In the last decade, cryptocurrencies ushered in a new era in finance. It gave a fresh perspective to how money can be handled without going to traditional institutions, using an arcane technology called the blockchain. Now, when the world has started appreciating the prospect of crypto, it seems the debates have deepened into what is the best approach to manage it. In that context, DeFi and CeFi have been contemplated a lot in the last couple of years.
What is DeFi?
Decentralized Finance or DeFi refers to the financial applications built on blockchain and does not involve traditional exchanges. Think of lending, borrowing, or trading crypto on a platform that is open for all, globally accessible, and has a minimum barrier of entry. Giving people complete control and responsibility is the foundation of DeFi. Users manage their keys that provide access to their crypto and hence are solely responsible for their digital assets. As a result, no authority can enforce regulations or deny service for non-compliance. DeFi allows everyone to seamlessly access money regardless of where they are or who they are.
What is CeFi?
Centralized Finance or CeFi is predominant in today’s crypto ecosystem. It involves a central exchange handling your trades. Users create accounts to manage funds on these platforms. Here institutions store users’ funds in their custodial wallets and hold their private keys.
In addition, most of the CeFi service providers strive to adhere to local regulatory compliance requirements. Hence, customers have to mandatorily submit to the KYC and AML checks enforced by such trading platforms. Furthermore, the exchanges decide which coins to list and the trading fees to levy. Binance and Coinbase are a few of the most popular platforms that provide CeFi services such as lending, borrowing, and trading.
What Are the Differences Between DeFi and CeFi?
DeFi and CeFi are different in the ways they operate. CeFi works similar to the traditional finance ecosystem where central entities wield control and authority. Crypto exchanges decide which customers to entertain and who to keep out. They act as custodians to users’ funds and access keys. Furthermore, they decide when people can withdraw their funds, at times even dictating the withdrawal limits. Despite the restrictions, with CeFi, users are often assured of having necessary provisions in place to protect them from losses.
On the contrary, DeFi platforms and protocols are entirely permissionless, making them open for anyone to use. DeFi gives users the power to manage their money and keys on their own without relying on any central authority. Though it sounds liberating, one should pay heed to the accompanying risks. Users bear full responsibility for their assets and keys. Lost keys or mistyped wallet addresses mean the irrevocable loss of assets as there is no fallback option.
Laws of the jurisdiction govern the CeFi platforms. In order to operate, they need to comply with the local KYC and AML regulations. As a result, they mandate thorough compliance checks for users to avail their services. Hence, users are compelled to share their personal information with CeFi exchanges.
Unlike CeFi, DeFi makes it easier to hop to the platform. There are practically no barriers of entry, which makes it an open and accessible solution, especially for those who are left out of the financial ecosystem – the unbanked.
Trust and Transparency
In CeFi, users trust exchanges and custodians to manage their funds. People behind these platforms are generally known individuals, and the companies are usually registered. As a result, they can be held accountable and responsible for customers’ money.
On the other hand, with DeFi, users trust Smart Contracts to execute the services as advertised. The transparency of the DeFi ecosystem allows users to audit the code behind the service, and hence there is less uncertainty on what happens behind the scenes. The openness of the system is what makes it trustworthy. One thing to consider, however, is there is no recourse if users fall prey to shady platforms or vulnerabilities in the code.
CeFi exchanges are more flexible when it comes to converting one crypto to another or exchanging fiat and crypto. They enable seamless cross-chain crypto swaps by holding custody of the assets on multiple blockchain platforms. Similarly, CeFi provides easy on- and off-ramps for fiat conversions since central entities are vital to facilitate the transfers.
DeFi platforms, however, are attempting to circumvent the inadequacies by being innovative. They are coming up with wrapped tokens whose value is pegged to the original cryptocurrency to enable users to access crypto without owning them directly.
In conclusion, today, the CeFi ecosystem is more prolific than DeFi and is far more well established. But, the DeFi industry is growing at a staggering pace, with innovative platforms striving to bridge the gap between DeFi and CeFi. Each system has its own merits and risks to be considered, and investors have to wisely choose the right platform for them by weighing them with caution.