What is Defi and Cefi | Decentralized finance vs. Centralized finance
Traditional financial services such as payments, lending, and borrowing were only available via established financial institutes and banks. But it transformed with the introduction of blockchain technology. When the idea of cryptocurrency started expanding, the discussion pivoted to a new set of considerations, i.e., decentralized finance (Defi) and centralized finance (CeFi).
What is Centralized Finance (CeFi)?
Before Defi was introduced, Centralized Finance was the pinnacle for trading cryptos. It handles a stronghold over the cryptocurrency industry. In centralized finance (CeFi), all crypto trade orders are managed through a central exchange. Funds are managed by specific running the central exchange. It means you don’t own a private key that provides you access to your wallet.
Moreover, the exchange identifies which coins they list for trading or how much fees you need to pay to trade with their exchange.
Concluding the concept of Centralized Finance, you don’t own your cryptocurrencies when buying /selling via a centralized exchange. Moreover, you are subject to a centralized exchange’s rules. Also, you are subject to the regulations set by the centralized exchange.
What is Decentralized Finance? (Defi)
No exchange is involved in the decentralized exchange. The complete process operates via automated applications developed on top of blockchain platforms. Also, decentralized finance creates a fair and transparent financial system where anyone can partake. It allows unbanked people to access financial and banking services via blockchain technology.
Defi aims to construct an open-source, permissionless, and transparent financial service ecosystem. The decentralized financial system offers services, including borrowing, yield farming, crypto lending, asset storage, etc.
The perks of using Defi over CeFi is that you have complete control over your assets and own the key pair for your wallet. Moreover, users who want to participate in Defi require to use decentralized applications (dApps) built on blockchain to access Defi services.
Differences between Defi and CeFi
One of the most notable differences between decentralized finance and centralized finance is that the system is regulated in the case of CeFi. In contrast, precisely the opposite is the case with Defi. In centralized finance, the responsibility of protecting the users’ money is with the exchanges. On the other hand, the assumption behind Defi is that the transactions would be successful as a result of smart contracts (an agreement between two parties that enforces specific rules/terms of negotiation when a particular/specific condition is met). The users are liable for managing their funds and activities in simple terms. In CeFi, it is possible to prevent trade and impose limitations on users. However, the same is not possible in the case of decentralized finance. Decentralized finance is permissionless, whereas this is not the case with CeFi. There are two areas where CeFi stands apart — One, the CeFi exchanges enable the conversion of fiat currency to cryptocurrency and vice-versa easily and seamlessly.
Features of CeFi
- Centralized Exchange (CEX)
- Using a traditional cryptocurrency exchange, for example, Binance, Kraken, or Coinbase, users send funds to the exchange to manage them within an internal account. Though funds are stored on the exchange, they are kept outside users’ custody. They are vulnerable to threats in case the security measures put in place by the exchange fail.
- Due to this, centralized exchanges have been the target of various security attacks. Customers on the centralized exchange do not mind sharing their personal information or putting funds into these companies’ custody as they consider central exchanges trustworthy.
- Moreover, large exchanges have complete departments with customer service teams offering assistance to customers. The high level of customer support provides the customer with comfort, strengthening the feeling that their funds are in good hands.
- The Flexibility of Fiat Conversion
- Centralized services represent more flexibility than decentralized services when turning fiat to cryptocurrency and vice versa. Conversion between cryptocurrency and fiat usually requires a centralized entity; however, Defi services do not offer fiat that flexibly. Onboarding customers in the Centralized Finance (CeFi) ecosystem is quite convenient and can offer a better customer experience.
- Cross-chain services
- CeFi services support the trading of LTC, XRP, BTC, and other coins issued on independent blockchain platforms. Defi services do not help these tokens because of the latency and complexity of performing cross-chain swaps. CeFi can overcome this issue by getting custody of funds from multiple chains. It is a significant benefit for CeFi as many of the frequently traded and highest-market-cap coins exist on independent blockchains and don’t implement interoperability standards.
Features of Defi
- Users do not require permission to use Defi. With CeFi, users need to complete a KYC process to access services, which means they have to share their personal information or deposit some money before accessing services.
- Users can directly access the services using a wallet and without providing personal information or depositing money with Defi. It is because Defi is openly accessible to all parties, without any barrier or discrimination.
- Moreover, individuals who plan to build on top of a decentralized platform can do that freely. It provides a high degree of accessibility and supports collaboration within the community. Products developed within the Defi ecosystem are designed to benefit from each other. That is why Defi products are also known as money legos.
- The most significant benefit of using Defi services is you don’t need to trust that the service will perform as promoted. Users can authenticate that Defi services perform as intended by auditing their code and using external tools such as Etherscan to identify if a transaction was correctly executed.
- Quick Innovation
- Another significant advantage of Defi is its quick rate of innovation. The Decentralized Finance Ecosystem constantly builds current capabilities and experiments with new capabilities. The build-centric nature of the Defi space has transformed into a rich ecosystem embedded with ground-breaking financial services. Defi space has been working to deliver alternative ways to solve the issue in functionalities where centralized financial services have thrived. For example, to overcome DeFi’s inability to facilitate the transfer of incompatible cryptocurrencies such as BTC, solutions like tBTC and WBTC that are compatible with decentralized protocols eliminate the gap by behaving as tokens pegged to the value of BTC. It enables Defi users to access Bitcoin via Defi without requiring them to use the token directly.
How do they work
Although centralized exchanges (CEXs) currently dominate cryptocurrency trading activity, decentralized exchanges (DEXs) are growing in popularity. DEXs facilitate peer-to-peer trading by relying on automated smart contracts to execute trades without an intermediary. However, not all DEXs employ the same underlying infrastructure. While some retain conventional order book models, others use emergent liquidity protocols. In addition to exchange and liquidity protocols, developers are building new aggregation tools to address the disjointed liquidity that’s inherent in decentralized exchanges.
Decentralized Exchanges (Order Book)
There are multiple generations of decentralized crypto exchanges and Defi products. The first generation of decentralized exchanges uses order books, similar to conventional centralized exchanges. These order books compile a record of all open buy and sell orders for a particular asset. The spread between these prices determines the depth of the order book and the prevailing market price. On DEXs with order books, this information is often held on-chain during trades, while your funds remain off-chain in your wallet. Many DEXs specialize in a particular financial instrument that is executed in a decentralized manner.
- dYdX: The dYdX protocol allows users to access derivative products in a decentralized environment. dYdX also supports peer-to-peer borrowing, which means you can earn passive income while your assets are held on the exchange.
- Loopring Exchange: The Loopring platform features an order-book-based DEX protocol known as zk-Rollups, which validates transactions using zk-SNARKs technology. Validity proofs update and verify the DEX asset holdings, make transactions more private, and improve the scalability of the Ethereum network.
- Binance DEX: The decentralized iteration of the centralized Binance platform, Binance DEX operates through a web-based application programming interface (API) that uses a similar user interface to Binance.com. The exchange offers the same functionality as a typical DEX but also integrates TradingView charts with technical indicators. By bringing conventional tools to a DEX, Binance eases the transition to unfamiliar infrastructure.
- DDEX: The DDEX exchange facilitates decentralized margin trading. Margin trading occurs when users borrow funds to amplify their potential returns. Margin trading may carry a high degree of risk as market downturns amplify losses of borrowed money.
Decentralized Exchanges (Swaps)
The next generation of decentralized exchanges does not use order books to facilitate trades or set prices. Instead, these platforms typically employ liquidity pool protocols to determine asset pricing. Peer-to-peer in nature, these exchanges instantly execute trades between users’ wallets — a process some refer to as a swap. The DEXs in this category are ranked in total value locked (TVL), or the value of assets held in the protocol’s smart contracts.
- Uniswap: Users of the Uniswap platform can swap any two Ethereum-built assets seamlessly atop an underlying liquidity pool. These highly accessible liquidity pools ensure that Uniswap remains permissionless and trustless, which democratizes lending and borrowing on the platform.
- Curve: Like Uniswap, Curve is a decentralized exchange that utilizes a liquidity pool. However, Curve specifically caters to stablecoin trading, allowing users to trade between them with low slippage and fees — all through the use of an algorithm that optimizes trading pairs.
- SushiSwap: SushiSwap emulates Uniswap, except that it started by offering liquidity providers a token known as SUSHI (which Uniswap later also provided with its UNI token). On Uniswap, the trading fee is 0.3%, but SushiSwap allocates the 0.3% differently, distributing 0.05% in the form of SUSHI tokens.
- DODO: Like others in this segment, DODO is a liquidity protocol. However, the DODO platform employs its Proactive Market Maker (PMM) algorithm to provide adequate liquidity.
- Balancer: Balancer builds on the concept of Uniswap but has more liquidity pool flexibility. While Uniswap has liquidity pools of equally weighted token pairs, Balancer allows for pools with different ratios (80/20 or 70/30 DAI/ETH, for example). Although a Balancer pool could be a mere token pair, it also allows for liquidity pools with as many as eight different assets.
- Bancor: The Bancor exchange model does not require a second party to execute a trade. Instead, you can exchange your ERC-20 tokens for Bancor’s native “smart” Bancor Network Token (BNT). You can then exchange these for other ERC-20 tokens on the platform.
- Kyber: The Kyber protocol operates as a stack of smart contracts that run on any blockchain, not just Ethereum. Kyber utilizes liquidity pools to facilitate peer-to-peer swaps like other exchanges operating without an order book.
Decentralized Exchange Aggregators
Decentralized exchanges use several different protocols and mechanisms. Although this dynamic results in higher security and autonomy, it also results in disjointed liquidity across platforms. This lack of liquidity can be a deterrent for institutional investors or wealthy independent traders who want to purchase a select crypto asset in large volumes. To address this, DEX aggregators have developed tools to deepen asset liquidity pools across centralized and decentralized crypto exchanges.
- 1inch Exchange: The 1inch platform aggregates liquidity from different DEXs to minimize slippage on large orders. Slippage occurs when there is insufficient liquidity on one platform, resulting in a buyer paying more to buy an asset than was expected. Capital is made available to a trader for the best price possible by eliminating slippage.
Binance is the biggest cryptocurrency exchange based on the average daily volumes being traded. It provides hundreds of currencies for trading and charges relatively lower fees than other commonly used exchanges. It also offers advanced charting systems without the user having to upgrade.
Coinbase has primarily avoided any crypto fraud so far and provides a robust platform for trading. It also offers a Pro version with significantly lower transaction costs and significantly more technical features. Coinbase allows transactions in 64 cryptocurrencies.
Decentralized Exchange Evolution
Although centralized exchanges account for the vast majority of market activity since they offer security, regulatory oversight, and often insurance, the growth of Defi has created room for the development of decentralized crypto exchange protocols and aggregation tools. Platforms like Uniswap, Curve, and Balancer display the potential for simple, user-friendly platforms that rely on liquidity protocols rather than order books. As the DEX market matures, the proliferation of new protocols and supporting mechanisms will likely only accelerate.
Both Decentralized and Centralized Finance aims to achieve the same goal. They plan to make crypto trading popular and improve the trading volume. However, the way these two ecosystems carry out their objectives is different.
CeFi promises security of funds and fair trade on those funds. Investors with conventional currency can also take part in crypto trading. Moreover, CeFi exchanges provide them with customer support services that Defi services do not offer. On the other side, Defi wants to make the space intrusion free. It provides a space for investors to implement their strategies without dealing with an intermediary body.
Both of these models have their pros and cons. It depends on the investor and their needs. Defi is the suitable model to choose from if you prefer transparency and privacy. On the other hand, if your priority is trust, sharing of risks, flexibility, and increased investment options, you should opt for CeFi.
Hope you had a fantastic reading
How a Decentralized Exchange Works | Gemini. https://www.gemini.com/cryptopedia/decentralized-exchange-dex-crypto
DeFi vs CeFi | Decentralized Finance vs Centralized Finance. https://www.leewayhertz.com/defi-vs-cefi/