The crypto ecosystem is composed of both centralized and decentralized finance, two segments that offer various financial products and services. This guide will compare CeFi vs. DeFi and highlights their respective opportunities and drawbacks.
What is Centralized Finance (CeFi)?
On the surface, centralized finance (CeFi) is similar to traditional finance (TradFi) since a user deals with trusted intermediaries. However, the two aren’t the same.
TradFi consists of legacy institutions that have existed for centuries and are about to venture into the digital asset space, while CeFi refers to digital asset companies that offer crypto-related products and services.
Among CeFi platforms, there are centralized crypto exchanges (CEXs), crypto lending companies, and digital currency payment providers. They provide custodial hot wallets to their users. That means the platforms actually hold the private keys of their users’ wallets and are, therefore, in control of their crypto assets. That leaves users at the mercy of these platforms should the latter decide to suspend their clients’ accounts and block their withdrawals.
Users are also subject to the rules that CeFi companies make. These rules are typically made behind closed doors, just as is the case in the traditional world of finance with private companies. For instance, they decide what rules their customers should follow and which coins will be listed.
Additionally, CEXs generally require users to complete the Know Your Customer (KYC) process before they can start trading.
CeFi is an easy point of entry for crypto beginners because of its similarities to TradFi. Before DeFi emerged, centralized finance platforms were the conventional places users would go for trading cryptocurrency.
What is Decentralized Finance (DeFi)?
In CeFi, customers put their trust in intermediaries, while DeFi removes these intermediaries and replaces them with smart contract protocols.
DeFi, which is short for decentralized finance, brings more decentralization to the world of finance by ensuring that digital assets can be traded on decentralized platforms.
DeFi enables the trading of peer-to-peer financial products through decentralized applications (DApps) offering services on the blockchain. These products and services are provided by applications built on existing blockchains such as Ethereum, BNB Chain, Tron, Avalanche, and Solana. The applications are built using smart contracts, which determine the rules the DeFi protocol is functioning by.
Just like CeFi and TradFi, DeFi offers trading, lending, and borrowing services. But there are several differences.
Firstly, operations on DeFi protocols run on code. Secondly, users can interact with DeFi protocols via non-custodial wallets. That way, they remain in full control of their crypto assets. Thirdly, there’s no need to register an account and complete KYC to use DeFi services. Users only need to connect a wallet to start using DeFi protocols.
CeFi vs. DeFi: A Comparison
The table below shows a side-by-side DeFi vs. CeFi comparison.
|Regulatory Compliance||Abides by regulations in the country where it operates, following KYC, anti-money laundering, and combating the financing of terrorism requirements.||Remains largely unregulated.|
|KYC||Users must disclose their personal information through a KYC process to use CeFi platforms.||KYC isn’t required.|
|Third-party Reliance||Users depend on trusted third parties to access financial products and services.||DeFi users do not rely on third parties to access financial products and services.|
|On-ramps||The available on-ramps are fiat-to-crypto and crypto-to-crypto.||DeFi only allows crypto-to-crypto on-ramps.|
|Custody||Users are not in control of their crypto assets.||Users are in control of their crypto assets which demands a higher level of responsibility and caution to keep them safe.|
|Platform Development||The companies behind CeFi platforms are often registered in the jurisdictions they operate.||The developers behind some DeFi protocols are anonymous or pseudonymous, and there is yet a regulatory debate about whether they should be made liable in a way.|
|Transparency||Decisions are made behind closed doors. Therefore, CeFi platforms may not reveal their trading processes and price formation practices. Also, they keep their systems off-chain. Hence, transactions within the exchange aren’t recorded on the blockchain.||All transactions are recorded on the blockchain and are visible to everyone as far as public blockchains are concerned.|
|Security||CeFi platforms are vulnerable to security breaches.||Bugs in smart contracts may be exploited to steal user funds.|
CeFi platforms supply a wide range of crypto investment services. Here are some of the top services available and the platforms that offer them.
CEXs that deliver spot trading services allow users to buy and sell crypto assets for immediate delivery. Spot trading is accessible on most CEXs like Coinbase, Kraken, Binance, KuCoin, Huobi Global, and FTX.
Crypto derivatives like futures, perpetual contracts, and options are provided by several CEXs. For instance, Binance, Deribit, Bybit, and BitMEX enable users to trade perpetual and futures contracts. Derivatives allow traders to speculate on the price of the underlying crypto asset.
Asset management service providers such as Grayscale Investments, Galaxy Digital, BlockFi, and Bitwise manage crypto assets on behalf of their clients.
Crypto users can stake their coins — lock them for a certain duration — on CEXs like Gemini, Binance, Coinbase, KuCoin, and Kraken to earn staking rewards.
Borrowing digital assets is possible on platforms that primarily focus on crypto loans, like CoinRabbit, Nexo, and Nebeus. They permit users to borrow money (fiat or crypto) against their crypto assets, which are used as collateral in the loan.
DeFi protocols focus on a diverse range of services, including those listed below.
Token swapping or trading takes place on decentralized exchanges (DEXs) like Curve, Uniswap, PancakeSwap, SushiSwap, and Balancer. These protocols are built on one or more blockchains. For example, Curve is available on about 11 chains, while Uniswap is on five.
Lending and Borrowing
Lending and borrowing protocols help crypto users lend their idle crypto assets and earn interest in return. Moreover, users can also borrow digital assets against their crypto holdings and pay interest to lenders. Aave, Compound, JustLend, Venus, Solend, and Tectonic are examples of lending and borrowing platforms from within the DeFi sector. They may be built on one or more blockchains.
Lido, Rocket Pool, Marinade Finance, Ankr, and Staker are protocols where crypto users stake their assets and earn rewards. Users’ stakes are tokenized, enabling them to swap the tokenized stake back to the original token whenever they want out (this is not yet the case for ETH). Liquid staking protocols may be present on one or more chains.
Collateralized Debt Position
Collateralized debt position (CDP) protocols permit users to mint stablecoins by locking collateral in a smart contract. CDP protocols include MakerDAO, JustStables, Kava Mint, Abracadabra, and QiDAO. These DeFi protocols may be built on one or more blockchains.
Bridging protocols connect blockchains, allowing the movement of crypto assets between them. WBTC, Multichain, JustCryptos, Poly Network, and Portal are examples of bridging protocols. DeFi protocols may be available on one or more chains. Bear in mind that such bridging protocols are still highly centralized. That way, they deviate from more decentralized DeFi protocols like Uniswap or Aave.
CeFi vs. DeFi: Pros & Cons
Familiar: CeFi platforms operate like traditional financial services providers. This means most people will find them familiar and relatively easy to use.
Fiat-to-crypto support: You can easily buy crypto on a centralized crypto exchange with your local currency. CEXs support various fiat currencies based on where they operate.
Custodial: CEXs are in control of the digital assets in their users’ wallets/accounts since they hold their private keys. Without these private keys, users can be denied access to their assets if the platform suspends withdrawals and deposits.
Personal information is required: Users must be ready to share their personal information, such as names, residential addresses, national ID details, and selfie pictures, to use CEXs.
Lack of transparency: CeFi companies make their decisions behind closed doors. Thus, users may not know what trading practices they use. Moreover, their systems are off-chain, which means transactions within the exchange are not recorded on the blockchain.
Restrictive: CEXs are not accessible to everyone because they may have location restrictions. For instance, certain exchanges may not allow people from specific (black-listed) countries to trade on their platform. Some of these restrictions may be implemented due to regulatory requirements.
Self-custody: Crypto users are in control of their assets because they hold the private keys. That means no one can block access to their funds.
Privacy: DeFi users enjoy privacy because their personal information isn’t required, and the wallet they use is not connected to their real identity.
Permissionless: Anyone can use DeFi products as long as they have a wallet and an internet connection. There are no restrictions.
Transparent: DeFi transactions are visible on the blockchain for public viewing. This creates transparency for users.
Smart contract risk: Attackers may exploit vulnerabilities in the smart contract to steal crypto assets locked within a DeFi protocol.
Steep learning curve: DeFi protocols are new and unconventional. Hence, beginners may find them difficult to use or understand. That means people have to take their time to understand DeFi and the products offered before they can start interacting with them.
Scalability: DeFi protocols rely on the blockchains on which they are built on. Therefore, they inherit the scalability issues of such blockchain networks. Scalability issues include low transaction throughputs, which leads to high transaction fees when the network is congested.
It’s difficult to say which of the two options to do finance is better because they both have their advantages and disadvantages. After all, it depends on the needs of different users.
To illustrate, those who value financial sovereignty and privacy may choose DeFi protocols, while institutional investors typically prefer regulated CeFi platforms. This could explain why CeFi and DeFi have been co-existing together for years.
In theory, decentralized finance is probably the better of the two for crypto investors. However, the DeFi market is yet to reach the level of maturity where it is genuinely safe to use for investors.