The New Financial System :: Decentralized Finance (DeFi) Vs Centralized Finance (CeFi)

5 mins read

Global finance witnessed a revolution with the advent of Blockchain and Bitcoin. We blogged about our adventurous experience in building a digital currency that was trying to be like Bitcoin. Over the last 10,000 years, money has transformed from cattle and shells to today’s electronic currency. Currently, almost every aspect of banking, trading, and lending is managed by centralized financial systems and regulated by governing bodies. However, the world is moving towards decentralized financial systems. Money needs to move fast. Fiat money is created by debt. And these debts have to be managed. Debts power economies. I will explain this better in another post. For now, we should remember that money needs to move fast globally. Decentralized Finance (DeFi) speeds up economic activities more than Centralized finance.

If you owe the bank a hundred thousand dollars, the bank owns you. If you owe the bank a hundred million dollars, you own the bank. -American Proverb

Either way, money got to move! … and fast!

Cryptocurrencies were invented with the intent of decentralizing the financial system, though somewhat limited to crypto trading. However, Decentralized Finance (DeFi) exchanges came into the picture, that not only supported the crypto-trading but also had several use cases like lending crypto loans, crypto derivative trading like Bitcoin Futures, tokenizing digital assets etc.

The core purpose of both Centralized Finance (CeFi) platforms and Decentralized Finance (DeFi) platforms are to facilitate the use of cryptocurrencies for all financial needs and services. Let’s look into Centralized Finance (CeFi) and Decentralized Finance (DeFi).

Centralized Finance (CeFi)

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In CeFi almost every aspect (banking, lending and trading) is managed by centralized systems, operated by governing bodies and gatekeepers. Regular consumers need to deal with middlemen to get access to everything (like loans, stocks and bonds etc).

Some cryptocurrency platforms are CeFi. BinanceCoinbaseLibra, etc are well-known CeFi exchanges. Users typically create an account with these companies and use the platform to primarily transfer and receive funds. Although other crypto-financial services like borrowing, lending, margin trading etc. are inclusive. However, due to the centralized nature of these platforms, there are possibilities of data security breach and thefts as these platforms are susceptible to leaks and cyber attacks. One key advantage of Centralized Finance (CeFi) over Decentralized Finance (DeFi) is that they support cross-chain exchange for multiple cryptocurrencies. Also, CeFi exchanges seamlessly enable the conversion of fiat currency to cryptocurrency and vice-versa.

Decentralized Finance (DeFi) – The New Rising Financial System

DeFi uses cryptocurrency and blockchain technology to manage financial transactions. It aims to democratize finance by replacing legacy, centralized institutions with peer-to-peer connections that can provide a full spectrum of financial services, from everyday banking and loans to complicated contractual relationships and asset trading. Due to its decentralized structure, DeFi is hands down the best when it comes to the protection of personal data. Users are responsible for managing their own funds and activities. It’s safe to say users are in control.

The omnipresent nature of blockchain empowers the adoption of DeFi.

DeFi challenges CeFi by disempowering middlemen and gatekeepers, and empowering everyday people via peer-to-peer exchanges.

Decentralized Finance (DeFi) is hosted on a Blockchain platform like Ethereum smart contracts. Smart Contracts are designed to automatically execute transactions when a particular condition is fulfilled. Users do not require permission to join a Decentralized Finance (DeFi) exchange since it is permissionless, which is not the case in Centralized Finance (CeFi) platforms. DeFi platforms fail in providing interoperability of exchanges.

DeFi is making its way into a wide variety of financial transactions. It’s powered by decentralized apps called “dapps,” or other programs called “protocols.” Dapps and protocols handle transactions in the two main cryptocurrencies, Bitcoin (BTC) and Ethereum (ETH).

When you make a transaction in your conventional banking account, it’s recorded in a central private ledger—your transaction history—which is owned and managed by your bank. Blockchain is a decentralized, distributed public ledger where financial transactions are recorded on the computer. DeFi applications have an identical copy of the public ledger, which encrypts and records each and every transaction. Decentralized means there is no gatekeeper or middleman managing the system.

DeFi Use Cases:

Decentralized exchanges (DEXs): Most cryptocurrency investors use centralized exchanges like Binance, Coinbase, or Gemini. DEXs facilitate peer-to-peer financial transactions and let users retain control over their money.

Non-fungible tokens (NFTs): NFTs create digital assets out of typically non-tradable assets, like artworks, videos, or the first tweet on Twitter. NFTs commodify the previously uncommodifiable.

Traditional financial transactions: Anything from trading securities, payments, and insurance, to borrowing and lending is already happening with DeFi.

E-wallets: DeFi developers are creating digital wallets that can operate independently of the largest cryptocurrency exchanges and give investors access to everything from cryptocurrency to blockchain-based apps.

Stable coins: While cryptocurrencies are vehemently volatile, stable coins attempt to stabilize their values by tying them to non-cryptocurrencies, like the Naira, U.S. dollar etc.

Yield harvesting: Dubbed the “rocket fuel” of crypto, DeFi makes it possible for speculative investors to lend crypto and potentially reap huge rewards when the proprietary coins DeFi borrowing platforms pay them for agreeing to the loan appreciate.

Flash loans: These are cryptocurrency loans that borrow and repay funds in the same transaction. How it works: Borrowers can make money by entering into a contract encoded on the Ethereum blockchain—no lawyers needed—that borrows funds, executes a transaction, and repays the loan instantly. If the transaction can’t be executed the funds automatically go back to the loaner. If you do make a profit, you can pocket it. Think of flash loans as decentralized arbitrage.

Challenges of DeFi

DeFi is a fast-rising innovation that comes with many challenges. Regulation by governing bodies is one of the major challenges.

Private key requirements: With DeFi and cryptocurrency, you must secure the wallets used to store your cryptocurrency assets with private keys. Private keys are long, unique codes known only to the owner of the wallet. If you lose a private key, you lose access to your funds—there is no way to recover a lost private key. 🙁

No consumer protections: DeFi has thrived in the absence of rules and regulations. The downside to this is that users may have little recourse should a transaction go foul. In centralized finance, for instance, a deposit insurance parastatal reimburses deposit account holders up to a certain amount per account, per institution if a bank fails. Moreover, banks are required by law to hold a certain amount of their capital as reserves, to maintain stability and cash you out of your account any time you need. No similar protections exist in DeFi.

Collateralization: Collateral is a thing of value used to secure a loan. When you get a loan, for instance, the loan is collateralized by an asset. Nearly all DeFi lending transactions require collateral equal to at least 100% of the value of the loan, if not more. These requirements vastly restrict who is eligible for many types of DeFi loans.

Conslusion

The promise and potential of DeFi are far-reaching. DeFi’s future looks bright. Investors will soon have more independence, which will allow them to deploy assets in creative ways that seem impossible today. DeFi offers new ways to commodify digital and non-digital things.

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