Finance is a constantly evolving landscape in today's digital economy. One of the most notable and impactful changes of recent years is the rise of decentralized finance applications (DeFi) as a new alternative to the established centralized financial system (CeFi).
This blog article will guide you through the important differences between CeFi vs DeFi, discuss the key pros and cons of both systems, and finally, outline the risks of using them.
What is CeFi
Starting with the incumbent in the red corner, Centralized finance (CeFi) is the financial system you probably already know (and don't love) where financial services are provided by centralized institutions that are responsible for handling financial transactions such as investments, lending, everyday transactions and more.
Centralized finance providers can vary from giant international banks, such as Goldman Sachs, to crypto exchanges such as Binance, from smaller fintech companies to local cooperatives and more. What ultimately matters is HOW these institutions handle financial services.
Specifically, CeFi refers to any kind of financial service which is settled through centralized companies. This is how most traditional financial services work. You don't perform the transaction yourself, rather, you ask an intermediary to settle the transaction for you. Whether exchanging a stock, trading crypto, or accessing funds for a mortgage, centralized finance always works through these centralized intermediaries.
Many crypto platforms, despite working in 'decentralized finance' and using decentralized blockchains, are nevertheless still CeFi platforms. As long as a platform has custody over your assets, it's not really a decentralized service provider. The most common example of CeFi services in crypto are centralized crypto exchanges (CEXs) such as Binance, Coinbase or Kucoin.
What is DeFi?
In the blue corner we have Decentralized finance (DeFi), an open, decentralized and permissionless alternative completely free of centralized control (or so you might believe). Instead of relying on centralized intermediaries, DeFi relies on blockchain technology and smart contracts – essentially self-executing computer code – to handle all financial transactions and services with authority distributed through a network of computers in a way intended to give individuals more power and control.
In DeFi, any transaction taking place – whether that's for for buying, selling, or organizing loans and payments with cryptocurrency – happen in a peer-to-peer approach and as such DeFi services represent a fundamental shift in how financial products operate. Decentralized exchanges (DEXs), for example, with prominent players including the likes of Uniswap or PancakeSwap, offer users the ability to buy and sell cryptocurrencies directly from each other – no middle man involved.
CeFi vs DeFi: Key Differences
Although both DeFi and CeFi offer cryptocurrency-related financial services, there are key differences that differentiate the two.
We've already touched on this in our definitions, but one of the key differences between the two is around who exactly is in control.
In CeFi, companies operate in a similar way to traditional financial institutions with a centralized entity in control of the funds and the financial services. That means that users don't have control over their own private key or indeed the funds themselves.
DeFi, on the other hand, is formed from a distributed network of computers and the funds and financial services are managed by this network rather than any centralized entity with users retaining control over their private key and funds.
DeFi platforms are also open-source. Anyone can view the code behind them. This allows developers to build and run their own applications on the platform while CeFi is typically a closed system.
In CeFi, you're forced to place your trust in a centralized entity. Although there are plenty of regulations these entities need to comply with, like Know Your Customer (KYC) and Anti Money Laundering (AML), at the end of the day, the centralized entity itself can act how it sees fit to a degree. This creates a danger of mismanagement (not to mention leaving them open to make decisions based on agendas). In extreme cases this can lead to financial collapse, like with FTX exchange, perish the thought.
Meanwhile, with DeFi protocols, you don't need to place your trust in any third party. The only thing you need to trust is the system itself. It's also easy for users to check transactions to ensure that the DeFi services are performing efficiently.
CeFi vs DeFi: Pros and Cons
So now that we've run through some of the key differences between CeFi and DeFi, what about the pros and cons? Let's take a look.
Although many people think of CeFi as representing the 'old' way of doing things, there's no denying it offers some notable advantages.
Ease of use
CeFi is generally quite simple and user friendly, with the kind of interfaces people are used to dealing with and feel comfortable with.
On a centralized crypto exchange, you can also easily use traditional currencies to purchase multiple different cryptocurrencies, and vice versa. That helps makes crypto trading much more accessible to the average person.
Centralized finance platforms are really just traditional companies. And that means they have a traditional structure offering some traditional services, customer service included. So there's no need to sit there scratching your head if you're in difficulty.
It's not all pros with CeFi though, there are cons to consider too.
A phrase you often hear bandied about in the world of crypto is, "not your keys, not your crypto". And that's because, when you use a centralized exchange, your private key is controlled by them, not you. And that means they have custody over your digital assets, too.
Through its very nature, CeFi involves intermediaries. Those intermediaries charge a fee for providing the services they do and that inevitably leads to an increased cost for you the user.
Although CeFi has opened up the possibility of trading to many individuals, it keeps many of the people who need financial access the most, the 1.4 billion unbanked across the globe, on the margins. The hoops people are forced to jump through and information and identification they must provide simply prove too much.
Lack of transparency
CeFi is a bit of a black box from a user perspective. As a customer, you have very little idea about what is going on behind the scenes. This can be extremely problematic as you might not know the true health of a company or even how what is really going on there day to day.
The DeFi approach offers many potential advantages.
One of the main advantages of a DeFi system is the fact that it's permissionless. That means a user doesn't have to jump through any hoops or provide a ton of personal information to access DeFi services.
It's typically more cost effective to use DeFi than a centralized system because of the low fees associated with running the system and the lack of intermediaries.
DeFi services tend to offer higher interest rates than their CeFi counterparts, which means a better rate of return for anyone investing in it.
The terms and conditions associated with the smart contracts that underpin DeFi are completely transparent and the code can be viewed by anyone, meaning it can be audited and analyzed without bias.
Like anything, though, there are also disadvantages.
Difficult to use
A crticism often leveled at DeFi is the relatively high level of technical knowledge needed to take part, as well as the clunky user experience lacking in intuitive interfaces.
Lack of support
With no centralized authority, there is no one to provide support to the users of any DeFi products should something go wrong.
Risks of Investing in CeFi and DeFi
So now we know the difference between the two, but before you consider investing in CeFi or DeFi, it pays to get your head around the risks associated with each.
Risks of CeFi
Given CeFi companies have a load of personal information they've collected through KYC processes, if a CeFi company gets hacked, all this personal information could potentially be compromised.
You can also never get away from the possibility of institutional collapse in the world of CeFi. We've seen it happen many times before with both banks and crypto exchanges and it's inevitable it will happen again in future.
Risks of DeFi
DeFi works on an open source basis using smart contracts. That means it can potentially be vulnerable to people finding weaknesses in the code and exploiting it. DeFi is also pretty much unregulated and without customer support in place, users are essentially left to fend for themselves if something goes wrong.
While the control you have with DeFi is in many ways a good thing, it does also mean that you are completely responsible for the safety of your private key, if you lose it, it's gone forever. As is access to your funds!
Making your choice
CeFi and DeFi are two very distinct approaches to finance. Both have their own pros and cons and both may prove useful to you depending on what exactly it is that you are looking for.
By noting the key differences, the pros and cons, and the risks of investing in them, you can enjoy a better understanding of the options that are available and make a more informed decision about which type of finance is right for you.