The crypto market consists of more than 20,000 currencies with a market capitalization of more than $1 trillion. While most of the $82 billion in daily transaction volume flows through centralized finance (CeFi) platforms, the decentralized finance (DeFi) ecosystem has more than $40 billion in total locked value – and had more than $100 billion until recently.
Let's look at the difference between centralized finance, or CeFi, and decentralized finance, or DeFi, and what these differences mean for cryptocurrency traders and investors seeking yield.
Decentralized finance platforms are opening the door to new possibilities, but it's essential to understand the differences and trade-offs with centralized finance platforms.
What is Centralized Finance (CeFi)?
Centralized finance involves routing every transaction through a central authority. For instance, Coinbase users keep their funds in a wallet controlled by the exchange. And when users place a trade, Coinbase identifies a counterparty and processes the transaction for a fee. These processes are similar to conventional financial institutions.
There are several CeFi benefits:
- Fiat Conversions – Centralized exchanges make it easy to convert fiat currency into cryptocurrencies and vice versa. As a result, they're much more friendly to crypto newbies.
- Cross-Chain Transactions – Centralized exchanges can easily facilitate trades across blockchains by maintaining their own liquidity pools and internal trading teams.
- Customer Service – Centralized finance institutions typically have a higher level of customer service since there's a single entity responsible for processing transactions.
There are also some drawbacks:
- Principles – Satoshi Nakamoto envisioned Bitcoin as a way to avoid financial intermediaries, and most crypto enthusiasts aspire to reach similar goals. Of course, CeFi is antithetical to these goals.
- Availability – It's not uncommon for CeFi platforms to pause trading during excessive market volatility, like a conventional stock exchange, which may upset some traders.
- Yield Risk – Some CeFi platforms generate yield by lending coins to other users – just like many DeFi platforms. However, each CeFi platform uses its own criteria for assessing credit risk and assigning interest rates, introducing potential credit risks.
- Ownership – Many CeFi platforms own their users’ private keys, meaning they have complete control over their users’ crypto holdings. Unfortunately, if a CeFi exchange has a liquidity problem, the private key ownership means they can freeze user funds.
Several CeFi platforms offer the opportunity to generate income. For instance, YouHodler offers a "savings account" that guarantees an 11% annual return with no need to set up a third-party wallet, lock funds in a smart contract, or purchase two different coins to take as a pair. As a result, it's a lot more approachable for newbies. But keep in mind, this 11% yield is not generated without its own risks.
Popular CeFi platforms include:
- Nexo – Earn daily interest with stablecoins and borrow and collateralize your digital assets.
- CoinLoan – Borrow, swap, and grow your assets using a certified custodian covered by insurance.
- Lend – Earn monthly compounded interest with a "savings account" and access dollar loans.
In recent months, many CeFi platforms have experienced liquidity problems, leading them to freeze customers' funds or even take them. For instance, Celsius Network froze withdrawals and transfers during the crypto meltdown in June before eventually filings for bankruptcy. Buried in the fine-print is a clause saying that any digital asset transfers to the platform constitute a loan from the user to Celsius, meaning customer funds are essentially unsecured loans. As a result, users are unsure whether they will be able to recover funds.
What is Decentralized Finance (DeFi)?
Decentralized finance involves using smart contracts to process transactions between users without any intermediaries. For example, Uniswap facilitates crypto-to-crypto trades by maintaining liquidity pools. Anybody can contribute to these liquidity pools in exchange for a share of the fees traders pay to make transactions.
There are several DeFi benefits:
- Permissionless – Decentralized exchanges don't require any personal information to process transactions, eliminating any possibility of discrimination or sovereign interference.
- Trustless – Decentralized finance doesn't require users to trust any intermediary to remain solvent or execute a trade, although they must trust the smart contract behind the scenes.
- Two-Sided Market – Anyone can become a liquidity provider or lender to generate yield rather than being limited to a "customer" of a centralized exchange or service.
The most significant drawbacks include:
- Security – DeFi platforms rely on smart contracts to execute transactions. If there are errors in these smart contracts, it may be impossible to recover any lost funds.
- Difficulty – CeFi platforms provide customer service, support cross-chain transactions, and even offer insurance in some cases, making them much easier to use for the average person. DeFi platforms also don’t yet have the most intuitive UI/UX.
Most DeFi platforms offer a way to generate income. For instance, Aave is an open-source liquidity protocol that lives on Ethereum and allows anyone to supply and borrow crypto assets. The yield is automatically calculated and algorithmically adjusted based on real-time supply and demand without an intermediary.
Popular DeFi platforms include:
- Compound – Lend and borrow assets against collateral through an open source money market protocol on Ethereum.
- Maker – Access a decentralized credit platform on Ethereum, enabling anyone to generate income by lending coins.
- Akropolis – A DeFi yield platform focused on generating income across multiple protocols while remaining market-neutral.
How DeFi & CeFi Work Together
Decentralized finance is rapidly evolving, but some limitations make centralized finance a must-have. For instance, DeFi platforms cannot facilitate the exchange of fiat currencies for cryptocurrencies. And cross-chain transactions are impossible without an intermediary stepping in to facilitate transactions between two blockchains.
Oracles are an excellent example of DeFi and CeFi working together. Since smart contracts cannot inherently interact with off-chain data, oracles are needed to create hybrid smart contracts that combine on-chain code and off-chain infrastructure. These technologies enable things like decentralized sports betting or stock market hedging.
DeFi and CeFi could also learn lessons from each other. For instance, during the extreme market volatility in mid-2021, DeFi platforms remained online (albeit with massive cost) as CeFi platforms paused trading. CeFi platforms could learn from DeFi platforms to keep trading open during market volatility, opening the door to trades at a higher cost.
What Should You Use?
Most beginners prefer centralized finance platforms due to their simplicity and customer support. In addition, these are the only platforms that support the exchange of fiat currency for cryptocurrency, meaning it's the only option available if you don't already own crypto. And for many, these platforms offer enough functionality for most use cases.
Many crypto traders and investors seek out decentralized finance platforms to generate yield on their existing investments. For example, they may want to stake the Bitcoin or stablecoins they own to earn income from their portfolio. DeFi may also be a good option for purists seeking to avoid using intermediaries on principle.
Ultimately, the best decision depends on your use case and risk tolerance. For instance, while DeFi platforms generate yield, they use smart contracts that may contain technical glitches. On the other hand, reputable CeFi platforms are generally well-insured against hacks or technical losses, making them a safer option.
The Bottom Line
Since they're similar to conventional financial services, most crypto traders and investors are familiar with centralized finance (CeFi) products. But the rise of decentralized finance (DeFi) is opening the door to new income opportunities while democratizing access to financial services.
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