With the advent of blockchain technology, this ensued a debate between the traditional world of finance and the newly introduced realm of cryptocurrencies, also referred to as decentralized finance (DeFi).
Over the years, blockchain gained momentum. People started getting used to blockchain technology. With the scope of blockchain technology and cryptocurrency expanding, the debate has now shifted to a new set of considerations. It’s now between two subsets of the same crypto world: centralized finance and decentralized finance.
To understand the comparative advantages and disadvantages - the benefits of one over another - we must first understand what these two concepts are.
Centralized finance used to be the standard for trading crypto before DeFi came into the picture. It still maintains a stronghold over the cryptocurrency industry. But decentralized finance is catching up with it as DeFi is seeing astounding growth this year through its yield farming trend.
In centralized finance (CeFi), all orders in the crypto trade are channeled through a central exchange. The funds are managed by responsible people running this exchange. This means you don’t own a private key that gives you access to your wallet. Furthermore, the exchange determines which coins they list for trading or how much fees you have to pay to trade using their exchange.
To summarize this section, you don’t truly own your cryptocurrencies when trading via a centralized exchange. Moreover, you are subject to the rules a centralized exchange imposes on you.
In decentralized finance, there is no involvement of an exchange. The entire process operates through automated applications that are built on top of blockchain platforms.
Furthermore, decentralized finance tries to create a fair financial system in which everyone can participate. Ideally, even unbanked people can access some form of banking services through blockchain technology and made possible by DeFi.
More specifically, decentralized finance aims to create a permissionless, open-source, and transparent finance service ecosystem. This decentralized financial system provides services such as crypto lending, borrowing, yield farming, asset storage, and many more.
The main benefit of using decentralized finance over centralized finance is your ability to stay in control over your assets. This means you own the key pair for your wallet and you’re the only person who can move your funds. Furthermore, users who want to participate in DeFi have to use decentralized applications (DApps) built on top of blockchain platforms to access those DeFi services.
Recommended reading: State of DApps - 5 Killer DApps You Should Know
The defining difference between centralized and decentralized finance is the involvement of an exchange. In centralized finance, the system is governed by exchanges. Whereas in decentralized finance, it is technology-dependent. DeFi users access financial services through DApps as discussed before.
This distinction rests on a more significant differentiator that is often overlooked. Due to the involvement of exchanges in CeFi, users transfer their risk to the exchanges. Therefore, exchanges are in charge to keep users’ funds safe.
In DeFi, these intermediaries are cut off. The transactions happen on the belief that smart contract protocols will work well.
There are some other differences as well. For example, centralized finance helps with fiat to crypto conversions and cross-chain solutions. If required, centralized finance is also able to move funds to help its customers or to block trading in case of a negative event such as a hack. On the other hand, DeFi is considered more transparent and non-intrusive because it does not ask for any personal information of the customer and is non-custodial. DeFi can also not block trading or put restrictions on users whereas CeFi can.
We will discuss these differences in more detail in the next segment.
In centralized finance, users transfer their crypto holdings to exchanges. These exchanges bear the risk of keeping the holdings secure and the responsibility of putting them to good use.
In this context, one needs to be mindful of the fact that these exchanges were not built in a day. They gained their reputation by successfully handling the funds of their customers for years. Since blockchain technology is a technology-intensive and rapidly developing field, many investors often find it challenging to properly trade. Exchanges share this responsibility.
The reputed exchanges employ 24/7 customer service teams that assist the customers and guide them through these challenges. Adoption is still complex due to the recent transformations in DeFi through yield farming. Many complex DeFi use cases have been created that are hard to explain to crypto beginners.
Therefore, these exchanges share the responsibility of educating their customers. This also allows them to slowly adopt more advanced use cases, such as yield farming, to offer it to their customer base. Just take a look at the great knowledge center Binance has created.
Converting fiat to crypto requires a centralized exchange. This makes client onboarding easier for the exchange and convenient for the client. Most of the new customers who come with fiat currencies can not convert them to crypto in DeFi. Similarly, taking withdrawals in fiat requires conversion from crypto. The presence of a centralized exchange is always beneficial in that regard.
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The decentralized finance system requires their tokens to follow Ethereum standards or the standards of the platform they are active on. For example, an Ethereum-based decentralized exchange (DEX) only supports trading ERC20-based tokens through its smart contracts.
On the other hand, centralized finance systems are free from such restrictions. CeFi supports a host of popular coins that are generally issued in independent blockchains. As trusted centralized exchanges, CeFi services can take custody of funds from these independent blockchains. Whereas DeFi services suffer from complexity and latency when performing swaps across multiple blockchains.
This diversity offered by the CeFi services goes a long way to differentiate the two. Most of the high-volume and high market-cap coins are traded on independent blockchains. These independent chains are still beyond the reach of decentralized finance.
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In CeFi, the customers transfer the custody of their holdings to the exchanges. They also provide their private details to these exchanges. In case the exchange is hacked or suffers from a cyber attack, there’s a real chance of losing funds. Even if the funds are safe, there is a risk of compromised privacy.
One needs to keep in mind that a transparent transfer of holdings and the associated risks are what makes centralized finance a trustworthy system. As far as the risk of hacks and attacks are concerned, almost all the exchanges deploy blockchain analysis companies or blockchain forensics. These companies monitor transactions, addresses, and the flow of funds continuously. They report any potentially fraudulent activity via alerts in real-time. This makes centralized finance reliable and mostly protects customers from the risks of cyber intrusions.
Both centralized finance and decentralized finance aim to achieve the same objective. They intend to make crypto trading popular and increase the trading volume. However, the way these two carry out their objectives is different.
CeFi acts by building trust on its way. It promises security of funds and fair trade on those funds. Also, it’s more inclusive with its fiat-crypto-fiat conversions. Investors holding conventional currency can also participate in crypto trading. Furthermore, CeFi exchanges offer them customer support services which DeFi services often lack.
On the other hand, DeFi wants to make the space intrusion free. It provides a space for investors to implement their strategies without having to deal with an intermediary body.
Both systems have their benefits and drawbacks. It depends on the investor and their priorities. If privacy and transparency are the priority, DeFi is the path to choose. If trust, sharing of risks, increased options to invest, and flexibility are your concerns, go for CeFi.
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