DeFi vs. CeFi – How Decentralized Finance Is Different From Centralized Finance?

Since the customers are usually not aware of the rules and agreements integrated with the traditional Centralized Finance (CeFi) protocol that may make it mysterious to them.

On the other hand, Decentralized Finance (DeFi) is making its place in the market by claiming to provide control and transparency to the users. It offers an opportunity for the traders to earn a higher yield than the traditional CeFi in addition to protecting the blockchain network.

However, there is no significant boundary chalked between DeFi and CeFi. Here is a detailed guide article that will help readers understand the concept and workings of DeFi and CeFi. Moreover, it will also explain the legal, security, economic, and market impacts of both protocols.

What is CeFi?

Centralized finance was invented a thousand years back in ancient Mesopotamia. After its inception, different goods and assets have been used by people as currency. These goods included land, livestock, precious metals such as gold, platinum, silver, etc., cowrie shells, or fiat currency in the most recent times.

This gave rise to the concept of assigning value to a particular currency. An asset such as land can also be given an intrinsic worth, or any fiat currency can also be used with an imputed value. The concept of the centralized institution, such as a government giving orders to a military force or deciding the worth of a currency, etc., provided the idea of developing a stable and eternal financial system.

How Does CeFi Work?

In crypto, a central exchange operating under centralized finance is used to carry out all trading orders. This is the main principle behind the development of centralized exchanges (CEXs). Kraken, Coinbase, and Binance are some of the most commonly CeFi companies. The users use these platforms to send and receive tokens after creating their accounts with these exchanges.

Apart from crypto trading, there are various services offered by these exchanges to their customers that may include margin trading, borrowing, lending, etc.

Although the users deposit their funds on the exchange, they have no control over them and are prone to any threat in case the security mechanism of the exchange fails to protect them. This is why various scammers have attacked these centralized exchanges in the past.

Usually, the customers have no issues revealing their credentials connected with these centralized exchanges and considering them trustworthy. Thus, they provide custody of their assets and funds to these platforms.

In addition, the exchanges operating at larger scales also facilitate their customers with their trained customer service staff. They take their customers in confidence and assure them that their funds are safe by providing them with a sense of safety.

What is DeFi?

Several new imputed currencies have come forward after the inception of blockchain technology in the crypto space and their permissionless and decentralized nature. One of the most powerful features of blockchain technology is the trade and transfer of finances without any involvement of mediating bodies.

The new sub-division of blockchain technology is decentralized finance. The main aim of this technology is to develop services and features by using smart contracts on top of ledgers. By using smart contracts and crypto assets, the benefits of DeFi can be accessed easily without any involvement of mediating bodies.

How Does DeFi Work?

In the present financial world, financial institutions operate as supporters of transactions. These institutions have a significant influence over the funds as they pass through them. In the decentralized network, a smart contract in the transaction replaces the role of a financial institution.

There is a lot of compatibility between CeFi products and DeFi that may include stablecoins, decentralized governance voting, leveraged trading, loans, and asset exchanges. But the number of goods offered by the protocol is multiplying with the evolving number of options and derivatives.

In addition, there are three distinct characteristics of DeFi that may include accessibility, control, and transparency of the system. The regulations that are used for governing financial assets and goods can be examined by the user. The system is constantly striving to remove critical barriers to CeFi, such as the elimination of private agreement protocols, centralization of power, and back deals.

Using the DeFi protocol, the users are the custodians of their assets and provide control to the user. Therefore, without their consent, no one can move, destroy or censor their assets and funds.

DeFi goods can be deployed and designed by anyone having a desktop device and a good internet connection. However, the actual operations of DeFi are handled by the distributed network of miners all over.

Comparison Between Various Properties of CeFi and DeFi

Here are some of the most distinct and prominent properties of CeFi vs. DeFi mentioned below.

  • Public Verifiability

It is not mandatory that the application code in DeFi will be open source always. However, to be categorized as a non-custodial DeFi, it is necessary that its bytecode and execution can be verified publicly.

Therefore, contrary to the traditional CeFi system, any user can verify and observe the proper execution of a transaction using the DeFi protocol. This feature of DeFi provides transparency to the system and builds user confidence.

  • Atomicity

Different sequential actions, such as various financial transactions, can be performed using blockchain. However, one can think of this combination as an atomic phenomenon. It means that the transaction will be either completed after fulfilling all the tasks or will collectively fail due to a minor inconvenience.

On the other hand, the CeFi protocol lacks this feature. However, legal and expensive agreements can be used to add atomicity to CeFi.

  • Anonymous Development and Deployment

The transactions in decentralized finance are more anonymous than the transactions in centralized finance. A number of unknown teams create and manage various DeFi projects, as no one actually knows about the founder of Bitcoin to date.

After successful installation, miners can efficiently operate DeFi smart contracts. The users can also engage directly with the smart contracts as these DeFi applications are functional without any front end.

  • Custody

Compared to CeFi, the customers have direct control over their assets using DeFi. They can have access to their funds and assets without waiting for the banks to open and entertain them. However, there is a lot of responsibility integrated with such colossal power. Most technical flaws are usually absorbed by the users unless they affirm any insurance.

Therefore, centralized exchanges having the same function as traditional banks, are primarily used by customers to keep their assets safe.

  • Crypto Trading

The foundation of centralized exchanges is the same as other centralized beneficiaries. The off-chain records of the special orders that are posted by traders and kept with the centralized exchanges are known as limit order books.

On the contrary, decentralized exchanges are entirely different in function. They match the counterparties involved in the transaction through the automated market maker protocol. Using mathematical algorithms, the users predict the prices by AMM that fluctuate with the volume of transactions.

  • Execution Order Malleability

When the transactions are carried out on blockchains without permission, they are usually shared by the users who deploy them. This is done by the peer-to-peer network. As there is no central authority that can order the execution of a transaction, therefore, the transactions can be steered by the peers undertaking the transaction fee in bidding contests.

This malleable behavior has enabled the user to demonstrate several manipulation techniques in the market and has also been applied to blockchain networks.

On the other hand, in centralized finance, specific rigid requirements are applied to the services and financial institutions by the regulatory authorities, such as the proper implementation of transaction orders. Only the centralized nature of intermediate bodies involved in CeFi has made it convenient for the users.

  • Transaction Charges

In order to avoid spam, transaction charges are essential in both DeFi and blockchain networks. However, some of the CeFi-operated financial institutions offer transaction services free of cost because they can depend on the Anti-Money Laundering (AML) verifications of their customers.

Sometimes, these institutions are also forced by the governing bodies to offer some of their services free of cost to their clients.

  • Continuous Market Hours

CeFi markets usually experience outages that make it notorious for users. The Nasdaq Stock Exchange and The New York Stock Exchange are a few of the very famous trading hubs in the US. These exchanges work from 9:30 am to 4:00 pm, five days a week.

On the contrary, most DeFi markets are open the whole week throughout the day because of the continuous nature of the blockchain network. However, this makes it difficult for the DeFi markets to carry out activities before and after the trading process compared to CeFi, which provides quite reasonable liquidity to the traders during these intervals.

  • Privacy

Blockchain networks that contain smart contracts with non-private settings can be found in decentralized finance. This provides these blockchains with partially anonymous characters instead of complete anonymity.

However, the centralized exchanges operating on AML policies and regulations can be used practically to convert funds into crypto assets. The ownership of the assets can be revealed by these exchanges to the law-enforcing bodies if needed.

  • Arbitrage Risks

To avoid any price fluctuations, it is preferred for the arbitrage to behave atomically. Suppose the exchanges and the arbitrageurs collaborate to ensure the execution of atomicity. In that case, it can provide direct exposure to the arbitrage on hybrid and Centralized exchanges to the fluctuation in market prices.

Moreover, when two decentralized exchanges are built in the same blockchain network, and transaction charges are ignored, the arbitrage between them can be considered free of threat. The atomicity feature of the blockchain allows the traders to compose smart contracts responsible for performing the arbitrage. Moreover, if the profit is not returned, the arbitrage can be reverted too.

The arbitrage threat is comparable to a centralized and hybrid exchange when two different decentralized exchanges are arbitraged on separate blockchain networks.

  • Inflation

When a new currency is supplied in the market, and the value of the existing ones depreciates, it is known as inflation. When a currency loses its purchasing power, the condition is also called inflation. However, the relationship between inflation and supply is never made clear. In some situations, without any inflationary conditions, the supply of a currency increases.

The control for the production of fiat money in centralized finance is with the banks. And the representative collection of consumer products, usually known as the consumer price index, determines the market inflation rate.

On the other hand, in decentralized finance, the asset supply of different cryptocurrencies is subject to change. The cryptocurrencies such as Bitcoin may face a challenging situation where the supply of the currency is limited while the economic crisis required for sustainability is unfavorable. This eventually leads to the scarcity of the coin in the market.

In addition, security issues may arise for Bitcoin or blockchains that do not offer any reward or inflationary condition. However, it is still to be discovered whether inflation in the fiat system can cause an income disparity for cryptocurrencies, as there is no proper evidence that crypto assets can tackle this issue.

  • Cross-chain Services

Usually, centralized finance services are used for trading Bitcoin or other cryptocurrencies that generate on the independent blockchain network. However, these tokens are not supported by DeFi services as they are complex, and the completion of atomic exchanges across the chains takes time.

This issue is solved by the CeFi services by storing funds from different chains. To achieve interoperability, the Ethereum token standards must be followed by the DeFi services. The most significant benefit of centralized finance is that most traded coins are on different blockchain networks and do not follow the interoperability rules.

  • Flexible Fiat Conversion

The centralized services usually have more flexibility than the decentralized ones when converting money to Bitcoin or any other. There is always a need for a central authority to convert fiat money to crypto funds, which is usually not offered by most DeFi platforms. In addition, the customer may have a better customer service experience at CeFi platforms as they are entertained better.

Similarities Between CeFi and DeFi

Decentralized finance is still a new concept in the crypto space compared to centralized finance. However, due to the blockchain settlement layer, there are certain remarkable qualities integrated with DeFi similar to DeFi, such as decentralization, no requirement of permission, and transparency of the network.

At the same time, privacy, latency, and transaction throughput are kept at stake because of the limitations of the blockchain network.

Decentralized finance has a significant dependence on the well-established financial system. One cannot deny that fiat currency is still used to recognize and evaluate the worth of crypto assets in DeFi. As the value of stablecoins is integrated with fiat currency, they are the most commonly used crypto assets.

However, central bank money can only be issued by the central banks. This makes the central banks outdated at the moment due to the dependence of DeFi on fiat currency.

The link between the crypto assets and the traditional economic system is provided by centralized finance services. The customers can directly borrow fiat money using these services and utilize their collateral crypto holdings.

However, the main aim of CeFi and DeFi is the same that is empowering the economy while providing high-quality financial services and goods to their customers. There are certain distinct benefits and flaws attached to both CeFi and DeFi, and they cannot be integrated conveniently.

Therefore, one can think of both these systems as existing separately and providing advantages to each other whenever required. Some of the common aspects of both systems are mentioned below.

  • As a Bridge

The financial institutions link the CeFi and Defi to become more efficient. The data can be transported from CeFi to the DeFi through Oracles such as Chainlink. Moreover, CeFi financial instruments can be traded as DeFi derivatives using Synthetix.

  • DeFi, an Innovation to CeFi

The properties of the traditional CeFi system are copied by the DeFi protocol and are improved to make them convenient for the users. The assets are taken from the liquidity providers using smart contracts known as AMMs. This also decreases the cost as it involves a relatively lesser number of contacts in the market.

CeFi is also improving the system by integrating new updates and developments. Multiple CeFi markets adapt to a combination of human interaction and AMM model to make their place in the DeFi market. In addition, it may also decrease the exposure of the clients to the arbitrageurs by adopting some CeFi approaches.

Conclusion

Users’ settlement approaches and adaption are different for both CeFi and DeFi. There is a lot to learn for CeFi in the test approaches of the decentralized system.

The excessively volatile nature of the crypto market is reduced by using circuit breakers by the CeFi, where the trade activity stops when volatility crosses a certain level. DeFi manages this situation more appropriately, thus assisting CeFi to adapt to crypto better.