DeFi vs. CeFi: Comparing decentralized to centralized finance

Decentralized vs centralized finance

The traditional centralized finance (CeFi) ecosystem may appear mysterious to non-experts since customers are often unaware of the underlying rules or agreements that govern financial assets and goods. 

Decentralized Finance (DeFi), on the other hand, is establishing its mark as an ecosystem that claims to provide transparency and control, thanks, in part, to the underlying integrity-protected blockchain, as well as higher financial asset yields than CeFi platforms. However, the line between CeFi and DeFi may not always be that apparent. 

This article outlines how DeFi differs from CeFi from a legal, security, economic, privacy, and market manipulation standpoint.

What is CeFi and how does it work?

Several thousand years ago, in ancient Mesopotamia, centralized finance was invented. Since then, humans have used a variety of goods and assets as currency, including livestock, land, and cowrie shells, as well as precious metals (such as gold, which has near-universal cultural acceptance as a store of value) and, more recently, fiat currencies. 

As a result, it has been demonstrated that a currency can have intrinsic worth (for example, land) or can be given an imputed value (fiat currency). All known attempts to construct an everlasting, stable currency and finance system were founded on the concept of a centralized institution, such as a government supporting the financial worth of a currency and commanding a military force. But, what does CeFi mean in crypto?

The primary principle behind centralized exchanges (CEXs) in crypto is that all crypto trading orders are routed through a central exchange under centralized finance. Examples of CeFi companies include Binance, Coinbase and Kraken. Users create accounts with these exchanges and utilize the same platform primarily to send and receive tokens. This isn't all, though. These exchanges offer a variety of services in addition to crypto trading, such as lending, borrowing and margin trading.

Even though funds are housed on the exchange, they are maintained outside of users' control and are exposed to threats if the exchange's security procedures fail. As a result, centralized exchanges have been targeted by various security attacks. Customers on centralized exchanges are comfortable revealing personal information and placing funds in the custody of these organizations because they believe central exchanges are trustworthy. 

Furthermore, large exchanges have entire departments with customer support staff available to assist customers. The excellent quality of customer service gives customers a sense of security, reassuring them that their finances are in good hands.

What is DeFi and how does it work?

Due to blockchains' introduction and decentralized, permissionless features, new imputed currencies have evolved. The transfer and trade of financial assets without trusted intermediaries is one of the blockchain's most powerful features. Furthermore, decentralized finance, a new sub-field of blockchain, focuses on developing financial technology and services on top of ledgers with smart contracts.

DeFi provides services without intermediaries by utilizing cryptocurrencies and smart contracts. Financial institutions operate as transaction guarantors in the current financial world. Because your money passes through these institutions, they have enormous influence. Nonetheless, in DeFi, the financial institution is replaced by a smart contract in the transaction.

DeFi is compatible with most of CeFi's products, including asset exchanges, loans, leveraged trading, decentralized governance voting and stablecoins. However, the number of goods available is continually increasing, and some of the most complicated products, like options and derivatives, are also evolving rapidly.

Furthermore, DeFi has three distinguishing characteristics: transparency, control and accessibility. In DeFi, a user can examine the precise rules that govern the operation of financial assets and goods. For example, DeFi makes an effort to eliminate private agreements, back-deals and centralization, which are critical barriers to CeFi transparency.

DeFi gives its users control by allowing them to remain the custodians of their assets, which means that no one should be allowed to censor, move or destroy their assets without their permission. Anyone with a decent computer, an internet connection and a little know-how can design and deploy DeFi goods. At the same time, the blockchain and its distributed network of miners handle the actual operation of the DeFi software.

DeFi vs. CeFi: Various properties compared

The most prevalent DeFi vs CeFi properties are discussed in the section below.

Public verifiability

While the DeFi application code may not always be open-source, its execution and bytecode must be publicly verifiable on a blockchain to be classified as non-custodial DeFi. As a result, unlike CeFi, any DeFi user can observe and verify the orderly execution of DeFi state changes. Such transparency gives the new DeFi technology an unrivaled power to transmit trust.

Atomicity

A blockchain transaction allows for sequential actions to be performed, which might include several financial transactions. This combination can be made atomic, meaning that the transaction will either complete with all of its activities or fail collectively. While this programmable atomicity attribute is not present in CeFi, expensive and slow legal agreements might be used to enforce atomicity in CeFi.

Anonymous development and deployment

Centralized finance provides users with lesser anonymity than transactions in DeFi. Many DeFi projects are created and managed by anonymous teams, and even Bitcoin's founder has remained unknown to this day. The miners operate the DeFi smart contracts implicitly once they've been installed. Anonymous DeFi applications can function without a front-end, forcing users to engage directly with the smart contract. 

Custody

In contrast to CeFi, DeFi allows customers to directly control their assets anytime (there is no need to wait for the bank to open). However, with such enormous power comes great responsibility. Unless such insurance is underwritten, users absorb the majority of technological hazards. As a result, centralized exchanges, which are substantially identical to traditional custodians, are particularly popular for keeping cryptocurrency assets.

Trading of crypto assets

The CEXs are built on the same foundations as their traditional counterparts. Limit order books are off-chain records of outstanding orders posted by traders that CEXs keep. Decentralized exchanges (DEXs), on the other hand, work in a very different way, matching the counterparties in a transaction using automated market-maker (AMM) protocols. Prices are determined by AMMs using mathematical algorithms depending on transaction volumes.

Execution order malleability

Users employing permissionless blockchains often openly share the transactions they intend to complete via a peer-to-peer network. For example, peers can undertake transaction fee bidding contests to steer the transaction execution order because there is no persistent centralized entity ordering transaction execution. As a result of this order malleability, many market manipulation tactics have been demonstrated, which are currently commonly employed on blockchains. 

On the contrary, regulatory organizations in CeFi establish stringent requirements on financial institutions and services, such as how transaction ordering must be implemented. However, this is conceivable due to the centralized nature of CeFi's financial intermediaries.

Transaction costs

Transaction fees in DeFi, as well as blockchains in general, are critical for avoiding spam. However, because of the capacity to rely on Anti-Money Laundering (AML) verifications of their clients, financial institutions in CeFi can choose to offer transaction services at no cost (or are compelled by governments to offer some services for free).

Non-stop market hours

CeFi markets are notorious for experiencing outages. The New York Stock Exchange and the Nasdaq Stock Exchange, for example, are the two primary trading venues in the United States, and their work hours are 9:30 am to 4:00 pm Eastern Time, Monday through Friday. 

Because of the nonstop nature of blockchains, 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, in contrast to CeFi, where liquidity on a variety of goods is generally thin during these times.

Privacy

DeFi can only be found on blockchains with non-privacy-preserving smart contracts. As a result, these blockchains provide pseudo-anonymity rather than true anonymity. Given that centralized exchanges with AML policies are frequently the only practical option for converting money to cryptocurrency assets, these exchanges have the power to reveal address ownership to law enforcement.

Arbitrage risks

An arbitrage should preferably operate atomically to avoid the risk of price swings. Unless the arbitrageurs are collaborating with the exchanges to assure execution atomicity, arbitrage on centralized and hybrid exchanges is inherently exposed to market price swings.

When transaction fees are ignored, arbitrage between two decentralized exchanges on the same blockchain can be deemed risk-free. This is due to the blockchain's atomicity characteristic, allowing traders to write a smart contract that performs the arbitrage and reverts if the arbitrage does not return a profit. When two DEXs on separate blockchains are arbitraged, the arbitrage risk is comparable to a CEX and hybrid exchange.

Inflation

Inflation is the depreciation of an existing currency supply caused by adding a new supply. While inflation is defined as the loss of a currency's purchasing power, the relationship between supply and inflation does not always reveal itself clearly; sometimes, the money supply increases without causing inflation.

In CeFi, central banks maintain the power to produce fiat money, and inflation is often evaluated against the value of a representative basket of consumer products, sometimes known as a consumer price index.

In the DeFi world, the asset supply of several cryptocurrencies is subject to change. Bitcoin (BTC) eventually is likely to run into the dilemma where supply has a hard cap — while the economic activity it has to sustain does not have a cap — leading to a scarcity of currency. Moreover, Bitcoin, or blockchains in general, without a block reward and thus no inflation, may be vulnerable to security instabilities.

It remains to be seen whether BTC and other cryptocurrencies suffer from severe income disparity due to the fiat system's inflation. There is no solid evidence that cryptocurrencies fix this problem.

Cross-chain services

BTC and other major coins generated on independent blockchains are frequently traded via CeFi services. DeFi services normally do not support these tokens due to the complexity and delay of completing atomic cross-chain exchanges. 

CeFi services solve this problem by storing funds from several chains (whereas decentralized services require that tokens follow Ethereum token standards to achieve interoperability). 

Because many of the highest-market-cap and most frequently traded coins exist on separate blockchains and do not adhere to interoperability rules, this is a significant advantage for CeFi.

Fiat conversion flexibility

When it comes to converting money to Bitcoin and vice versa, centralized services are usually more flexible than decentralized services. Because fiat to cryptocurrency conversion requires a centralized institution, most DeFi providers do not offer fiat on-ramps. Also, customers can be onboarded considerably more quickly in CeFi, contributing to a better customer experience.

The summary of DeFi vs CeFi is listed in the table below:

Synergies between CeFi and DeFi

DeFi is currently in its early stages. DeFi, like CeFi, has unique qualities, including transparency, non-custody and decentralization, thanks to the blockchain settlement layer. On the other hand, the blockchain limits DeFi's transaction throughput, confirmation latency and privacy.

DeFi continues to rely significantly on the long-standing financial system. Notably, the value of crypto-assets on DeFi is still primarily determined and recognized in fiat currency. Stablecoins are among the most extensively used crypto-assets since their value is tied to fiat currency. As stated at the outset of this article, only central banks are permitted to issue central bank money. 

As a result, DeFi's reliance on fiat currency renders central banks obsolete, at least for now.

CeFi lending platforms act as a link between the traditional monetary system and the crypto-asset market. Those services allow users to borrow fiat money directly (rather than fiat-pegged stablecoins) and use their crypto holdings as collateral.

Those platforms are run by recognized businesses that serve as counterparties to both depositing and borrowing customers. As a result, these businesses are often known as crypto banks.

Furthermore, DeFi and CeFi have the same goal: to provide high-quality financial goods and services to customers while also powering the economy. To summarize, both DeFi and CeFi have their own set of benefits and drawbacks, and there is no simple method to combine the best of both systems.

As a result, we believe that these two separate but intertwined financial systems will coexist and benefit one another. In the below section, a few synergy prospects are highlighted.

Bridges

To boost their efficiency, financial institutions are linking DeFi and CeFi. Oracles like Chainlink transport CeFi data to DeFi; Synthetix allows users to trade CeFi financial instruments as DeFi derivatives; and the Grayscale Bitcoin Trust allows users to trade Bitcoin on the CeFi over-the-counter market.

DeFi as an innovative addition to CeFi

DeFi protocols don't only mimic basic CeFi services; they also optimize them for the unique qualities of blockchains. In DeFi, for example, a new exchange mechanism known as AMM has taken the role of CeFi's popular order-book architecture.

AMM is a smart contract that takes assets from liquidity providers. As a result, traders trade against the AMM smart contract rather than directly with liquidity providers. Because the AMM design involves fewer contacts with market makers than a CeFi order book, transaction costs are reduced.

CeFi, in turn, is adopting such developments. Following the AMM concept, centralized exchanges (like Binance) began to provide market-making services. Certain CeFi markets, such as foreign exchanges, which have used a combination of the AMM model and human interaction, are well-positioned to enter the DeFi market-making industry while existing DeFi markets are not. Some CeFi approaches may be adopted by AMM providers to decrease their clients' exposure to arbitrageurs.

Lesson for CeFi: DeFi collapse

The cryptocurrency market crashed on March 12th, 2020, with the price of ETH falling by more than 30% in less than 24 hours. On May 19th, 2021, the price of ETH plummeted by more than 40%. The Dow Jones Industrial Average fell by 9.99%, garnering the moniker "Black Thursday" in CeFi markets (but with less dramatic daily moves).

During the crashes, CeFi and DeFi were both extremely stressed. Due to an unusual quantity of trading activity, centralized exchange systems were disrupted (for example, Coinbase paused trading for almost an hour, and exchanges were momentarily shut down after exceeding pre-determined daily movement limitations). Similarly, the price of gas on Ethereum (ETH) skyrocketed to the point that a standard ETH transfer cost over a hundred dollars.

The consequent network load caused the MakerDAO liquidation bots to fail in February 2020, delaying the confirmation of users' transactions. Because of the distributed nature of blockchains, DeFi services are technically always available, unlike CeFi. DeFi systems, on the other hand, become prohibitively expensive for most users in the aforementioned extreme scenarios. Since then, the resilience of DeFi protocols has received greater attention.

Although CeFi and DeFi have different settlement processes and user behaviors, CeFi might learn a lot from DeFi's stress tests. While CeFi relies on circuit-breakers to mitigate excessive asset volatility (markets cease trading when volatility exceeds specified levels), DeFi appears to have managed to avoid such disruptions thus far, which could assist CeFi to better grasp its boundaries.