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One often-debated subject in crypto is the classification of decentralized finance (DeFi) and centralized finance (CeFi). DeFi — which is built on blockchain technology and functions peer-to-peer with no centralized intermediary — most closely follows the ethos of crypto. CeFi can include traditional financial markets with intermediaries like banks and platforms that offer some of the same DeFi technology and crypto exchanges. CeFi relies on centralized entities to facilitate, control and protect users as they make financial transactions.
Some CeFi exchanges went under attack by crypto natives when major players went belly up, hurting investors in the process. Celsius, a centralized crypto bank, became insolvent when the market tanked this year, leaving millions of large and small investors without funds. True DeFi requires no trust because it is governed by open source code and its transactions are designed to be public and transparent. CeFi keeps some aspects of transactions private and requires trust from users.
What is DeFi?
DeFi is a relatively new term, and its real-world use is even more recent. Most DeFi operations take place through Ethereum because it is the most popular decentralized network with a relatively simple way to build smart contract functionality on top. The token Ether is used to run operations on this decentralized software. It is also often used as a form of investment for those who believe in the future of the Ethereum network.
Other decentralized networks can run DeFi applications. Solana, known for its faster speed and diminished security is often compared to Ethereum. However, while Solana can run transactions faster than Ethereum, it is a far more centralized network, causing distrust in many technical users. It is also more difficult to code on Solana, which causes a dramatic difference in developer activity between the two blockchains.
What is CeFi?
CeFi, as it exists in the crypto ecosystem, is any centralized entity that provides access to DeFi technology like applications and tokens. The key reason users are on CeFi is the simplicity of onboarding. CeFi has applications on the app store, and users can plug in their information and credit cards much like they would when setting up a typical bank account. These crypto users do not hold their own private keys, which means that, like a bank or brokerage firm, the CeFi entity has custody of the traded crypto assets, not the user.
How is DeFi Different From CeFi?
One key sign to look for to be able to tell if something is considered DeFi or CeFi is by checking its form of governance. If there is a business making decisions it is CeFi. A common example would be a trading platform like Coinbase. If something is governed by a decentralized autonomous organization (DAO) it is likely to be DeFi. Examples would be the peer-to-peer loan decentralized application (dApp) Aave or the decentralized exchange Uniswap.
CeFi entities hold users' private keys. In DeFi, the user is strictly responsible for holding the keys and has ownership of the crypto assets. This feature allows DeFi users to access different dApps and take advantage of Web3. CeFi users rely on banks or exchanges and cannot do much more than trade.
Centralization
Centralization is typically referring to power structures. If a company or a few people are making the decisions, that is centralization. The same goes for a small entity profiting from transactions by being an intermediary. Decentralization would be many people holding power or a say in governance. Also, peer-to-peer structures represent decentralization.
Permission
CeFi platforms can give or refuse permission to access their services, whereas DeFi platforms aim to be free to use for all. Permission also ties into knowing your customer (KYC) requirements in which a company or bank needs to verify your identity. Much of the decentralization thesis goes against requiring KYC info.
Trust
In a decentralized world, the system is trustless because smart contracts are governed by code, so the rules are written beforehand. So, in a non-custodial situation, it would be considered trustless. In a custodial situation, you trust another person or organization to do what they say.
Responsibility
While there are obvious perks to holding your own keys, it also increases your personal responsibility. If your password and seed phrase is lost, no recovery process exists. Be careful when choosing to use DeFi.
Use Cases for DeFi vs CeFi
DeFi
Many use cases exist for DeFi, including peer-to-peer lending and borrowing, derivatives, decentralized exchanges, synthetics and DAOs. DeFi is also digitally native; it has an advantage over typical finance and corporation structures by finalizing instantly on the blockchain. Code is law in DeFi.
CeFi
CeFi has a bad reputation among crypto natives but has beneficial use cases. Trading platforms for example are a great use of CeFi. Not everyone who wants to get involved in crypto also wants to hold their own keys. For some, there is a higher chance that they lose their seed phrase than there is the centralized trading platform they operate on goes bust.
Limitations of DeFi vs CeFi
CeFi
- Central point of failure
- Fees
- Requires trust
- Can offer protection and backup for instances of error and fraud
DeFi
- Difficult to onboard new users
- Hackable
- Loss of keys is a permanent loss of funds
- Less recourse when fraud. mistakes or loss occurs
Conclusion: CeFi vs DeFi
Both CeFi and DeFi play a role in the ever-developing crypto world. However, their roles are much different and both come with a different set of advantages. DeFi has far more functionality and can be safer when centralized organizations go belly up. CeFi is an easier way to onboard new users to crypto and has more ways to recover funds if the password is lost. Experienced users who are looking to harness Web3 might try DeFi, while a new trader is likely to first experiment with a CeFi trading platform.