BitDelta
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Published on: Mar 19, 2024
#Blockchain
#Crypto 360
A look at centralised and decentralised finance to see how they shape the future of the financial markets.
➔ DeFi is anchored on using no intermediate parties in the trading process, which makes it easier to understand and more transparent but comes with security implications.
➔ DeFi has no middleman and leverages smart contracts on blockchain for fair and secure peer-to-peer financial services.
➔ CeFi platforms are easier to use than DeFi platforms, as the latter focuses more on smart contracts and security.
➔ Centralised finance is more regulated than DeFi, which remains relatively unregulated and offers plenty of potential and lower risk.
➔ CeFi and DeFi are both critical in the financial environment, each with strengths and weaknesses.
The world of finance, traditionally known by its centralised model, or CeFi, has recently witnessed the emergence of another model—decentralised finance (DeFi). DeFi has become the centre of a major discussion on the future of finance, with the advocates of the two systems presenting their advantages and disadvantages. Below, we will discuss what CeFi and DeFi represent and how they differ.
Image: A bank represents centralised finance, by Hodlnaut
Centralised finance, or CeFi, platforms provide various services such as cryptocurrency exchange, lending and borrowing, wealth management, etc. A major benefit of CeFi is the ability to link with conventional banking systems, allowing easy conversion between fiat currencies and cryptocurrencies. Also, CeFi platforms include customer service to address users’ issues when they happen.
But CeFi is not without issues. The use of central authorities brings open issues to the table, one of which is the security risks associated with the fact that these authorities can be hacked, involved in fraud, or manipulated. A major disadvantage of CeFi is the existence of regulatory oversight, as these platforms have to meet numerous compliance standards that may limit the potential for innovation.
However, CeFi remains an essential part of the global financial architecture and links the classical and new financial system models, which include cryptocurrencies.
Decentralised finance, or DeFi, is an entirely different model of finance. DeFi intends to build an open, efficient and inclusive financial system based on blockchain technology and eliminate the middlemen in the system. In its simplest form, DeFi can be described as a decentralised finance incorporating a host of financial services using open-sourced blockchain networks and smart contracts primarily built on the Ethereum network.
Image by Unicsoft
DeFi, in essence, started with the creation of Bitcoin in 2009, which gave people the idea of a decentralised currency. However, Bitcoin was the first cryptocurrency to be launched into the market; Ethereum launched in 2015 with the smart contract, paving the way for DeFi. Smart contracts are digital contracts that are coded so that the contract terms themselves determine the execution, enabling the automation of complicated financial transactions.
DeFi has been on the rise and has integrated various products such as decentralised exchanges (DEXs), lending and borrowing, yield farming, and others. These platforms are built on public blockchains and are secure and transparent because the records cannot be altered once they are applied. Anyone in the world can access DeFi, and as long as there is internet access, everyone can get involved in financial activities.
But there are always two sides to a coin, and DeFi is no exception. Since there are no middlemen, users are fully aware that only they are in charge of their funds and that any weaknesses in smart contracts can result in severe financial losses. Also, since DeFi lacks legal frameworks, there are legal issues and risks for the platform users.
Nonetheless, DeFi is one of the most exciting areas that will change the financial world and open new perspectives for a more decentralised approach.
Recommended Read: Smart Contracts Explained
DeFi removes the need for middlemen and provides a peer-to-peer system in which users complete transactions with the help of smart contracts. This is one of the key characteristics of DeFi – the trustlessness of the system, which means that a user does not have to rely on intermediaries.
The first and one of the most essential principles of DeFi is the openness. All transactions on DeFi platforms are saved on the public ledgers of blockchains, which are unchangeable. This level of transparency assists in developing trust because users can check and validate the transactions by themselves.
DeFi platforms are also available worldwide, making them accessible to anyone with internet access. This accessibility removes common constraints linked to the individual's physical location or economic status, which are core determinants of e-banking accessibility in the traditional banking system.
DeFi allows people to choose the type of financial products they desire. Whether it is creating a lending protocol, yield farming, or trading assets on a decentralised exchange, DeFi seems to equip users with everything they need to manage their financial activity.
Many DeFi platforms are built to integrate with other decentralised applications (dApps) and blockchains in the ecosystem. This interoperability enables users to transfer their assets and data from one platform to another, forming a more integrated and efficient market.
Image: Centralised and decentralised finance, by PacketLabs
Smart contracts are the lifeblood of DeFi, powering transparent and self-executing transactions. These so-called smart contracts have the terms of the agreement coded directly into the contract. Smart contracts eliminate the requirement of middlemen; hence, they are cheaper and faster than normal financial transactions. They also have a high level of security since once recorded, they cannot be altered and can only be put into action when certain conditions are met.
Decentralised exchanges (DEXs) are exchange platforms that enable swapping cryptos between parties with no intermediary. DEXs utilise blockchain as a means of executing the transactions. Therefore, transactions are safe and transparent and do not require an intermediary. As opposed to CEXs, DEXs do not store users’ funds, hence minimising the risk of theft or other attacks. Another advantage of DEXs is that they are more private since most do not demand the KYC process.
DeFi platforms provide the opportunity to get lending and borrowing services with the help of users, who can interact without intermediaries. Owners of digital assets can lend them out to others and receive interest or borrow assets and provide collateral for this. These protocols rely on the possibility of smart contracts to enable the lending process and ensure loan repayment on the stated terms. This system offers credit that is more easily accessible than traditional banking systems, especially to needy people.
Recommended Read: What Bitcoin and Cryptocurrency Adoption Could Present for Developing Countries
CeFi and DeFi are two models of finance at opposite ends of the spectrum. Below are some ways in which they differ.
In CeFi, trust is given to centralised entities like banks, exchanges, and other financial institutions. Thus, the entities that manage these assets monitor compliance with the relevant legislation and offer their clients assistance.
On the other hand, DeFi is a decentralised model in which people rely on code and smart contracts as their point of trust. All users are connected peer-to-peer and make direct transactions with other users. This decentralisation minimises the possibility of a mistake or an act of fraud, but it also shifts the control to the user when it comes to managing their assets.
CeFi platforms may demand users complete the so-called KYC procedures, which means sharing some personal data to prove the user’s identity. On the other hand, DeFi allows users to transact under pseudonyms, meaning that they can engage in financial activities without being identified. This anonymity, together with the fact that DeFi platforms are accessible worldwide, makes DeFi appealing to those who want more control and privacy over their finances.
The CeFi platforms provide diverse services intended to satisfy users' needs. CeFi, in turn, offers a range of services, from fiat to cryptocurrency exchange to cross-chain swaps, making this form of decentralised finance perfect for crypto newbies. But DeFi raises the bar when it comes to flexibility.
These contracts can be used to develop decentralised applications (DApps) that can perform and complete financial operations without involving middlemen. This level of programmability creates the potential for a wide array of new and exciting financial products and services, including decentralised lending platforms, automated market makers, and decentralised insurance protocols.
The authorities supervise the traditional CeFi platforms and meet specific legal standards, supporting the platforms’ security. Nevertheless, these platforms are not without risks of cybercrimes, hacks, or other forms of security)) If the central authority is somehow infiltrated, users’ funds may be in danger.
On the other hand, DeFi platforms are secured by the blockchain and smart contracts behind them. This gives a high level of openness, eliminating chances of censorship, but at the same time, it introduces new risks. Smart contract flaws and glitches can be adverse and can be manipulated by hackers, resulting in great losses.
As of August 2022, the DeFi industry reported $69 billion in asset management, pointing to its growth and adoption. CeFi and DeFi are not entirely separate; both are vital in the contemporary financial system. CeFi gives the user a convenient onboarding process, customer service, and the possibility of using traditional banking systems. At the same time, DeFi is a source of innovation and higher returns using decentralised financial instruments.
The future of finance will be a hybrid of centralised and decentralised finance. These two models are still relatively new in the financial world, and as the financial landscape progresses, their benefits will become increasingly apparent, creating new possibilities for alliances and innovation.
Centralised finance complies with legal norms and regulations, whereby entities are bound by several laws and regulations. This is important to ensure that the CeFi platforms are answerable to the users and regulators, thus creating a good level of confidence.
DeFi still has to function in an unregulated environment, which may be why it is so popular. Of course, this gives a certain freedom and opportunities for innovations, but it also entails legal risks and uncertainties. There are no regulators to save the day in DeFi, meaning the users must be careful and thoroughly research DeFi protocols.
CeFi platforms bring counterparty risk, as users must trust the platform to perform its contractual obligations. On the other hand, DeFi eliminates counterparty risk by using smart contracts to perform the transactions.
CeFi provides the comfort and reliability of centralised financial systems; on the other hand, DeFi brings innovation in financial systems with openness, self-sovereignty, and inclusiveness.
The CeFi model offers users a familiar and regulated environment since it relies on trusted intermediaries and adheres to the rules of the traditional financial system; however, it does not immunise from threats like hacks and gives the possibility of central authority abuse. On the other hand, DeFi does not involve intermediaries and provides a trustless and decentralised system that enables individuals to control their financial transactions. However, DeFi has drawbacks due to decentralisation, such as smart contract threats and difficulty operating in uncharted territory.
Therefore, the interoperability between these two models can present potential for partnership, creativity, and building a more efficient and inclusive financial system that opens up new opportunities for further evolution.
It is impossible to say which is better, CeFi or DeFi, as they both have advantages and disadvantages, and the decision depends on the user’s requirements.
DeFi is decentralised, and transactions do not involve middlemen like banks. In contrast, centralised finance involves using middlemen like banks to perform transactions.
DeFi, conversely, denotes all decentralised financial services and applications, while ‘crypto’ describes the digital currencies and assets that exist in or outside DeFi.
The major risks to DeFi are the vulnerability of smart contracts, price fluctuations, and the absence of protection against fraud.
DeFi presents more returns through activities like yield farming but generally involves more risks than CeFi.
This article is for informational purposes only and not intended as investment or financial advice. It contains opinions and speculations that are subject to change without notice.
The author and publisher disclaim any liability for decisions made based on the content of this article. Readers are advised to conduct their own research and consult a financial advisor before making investment decisions.
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