and customer service. Both CeFi and DeFi have their own examples and application scenarios, and users can choose the model that suits them based on their needs and preferences.
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