The explosion in decentralized finance (DeFi) has created a divergence in the types of cryptocurrency services available on the market today. On the one hand, centralized companies provide exchanges, wallets, loans, and even issue instruments such as futures or options. But, while these services come with a degree of automation, they are owned and operated by central entities.
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In contrast, DeFi has evolved because financial services can be run entirely on the blockchain using smart contracts without any centralized control.
Of course, nothing is ever black and white, and even DeFi applications may be subject to a degree of centralization. For instance, while a DeFi application is programmed to run on the blockchain, it’s usually accessed via a user interface hosted on a website. An internet service provider could technically block the website, or a hosting service could take it down temporarily. However, the underlying smart contracts on the blockchain would still exist and operate without interruption.
On the other side of the coin, some blockchain platforms stand accused of being overly centralized, relying on only a small group of validators. Despite these gray areas, there are some critical delineations between CeFi and DeFi, and each comes with benefits and drawbacks.
CeFi, or centralized finance, refers to banking and traditional finance, but it also refers to the cryptocurrency sector branch based on centralized entities. Exchanges like EQONEX, general cryptocurrency service providers, and lending platforms are all classed as CeFi.
There are several advantages to using CeFi providers. Many of them have established solid reputations over many years and have garnered links with existing financial services to provide services such as fiat onboarding or insurance to cover issues such as hacks. They’re often well-funded companies with the resources to develop user-friendly apps that will be accepted into the most popular marketplaces such as Apple’s App Store.
CeFi companies offer ancillary services such as customer support for when things go wrong, and, as a legally established entity, they have specific accountabilities to the authorities.
The user-friendly nature of CeFi compared to DeFi, along with the ability to onboard from fiat, means that CeFi is an obvious choice for many users, particularly newcomers.
On the other side of the balance, trust is the biggest issue for CeFi companies, and it’s still all too common to find scam outfits in crypto CeFi. One recent survey estimated that U.S. citizens lost $80 million to crypto scams in six months during 2021. Therefore, finding a trusted provider is not so much a challenge, but an absolute must.
Another consideration is that centralized entities can and do change their terms at any given moment. Such changes may be minor, for instance, fluctuating interest rates on lending, but they may also be more significant. For example, OKEx temporarily halted withdrawals during 2020, which meant that customers could not access their funds.
However, perhaps the biggest pull for those choosing DeFi over CeFi is the superior returns on investment. CeFi companies are beholden to investors or shareholders and have more overheads for staffing, premises, and other costs. CeFi cannot match the returns available to those willing to invest in DeFi.
The generous yields available in DeFi are one thing, but what else is pulling in users? After all, this is a sector that’s grown from under $1 billion to reach more than $150 billion in a little more than a year.
DeFi offers an almost cultish appeal to its most ardent followers and represents an entirely new way of doing finance.
While he was acting Comptroller of the Currency, Brian Brooks penned a piece for the Financial Times in which he stated that DeFi would soon morph into a future of “self-driving banks.” Bloomberg’s Odd Lots podcast has covered DeFi extensively over recent months, and DeFi lending protocol Aave recently announced its intention to launch permissioned institutional pools in response to demand from the sector.
DeFi offers the opportunity to get in early on up-and-coming projects and tokens, which has proven to be a magnet for retail investors to date. Another attraction is that the smart contract code is visible for anyone to see, so if you know how to write code, you can easily check that the application will perform as expected.
If the issues of CeFi can be summed up using the word trust, DeFi’s issues are predominantly related to risk. On the last point above regarding code, many DeFi protocols have fallen prey to savvy hackers who’ve managed to spot vulnerabilities in the underlying programming.
The most recent example is Poly Network, which turned out to be the biggest-ever hack in DeFi when an attacker managed to siphon off over $600 million from three blockchains. While many DeFi protocols now take the time to have their programming audited, the Poly incident illustrates that security is still an issue.
There’s also a significant amount of risk tied up in the generous returns on offer, which often depend on token volatility. Depositing funds into liquidity pools comes with the risk of impermanent loss when the markets move.
DeFi is also a nascent sector where developers are generally focused on function over form. Even where smart contracts are robust, user interfaces are often crude and not particularly friendly, and users can’t expect to find libraries of support documentation or FAQs—let alone a customer support person to talk to if something goes wrong.
Despite its drawbacks, DeFi is nevertheless a revolutionary shift in finance, and as such, it seems likely that it will continue to gain adoption. If the future of self-driving banks is really on the horizon, it may not be long before DeFi is simply the new finance.
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