DeFi vs CeFi
The financial world has transformed drastically over the last decade. We have witnessed unprecedented growth of fintech and digitalization of financial services at scale. However, nothing comes close to the revolution brought with the origin of Blockchain, through the first cryptocurrency — bitcoin.
Back in 2008, when the world was hit with economic recession due to the bankruptcy of US investment bank, Lehman Brothers Holdings, people’s shattered trust demanded a change in the financial ecosystem which led to the commencement of bitcoin, introducing the world of finance to a simple yet powerful concept of decentralization through Blockchain.
Aiming towards Decentralized Finance (DeFi), we need to understand that a total replacement of the traditional system is impossible. On the other hand, we have had a taste of the powers of DeFi such as high interest, more transparency, and lower transaction fee. Therefore, we are stuck in a world which is not ready to replace the traditional system but not ready to give up on this futuristic technology as well.
Filling the gap between traditional financial systems and decentralized systems is where our dilemma ends. And this is where Centralized Finance (CeFi) comes into picture.
Let us take a detailed but quick look at DeFi and CeFi
DeFi (short for ‘Decentralized Finance’) refers to the financial service that uses smart contracts instead of any third party intermediaries like a bank or any middle man. Smart contracts are automated enforceable agreements that work on the top of Blockchain technology which creates a transparent ecosystem, eliminating the need for regulation and governance by any third party.
Most of the DeFi applications are built on Ethereum as it is the first platform to introduce the concept of smart contracts. Various facilities such as insurance, flash loans, permission less trading & margin calls, derivatives, so on are accessible because of DeFi, some of the most famous DeFi applications include MakerDAO, Compound, dYdX, Uniswap, and Balancer.
CeFi (short for ‘Centralized Finance’) refers to the financial service that allows the user to leverage the benefits of decentralization, under the governance of a third party. It is a perfect blend of traditional financial systems incorporating decentralization where the user trusts a third party, maybe an organization or middle man, to store and manage their funds. At the same time, they enjoy complete transparency which instills a sense of responsibility among the authorities.
Among several other facilities, users can earn interest and get loans based on the cryptocurrencies that they own by giving its custody to the trusted third party. This synergy allows CeFi to bridge the gap between the traditional financial system and decentralized system, shaping the future of finance.
Some of the popular examples of CeFi are Binance, Coinbase and SALT.
Let us now compare both, DefI and CeFi, on the basis of different factors:
Risk management has utmost significance in any financial system. In any DeFi application, the use of smart contracts eradicates the feasibility of hush money or any manual errors which are definitely possible, maybe with relatively higher occurrences, in any of CeFi applications.
But at the same time, it is important to note that DeFi is unable to deal with unforeseen market situations such as mass liquidation, fluctuation, and several other potential disasters. Whereas CeFi can handle such situations effortlessly. Because of the involvement of a trusted third party in CeFi, they can quickly respond to unexpected situations and can manage the risk systematically, minimizing the loss.
Decentralized finance has not seen significant adoption when compared to the traditional financial system. Therefore, the need of a platform offering decentralized financial services to provide cross-platform exchange of currency has become prominent. In essence, such a platform will facilitate the conversion of fiat to cryptocurrency and vice versa.
To support this conversion, a central authority is needed which is offered only by CeFi in the form of trusted third parties. This need of a central authority makes DeFi applications incapable of accommodating such conversions and opens the possibility of transforming them into CeFi.
A DeFi application is highly secure. If we talk about ownership, the user has to trust the technology as the user’s holdings are managed by smart contracts, and technology doesn’t take rest or make mistakes. While in a CeFi application, user’s holdings are in custody of a trusted third party which is responsible for all the financial activities of the user’s holdings.
DeFi applications do not require any document for verification of the user. Anybody can access these applications through the unique account id owned by them. A noteworthy observation here is that the user is responsible for maintaining their own keys or credentials to log in to the application later.
On the other hand, CeFi applications require KYC where the user has to provide a certain set of documents to verify their identity. Two-factor authentication takes care of the user trying to login to the application later.
To ensure correct usage of a DeFi application, the user needs to understand various technical concepts. This surely gives more power and independence to the user but to understand such concepts might not be possible for everyone. Whereas, CeFi provides a seamless user interface, with advanced UI/UX, results in CeFi applications being much easier to use. The user, in this case, is not required to have any conceptual knowledge, just an understanding of how to navigate throughout the application is adequate.
While DeFi is, without a doubt, a revolutionary concept, it is impossible to replace the deep-rooted traditional financial system. CeFi brings us to a conclusion that the synergy of DeFi with traditional financial systems is much more powerful and appropriate for the world.
Originally published at https://medium.com on February 18, 2021.
