In the burgeoning and fast-moving world of cryptocurrency, a clear divide is beginning to appear: that between centralized finance (CeFi) and decentralized finance (DeFi). CeFi, as epitomized by mega-exchanges Coinbase and Binance, is a fully managed space where executives, managers, developers and support staff run the infrastructure that allows users to buy, sell, trade and store any number of cryptocurrencies.
In contrast, DeFi is a largely autonomous ecosystem of platforms and protocols operating through smart contracts that allow users to trade, lend, borrow and earn interest on their crypto assets. Though created by developers, the protocols are not controlled or operated by any single party. With its first shoots appearing around 2017, DeFi is a relatively new space that began to firmly establish itself last year, when total value locked in the sector sky-rocketed from a few hundred million to more than $15 billion by December.
A CeFi platform is typically a gateway to cryptocurrency. Through the big players already mentioned, users can buy cryptocurrency with traditional “fiat” currencies like US dollars or Euros and then store it in wallets or trade it through the provider’s exchange. Some of the bigger exchanges allow you to make leveraged trades (i.e. borrowing to bet on a token price rise) as well as deposit your cryptocurrency in savings plans to earn interest. CeFi products also offer significantly lower fees than their DeFi counterparts right now.
Away from the big exchanges, there are also single service providers that allow you to buy and store crypto, as well as “on/off ramps” like Wirex where you can buy and exchange your coins and tokens for fiat and transfer them back to your traditional finance (TradFi) bank account. CeFi providers often link with traditional financial tools and offer familiar services such as debit cards. Altogether, CeFi does many things well, and there’s a reason its adoption has reached a global scale.
The struggle over consumer data
One of the fundamental differences between CeFi and DeFi is the collection of KYC (“know your customer”) data. CeFi companies— especially those dealing with fiat currencies — typically require high levels of KYC information, while DeFi requires none. Indeed, for many, this is one of the most attractive aspects of DeFi and one that makes it the true inheritor of the value proposition set out during the founding of Bitcoin: namely, the establishment of an alternative financial system.
Leading DeFi protocols and exchanges allow users to transact without providing any information whatsoever, allowing for a completely free-flowing system unencumbered by the arduous level of data collection required in CeFi and TradFi. On DeFi platforms such as dYdX, users can borrow millions of dollars for a “flash loan” (a loan that is borrowed and paid back in the same block) for arbitrage opportunities on exchanges. Furthermore, lending protocols such as Aave and Compound allow individuals to deposit their crypto assets to a liquidity pool for others to borrow, and can do it in a manner that is safe and censorship-resistant for both parties. This is all possible because of smart contracts, which dictate how much the lender receives in interest and how much the borrower can take. Most importantly, none of this requires users to provide any personal information.
In CeFi, however, KYC information can be beneficial for the end-user as it keeps businesses accountable and compliant. For all the many things that DeFi does well, it does not particularly grant its users much protection. Indeed, both CeFi and DeFi have their own strengths and weaknesses: CeFi has proven to be the more secure option in many cases (particularly in digital banking), but often requires the collection of user data. As demonstrated by the hack of Equifax’s customer data in 2017, which compromised over 140 million peoples’ private information, user data is highly valuable and therefore a target for blackhat attacks. In the case of DeFi, no user data can be jeopardized, but the money circulating in the DeFi ecosystem is arguably more vulnerable than the money secured on centralized servers.
Freedom versus security and speed
With freedom, though, comes responsibility. In the case of DeFi, user error and smart contract exploits can result in enormous losses. Unfortunately, there is little to no recourse in most of these scenarios. Flash loans are, in fact, a good example of how DeFi can be misused, with tens of millions of dollars drained from protocols over the past year by canny users finding loopholes in leaky smart contracts. Frequently these losses are incurred by other users, making this a highly undesirable aspect of the permissionless, non-managed world of DeFi.
Generally speaking, CeFi is a more secure space thanks to the aforementioned legions of staff and sophisticated systems working to ensure the safety and security of platforms. This is often reinforced by the need to comply with regulations that apply to the use of fiat currency, which are stringent in the US, Europe and many other parts of the world including developed and developing Asia. For regulators, KYC is essential for safety and security, ensuring that money laundering, fraud and theft cannot go unnoticed and unpunished at any financial provider.
Both CeFi and DeFi are growing and developing areas of a new world of digital finance that currently boasts a market cap of $1.6 trillion. This is just over a decade on from the founding of the first-ever cryptocurrency, which was roundly dismissed by traditional finance but now embraced by some of the world’s biggest banks, asset managers and companies. Each area has its benefits and drawbacks and will continue to evolve to tackle inherent issues with security while also maintaining flexibility. In time, we may see a more integrated ecosystem that features the best of both worlds.