CeFi vs DeFi: Everything You Need to Know!

The financial industry is evolving rapidly, and two terms frequently heard nowadays are CeFi and DeFi. CeFi stands for "Centralized Finance," the traditional form of finance that has existed for centuries. This type of finance, which serves as the backbone of the global financial system, is typically managed by a central authority. Blockchain technology has given rise to a new financial sector known as Decentralized Finance (DeFi), which is not controlled by a single organization.

What is CeFi?

Centralized Finance (CeFi) resembles traditional finance (TradFi) due to users interacting with trusted intermediaries. However, they are not the same.

TradFi refers to legacy organizations that have existed for centuries and have recently shown interest in the digital asset space. In contrast, CeFi refers to digital asset companies that offer cryptocurrency-related products and services.

In centralized finance, the core principle underlying centralized exchanges (CEXs) in cryptocurrency is that all cryptocurrency trading orders are routed through a central exchange. Gate and Coinbase are two examples of CeFi companies. Users register on these exchanges and use the same platform for cryptocurrency trading. Additionally, these exchanges provide lending, borrowing, and margin trading services.

Although funds are stored on the exchange, they are beyond users' control and vulnerable to threats if the exchange's security procedures fail. As a result, various security system attacks have targeted centralized exchanges. Customers of centralized exchanges feel secure disclosing personal information and entrusting funds to these organizations because they believe central exchanges are trustworthy.

What is DeFi?

While CeFi customers trust intermediaries, DeFi eliminates intermediaries and replaces them with smart contract protocols.

The implementation of blockchains and their decentralized, permissionless features has led to the emergence of new implied currencies. One of the most powerful features of blockchain is the ability to transfer and trade financial assets without using trusted intermediaries. Moreover, decentralized finance, a new blockchain direction, focuses on developing financial technologies and services on top of ledgers using smart contracts.

DeFi allows peer-to-peer trading of financial products through blockchain-based decentralized applications (DApps). Applications built on existing blockchains such as Ethereum, BNB Chain, Tron, and Solana provide these products and services. The applications are created using smart contracts that govern the operation of the DeFi protocol.

Like CeFi and TradFi, DeFi provides trading, lending, and borrowing. However, there are several differences.

DeFi protocol operations are based on code, and non-custodial wallets can interact with DeFi protocols. Thus, they maintain full control over their crypto assets. Thirdly, there is no need to create an account or undergo KYC to use DeFi services.

DeFi vs CeFi: Comparing Different Properties

The most common properties of DeFi and CeFi are discussed in the section below.

1. Public verifiability

Although DeFi application code is not always open-source, its execution and byte-code must be publicly verified on the blockchain to be classified as non-custodial DeFi. As a result, unlike CeFi, any DeFi user can observe and verify that DeFi state changes are executed in a timely manner. This transparency gives the new DeFi technology an unparalleled ability to transfer trust.

2. Atomicity

A blockchain transaction allows for the execution of sequential actions that may include multiple financial transactions. This combination can be made atomic, meaning the transaction will complete all its actions or fail as a whole. CeFi lacks this programmable attribute of atomicity.

3. Custody

DeFi allows clients to directly control their assets at any time (no need to wait for the bank to open). However, with great power comes great responsibility. Users bear most of the technological risks unless such insurance is acquired. As a result, centralized exchanges, which are essentially similar to traditional custodians, are becoming increasingly popular for storing cryptocurrency assets.

4. Transaction costs

Transaction fees are crucial in DeFi and blockchains in general to prevent spam. However, since financial institutions in CeFi can rely on their customers' anti-money laundering (AML) checks, they can provide transaction services for free (or governments force them to offer some services for free).

5. 24/7 market time

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 typically has low liquidity for various commodities during these times.

6. Privacy

DeFi is only available on blockchains that use non-privacy-preserving smart contracts. As a result, instead of true anonymity, these blockchains provide pseudonymity. Since centralized exchanges with AML policies are often the only viable option for converting money into cryptocurrency assets, these exchanges have the right to disclose address ownership to law enforcement.

7. Arbitrage risks

Arbitrage between two decentralized exchanges on the same blockchain is risk-free due to blockchain atomicity, allowing traders to write a smart contract that performs arbitrage and rolls back if the arbitrage is not profitable. Arbitrage risk is comparable with CEX and hybrid exchange when arbitrage is carried out on two DEXs in different blockchains.

8. Inflation

Central banks retain the ability to create paper money in CeFi, and inflation is often measured by the cost of a representative basket of consumer goods known as the Consumer Price Index (CPI).

The supply of assets of several cryptocurrencies can be changed in the DeFi ecosystem. Bitcoin (BTC) is likely to face a dilemma where the supply has a hard cap, but the economic activity it needs to support does not, leading to currency scarcity. Moreover, without block rewards and, consequently, without inflation, Bitcoin and blockchains, in general, may be vulnerable to security instability. It is yet unknown whether BTC and other cryptocurrencies suffer from severe income inequality due to the paper system's inflation. There is no convincing evidence that cryptocurrencies solve this problem.

Pros and Cons of CeFi and DeFi

• CeFi:

Pros

Familiar: CeFi platforms operate similarly to traditional financial service providers. This means that most people find them familiar and easy to use.

Support for fiat-to-crypto exchange: You can easily buy cryptocurrency with local currency on a centralized crypto exchange. Depending on where they operate, CEXs accept various paper currencies.

Cons

Custody: CEXs control digital assets in their users' wallets/accounts as they own the private keys. Users may be denied access to their assets if the platform suspends withdrawals and deposits without these private keys.

Personal information required: To use a CEX, users must be willing to share personal information such as their names, residential addresses, national ID details, and selfie photos.

Lack of transparency: CeFi companies make decisions behind closed doors. As a result, users may not know about the trading practices they employ. Moreover, their systems operate off-chain, meaning exchange transactions are not recorded on the blockchain.

Restrictive: Due to location restrictions, CEXs may not be accessible to everyone. For example, some exchanges may not allow traders from certain (blacklisted) countries to trade on their platform. Some of these restrictions may be imposed as a result of regulatory requirements.

• DeFi:

Pros

Self-custody: Since users own the private keys, cryptocurrency users have control over their assets. This means no one can prevent them from accessing their funds.

Privacy: DeFi users find this easy to do as no personal information is required, and their wallet is not linked to their real identity.

Permissionless: Anyone with a wallet and internet connection can use DeFi products. There are no restrictions.

Transparency: DeFi transactions are publicly visible on the blockchain. This provides users with transparency.

Cons

Smart contract risk: Malicious actors can exploit smart contract vulnerabilities to steal crypto assets locked in a DeFi protocol.

Steep learning curve: DeFi protocols are new and unconventional. As a result, newcomers may need assistance in using or understanding them. This means people must first learn about DeFi and available products before interacting with them.

Scalability: DeFi protocols rely on the blockchains they are built on. As a result, they inherit the scalability issues associated with such blockchain networks. Low transaction throughput, which leads to high transaction fees in case of network congestion, is an example of scalability issues.

Which is Better?

This is based on various user requirements and what they are looking for. For instance, those who value financial sovereignty and privacy may prefer DeFi protocols, while institutional investors typically prefer regulated CeFi platforms. This may explain why CeFi and DeFi have coexisted for so long.