The advent of blockchain has given birth to a new kind of financial system that goes by the name of “decentralized finance”.
DeFi, as it has come to be known, is pushing to upend the world of traditional “centralized finance”, or CeFi, by providing opportunities to “bank the unbanked” and give anyone the means to access tools for lending, borrowing, with no need to possess a bank account or undergo credit checks.
The world of CeFi can be a daunting and mysterious one for many people, what with all of the strict rules and regulations that govern the banking industry. In contrast, DeFi is all about transparency, which is enabled through its integration with publicly viewable blockchain ledgers that are used to protect its integrity. DeFi is also about providing more opportunities for inclusion and higher returns, though critics say it can be equally confusing, not to mention higher risk na, due to its decentralized nature.
In any case, the line between CeFi and DeFi is not always that clear and the benefits of both systems are hard to ascertain, hence the need for a quick explainer.
What is CeFi?
CeFi is the name for the ancient system of finance that was first born several thousand years ago in the world’s first civilization, Mesopotamia. With the rise of agriculture, it’s believed that humans first began trading using mediums such as livestock, crops, land and precious metals. Those makeshift currencies eventually have way to precious metals, and finally fiat money, backed by a central authority, i.e. the government.
CeFi therefore refers to the world of banks and traditional financial institutions and fiat currencies such as the U.S. dollar, U.K. pound, the Euro, the Yen and others. It also encompasses the services those banks and institutions provide, as well as mechanisms like the stock market, where users can buy and sell shares in companies and commodities using fiat currencies.
CeFi even exists in the world of cryptocurrency. Indeed, centralized exchanges such as Binance, Gemini and Coinbase are all CeFi exchanges, controlled by a single organization. These platforms have evolved beyond simple trading to provide all manner of crypto financial services, including lending, borrowing and margin trading.
The risk of using centralized exchanges is that, even though users have their own wallet, access to it is controlled by the exchange. It means that they could potentially be cut off from their funds at any moment. In addition, their funds could be at risk if the exchange is somehow hacked, though a lot of CeFi cryptocurrency exchanges do have extremely strong security measures in place to prevent this.
To use centralized exchanges, customers will have to provide their personal information and go through a KYC process, then trust their funds in the custody of the organization that runs the platform.
Exchanges do however hire a large customer support staff that’s available 24/7 to deal with customer concerns and complaints. Many offer a very high standard of customer support, and as a result they do have very positive reputations among most users.
The world of CeFi is highly regulated, with banks forced to comply with numerous rules and regulations implemented by national governments. These rules are ostensibly designed to protect user’s funds and to uphold the law by preventing crimes such as money laundering and fraud. However, while these rules and regulations do help to create a more secure environment that’s conducive to doing business, they also mean a lot of users are prevented from accessing financial services, either because they lack the formal identification required to open a bank account, or they have an insufficient credit score to qualify for loans, credit cards and similar products.
What is DeFi?
DeFi is the name for a newer, alternative financial system that operates without any central authority. It’s a decentralized and permissionless system built on blockchain.
Blockchain technology, combined with smart contracts, enables the transfer and trade of financial assets to take place without a trusted intermediary, and a whole host of related financial services that go beyond that basic mechanism of exchange.
Rather than fiat, DeFi goes hand-in-hand with cryptocurrency and tokens such as NFTs. Whereas with CeFi, a loan is offered by a centralized institution such as a bank, in DeFi, one user is able to loan a token such as Bitcoin or Ethereum to another, using smart contracts to guarantee the contract.
DeFi offers many of the same services as CeFi, including loans, asset exchanges, leveraged trading and more. In fact, in some areas it goes beyond CeFi, enabling decentralized governance voting and the issuance of stablecoins that are pegged to national fiat currencies.
The three distinguishing characteristics of DeFi are transparency, control and accessibility. The transparency ensures all users can examine the precise rules that govern the operation of financial transactions, assets and services. On the other hand, CeFi lacks transparency as it’s open to private agreements and corruption in the form of bribes.
Control comes from the fact that users keep full custody of the assets they own, meaning that no one is able to move, censor or block their access to those assets without their permission. That’s unlike banks, which can freeze anyone’s account on a whim. Finally, accessibility arises from DeFi’s openness. Anyone is free to access DeFi’s platforms and services, with no need to show ID or undergo credit checks first.
Advantages of CeFi
The centralization of CeFi itself is often seen as a big advantage. While crypto purists may sneer at the thought of trading with centralized exchanges, the likes of Binance have solid reputations and many protocols in place to ensure their user’s funds are secure.
CEXs, as they’re known, have successfully held and secured the assets of millions of investors for many, many years. As a result, such exchanges have a lot of liquidity, ensuring users can always trade at the price they want without any delays or slippage – something that isn’t true of most decentralized exchanges (DEXs), which suffer from a lack of liquidity.
CeFi also provides more flexibility when it comes to converting crypto to fiat. With DEXs, it’s impossible to exchange fiat for cryptocurrencies, and vice versa. CEXs on the other hand can instantly convert users’ funds to fiat, or allow users to buy tokens with their fiat currency, by credit card or bank transfer or some other means. That ensures client onboarding is much easier and allows users to cash out immediately whenever they decide to do so.
CeFi is highly regulated, with users required to undergo KYC checks before they can start using most CEX platforms. DeFi’s unregulated nature may make it more accessible, but it also dissuades institutional investors from embracing DeFi and adding more liquidity to the industry, which is something that would benefit all of its users.
However, there are some innovators aiming to bridge this gap. A good example of this is Alkemi Network, which is aiming to bring all of the regulatory compliance, security and institutional-grade tools found in CeFi to the world of DeFi. Alkemi, which has partnerships with Verite and FTX, offers a suite of tools that can unlock DeFi yield opportunities for institutions without the regulatory risk. Its flagship protocol, Alkemi Earn, enables borrowing and lending within a trusted environment through a verified liquidity pool. Through this, institutional investors such as hedge funds can now access DeFi markets that often have much higher growth potential than their equivalent CeFi markets.
The last main advantage of CeFi and CEXs is their diversity of trading options. Whereas DeFi platforms are restricted to trading in assets such as ERC20-based tokens, CeFi faces no such restrictions The main advantage of CeFi in terms of trading is its support for traditional financial assets such as stocks and shares, foreign exchange, derivatives and more. CeFi also supports a wide range of cryptocurrencies, including many of the most obscure tokens around. DeFi struggles to support even a wide range of cryptocurrency options due to the complexity and latency involved from performing swaps across different blockchains.
Advantages of DeFi
Although DeFi struggles to compete with CeFi in many areas, it is also quite unique and that gives it a number of advantages that mean it’s poised to disrupt traditional financial markets.
Probably the most widely cited benefit of DeFi is its ability to bank the unbanked. There are millions of people all over the world who’re unable to open a bank account, meaning they can never benefit from financial services such as loans, credit cards, or even a straightforward debit card. With DeFi, anyone can create a digital wallet to store their crypto assets, which can be purchased with cash if necessary. All that’s required is a mobile device and internet connectivity and users can become their own bank, with faster transaction times too.
Once users have a digital wallet they can access DeFi lending and borrowing services such as Aave. Leaving savings in a traditional bank account, people generally earn very little interest. With DeFi, users can lend their money to other users directly via a protocol, earning much higher interest on those assets than they would if they were to keep it in the bank. And if a user possesses crypto assets, they can use them as collateral to secure an instant loan in the form of other tokens. That compares to the uncertainty and lengthy wait to secure a traditional bank loan.
DeFi also opens up business opportunities for creatives. For instance an artist would typically struggle to sell their paintings. With DeFi, they can tokenize their artwork and offer it for sale on marketplaces such as OpenSea, and get their hands on the funds as soon as it’s sold, with minimal fees.
Investing also becomes a reality for anyone with DeFi. In the world of stocks and shares it can be very difficult to open a trading account, while investing in startups is limited to accredited investors. With DeFi, investment opportunities abound. Users can take part in token sales on launchpads such as TrustPad, where they can get early access to all manner of exciting crypto projects. They can buy cryptocurrencies and NFTs in the hope their value will accrue, and there are more complex trading opportunities around staking and yield farming, providing liquidity and more.
Even those complex investing strategies are becoming more accessible. Through HyperDEX’s platform, it’s simple for anyone to invest in DeFi without any understanding of how the various protocols work. Users simply choose from one of three “cubes” according to their level of risk tolerance. For instance, HyperDEX offers a Fixed Income Cube that provides a fixed return over the length of a specified period. For those eying bigger returns, they can opt for an Algo Trading Cube that uses algorithms to trade on their behalf, with a variable return offered over a given duration. Finally, those who’re willing to roll the dice can go for a Race Trading Cube that enables them to speculate on the price of a specific crypto asset.
A final benefit of DeFi is that it can enable more equitable access to credit services. One such innovation is Gluwa Bond accounts, which gives investors a way to earn a solid APY while providing credit to underbanked businesses in emerging markets. With Gluwa, investors can convert their idle crypto into real-world lending liquidity and earn a decent yield while simultaneously helping others.
Gluwa’s bond accounts are short, three-month, high interest-bearing accounts that generate an APY of between 3% and 12% over the period of the contract. The funds invested in Gluwa Bond accounts are then used to provide liquidity to carefully vetted partners as well as underbanked individuals who cannot access financing elsewhere.
Which Is Best: CeFi Vs DeFi?
Both CeFi and DeFi have the same goals, namely to provide people with access to the financial system and an ecosystem of products that make the economy go round. However, they achieve these goals in a very different fashion.
With CeFi, it aims to reach its objectives by building trust along the way. CeFi’s main promise is security of funds and fair trade according to its terms. CeFi has been around a lot longer and is more flexible regarding the sheer number of trading options and its array of financial services, but on the downside it’s harder to access.
On the other hand, DeFi aims to facilitate economic activity without any barrier to entry. It enables anyone to play the game without having to deal with an intermediary and follow set rules. Both systems have their advantages and disadvantages. For investors the choice between CeFi and DeFi will depend upon their priorities and their investment goals. For those who prefer a regulated, trusted environment with fewer risks, CeFi might be the way to go. However, investors who prefer transparency and potentially bigger rewards may want to look at the opportunities in DeFi.
As for the unbanked, exclusion from CeFi means DeFi is the only option on the table.