loader

DeFi vs. CeFi: Understanding the Key Differences

date_range December 16, 2022
person Vanessa MagicSquare
post-image

The concept of finance has been around for a very long time. Finance evolved from the need for human interaction and economic prosperity. Even more, the idea of centralized finance emerged out of the need to establish legally sanctioned methods of conducting transactions. 

The idea of centralized finance revolves around the regulatory frameworks and the requirements that must be met before anyone can access financial services. However, the prospects of decentralized finance have unquestionably presented a novel and fruitful alternative to traditional centralized finance, since it eliminates various systemic flaws.

Before we get into the differences, let’s examine what DeFi and CeFi mean.

What is Centralized Finance (CeFi)

Centralized finance refers to regulated financial institutions legally licensed by the government and constrained by national financial regulatory frameworks. Traditional banks, neobanks, stock exchanges, insurance firms, and other financial institutions all function under the framework of national governments and are thus classified as centralized financial institutions.

Centralized finance also exists in the crypto space. Several of the most prominent cryptocurrency exchanges fall into this group. Binance, Kraken, and Coinbase should spring to mind. Despite the fact that these crypto exchanges conduct transactions on the blockchain – a decentralized network – customers are still required to disclose vital personal information before using their services. This is essential because it ensures that these companies comply with the laws of the countries in which they are registered.

As a result, centralized exchanges have the right to flag a transaction that they deem harmful and can even freeze a user’s account, given that they have complete custody over all users’ accounts and funds.

What is Decentralized Finance (DeFi)

With the advancement of blockchain technology and the development of smart contracts, decentralized finance has become feasible. In DeFi, there is no central authority and users have complete control over their digital assets.

DeFi operates through the use of smart contracts, which replace the role of centralized financial institutions as intermediaries. With smart contracts, peer-to-peer transactions can be executed based on predefined rules and smart codes. Among the leading companies in DeFi are Uniswap, Aave, Pancakeswap, and others.

Users of DeFi, like those of CeFi, have access to financial services such as crypto trading, lending and borrowing, margin and futures trading, and so on. As a result, it overcomes the institutional barrier while being non-custodial. 

Key differences between DeFi & CeFi

We will explore the differences between centralized and decentralized finance based on five distinct metrics, namely, custody, privacy, flexibility, lending and borrowing, and cross-chain capabilities.

Custody

It has already been established that centralized financial institutions are custodial. This means they hold their users’ assets as well as the private keys to their wallets. This makes them vulnerable to attacks and a successful hack might result in the theft of users’ funds and personal information. DeFi on the other hand is fully non-custodial. In contrast, DeFi is non-custodial as users have complete control over their assets and private keys. 

Privacy

To comply with regulatory standards, centralized exchanges typically demand all users to submit personal information through a procedure known as Know-Your-Customer (KYC).  However, KYC is not required in DeFi, and users’ identities remain confidential.

Lending and Borrowing

Both of these entities are capable of providing users with financial services. Although, CeFi has an advantage in this area because it can delve into regulatory markets and offer traditional financial services to blockchain users.

Crypto-Fiat Conversion Flexibility

Despite all of its advantages, DeFi is still less adaptable than CeFi. This is because users are solely limited to swapping cryptocurrencies, as opposed to CeFi, where users can also trade cryptocurrency for cash. This flexibility makes CeFi even more appealing to margin traders.

Cross Chain Solution

Centralized crypto exchanges, in general, function as a melting pot for all types of crypto assets to be traded, regardless of their originating chain. This is due, in large part, to CeFi’s ability to store various assets and execute trades. Compatibility is critical in DeFi because most assets must meet a specific standard (especially the ERC20 standard). Executing atomic cross-chain swaps is known to be expensive and time-consuming in DeFi, thus, CeFi holds a distinct advantage here.

Final thoughts

While CeFi and DeFi may take different approaches to delivering financial services to their customers, they both serve the same overarching purpose. As DeFi continues to alleviate the drawbacks of centralized finance, the technology, and its usage are projected to increase over the next few years.
Explore the trending DeFi and CeFi platforms on the Magic Store today!