Decentralized vs Centralized Finance: Who Wins the Race of Economy Growth

Since customers are frequently unaware of the underlying laws or agreements regulating financial assets and products, the traditional centralized finance (CeFi) environment may seem confusing to non-experts.

On the other hand, the underlying integrity-protected blockchain of Decentralized Finance (DeFi) is helping the ecosystem make a name for itself as one that wants to give transparency and control. DeFi platforms also promise to offer greater financial asset yields than CeFi platforms. The distinction between CeFi and DeFi might not always be clear, though.

This article compares and contrasts DeFi with CeFi in terms of law, security, economy, privacy, and market manipulation.

What is CeFi and how does it work?

Centralized finance was created thousands of years ago in ancient Mesopotamia. Since then, people have utilized a variety of products and resources as currency, including animals, land, and cowrie shells, as well as precious metals (such as gold, which has almost universal cultural acceptability as a store of value), and, more recently, fiat currencies.

Thus, it has been shown that a currency can have inherent value (for instance, land) or can have an assumed value (fiat currency). All known efforts to create an eternal, stable monetary and financial system were predicated on the idea of a centralized entity, such as a government maintaining the value of a currency and in charge of a military force. However, what exactly does CeFi imply in crypto?

All crypto trade orders are routed through a central exchange under centralized financing, which is the main idea behind centralized exchanges (CEXs) in the world of cryptocurrencies. Firms like Binance, Coinbase, and Kraken are examples of Cefi companies. The same platform is used by users to transfer and receive tokens when they open accounts with various exchanges. But this isn’t everything. Along with cryptocurrency trading, these exchanges also provide lending, borrowing, and margin trading.

Large exchanges also have departments full of customer service personnel accessible to help clients. Customers feel secure because of the high caliber of customer care, knowing that their funds are in capable hands.

What is DeFi and how does it work?

New imputed currencies have emerged as a result of blockchain technology’s debut and its decentralized, permissionless properties. One of the most potent capabilities of the blockchain is the transfer and trading of financial assets without the use of reliable middlemen. In addition, decentralized finance, a recent blockchain subfield, is devoted to creating financial services and technologies on top of ledgers with smart contracts.

DeFi uses smart contracts and cryptocurrency to deliver services directly to customers. In today’s financial environment, financial institutions function as transaction guarantees. Your money goes via these institutions, thus they have a lot of power. However, with DeFi, a smart contract takes the position of the financial institution in the transaction.

The majority of CeFi’s offerings, including loans, leveraged trading, decentralized governance voting, stablecoins, and asset exchanges, are compatible with DeFi. Although there are more products accessible than ever before, some of the most complex ones, including options and derivatives, are also developing quickly.

DeFi grants its users control by letting them keep custody of their assets; as a result, nobody should be able to censor, relocate, or destroy their assets without their consent. Anyone can create and use DeFi products if they have a functional computer, an internet connection, and some knowledge. The DeFi software is really operated by the blockchain and its distributed network of miners concurrently.

DeFi vs. CeFi: Various properties compared

The section below discusses the most common DeFi versus CeFi attributes:

Public verifiability

While the underlying DeFi application code might not always be open-source, non-custodial DeFi must have publicly verifiable execution and bytecode on a blockchain. Therefore, unlike CeFi, each DeFi user may see and confirm that DeFi state changes are carried out properly. The new DeFi technology has an unmatched ability to transfer trust because to this openness.

Atomicity

Sequential actions, including several financial transactions, may be carried out as part of a blockchain transaction. This combination can be made atomic, which means that the entire transaction will either succeed or fail simultaneously. CeFi does not have this programmable atomicity property, although it may be possible to enforce atomicity in CeFi through expensive and time-consuming legal agreements.

Anonymous development and deployment

Less privacy is offered to users by centralized finance than by DeFi transactions. Even Bitcoin’s creator has remained a mystery up to this point, and many DeFi initiatives are developed and run by anonymous teams. Once they are implemented, the DeFi smart contracts are run implicitly by the miners. Without a front-end, anonymous DeFi applications can operate, forcing users to interact with the smart contract directly.

Custody

DeFi, as opposed to CeFi, enables users to instantly control their assets (there is no need to wait for the bank to open). But with immense power also comes great responsibility. Users bear the majority of technology risks unless such insurance is insured. As a result, holding bitcoin assets is particularly common with centralized exchanges, which are essentially the same as conventional custodians.

Trading of crypto assets

The CEXs are constructed using the same principles as their conventional equivalents. Limit order books are off-chain archives of pending trades that CEXs maintain. AMM protocols are used by decentralized exchanges (DEXs) to match the counterparties in a transaction, which is how they operate substantially differently from centralized exchanges. Depending on the volume of transactions, AMMs use mathematical algorithms to set prices.

Execution order malleability

When using permissionless blockchains, users frequently use a peer-to-peer network to publicly disclose the transactions they want to carry out. Because there is no persistent centralized body directing the sequence of transaction execution, peers might, for instance, engage in competitions for transaction fee bids. This order malleability has led to the demonstration of several market manipulation strategies that are presently used often on blockchains.

Contrarily, CeFi regulatory bodies impose strict standards on financial institutions and services, including the manner in which transaction order must be carried out. The centralized nature of CeFi’s financial intermediaries makes this possible, nevertheless.

Transaction costs

Blockchains in general and DeFi’s transaction fees are essential for preventing spam. However, financial institutions in CeFi have the option to provide transaction services for free due to the ability to depend on client anti-money laundering (AML) verifications (or are compelled by governments to offer some services for free).

Non-stop market hours

Markets on CeFi are renowned for having outages. For instance, the two main trading exchanges in the United States are the New York Stock Exchange and the Nasdaq Stock Exchange. Their business hours are 9:30 am to 4:00 pm Eastern Time, Monday through Friday.

Most, if not all, DeFi markets remain open 24 hours a day, 7 days a week due to the constant nature of blockchains. DeFi, in contrast to CeFi, where liquidity on a range of items is typically low at these periods, lacks pre- and post-market trading as a result.

Privacy

Only blockchains with non-privacy-preserving smart contracts can contain DeFi. As a result, rather of offering actual anonymity, these blockchains offer pseudo-anonymity. These exchanges have the authority to disclose address ownership to law enforcement given that centralized exchanges with AML standards are typically the only feasible alternative for converting money to cryptocurrency assets.

Arbitrage risks

In order to reduce the danger of price fluctuations, an arbitrage should ideally work atomically. Arbitrage on centralized and hybrid exchanges is inherently vulnerable to market pricing fluctuations unless the arbitrageurs work with the exchanges to ensure execution atomicity.

Arbitrage between two decentralized exchanges on the same blockchain can be considered risk-free when transaction costs are disregarded. This is due to the atomicity feature of the blockchain, which enables traders to create a smart contract that conducts the arbitrage and reverts if the arbitrage is unsuccessful. Arbitrage risk between two DEXs on different blockchains is equivalent to that of a CEX and hybrid exchange.

Inflation

When additional money is added to an existing currency supply, inflation results. Although the definition of inflation is the decline in a currency’s buying power, the connection between supply and inflation is not always obvious; occasionally, the money supply might rise without contributing to inflation.

In CeFi, central banks retain the authority to issue fiat currency, and inflation is frequently measured in relation to the price of a representative basket of consumer goods, also referred to as a consumer price index.

The asset supply of multiple cryptocurrencies is a moving target in the DeFi universe. Bitcoin (BTC) will likely ultimately face a problem where the supply has a hard cap but the economic activity it must support does not, resulting in a shortage of money. Without a block reward and hence no inflation, blockchains in general, including Bitcoin, may also be susceptible to security instability.

It will be interesting to watch if the inflation of the currency system causes BTC and other cryptocurrencies to experience substantial income disparities. There is no conclusive proof that cryptocurrencies solve this issue.

Cross-chain services

CeFi services are used regularly for trading BTC and other significant currencies created on distinct blockchains. DeFi services often do not handle these coins since atomic cross-chain trades are difficult and time-consuming to complete.

CeFi services address this issue by keeping cash from many chains (whereas decentralized services require that tokens follow Ethereum token standards to achieve interoperability).

This is a huge advantage for CeFi because many of the greatest market capitalization and most traded currencies live on different blockchains and do not follow interoperability regulations.

Final Verdict

Therefore, it is anticipated that these two unique yet interconnected financial systems would endure and mutually profit. The section below highlights a few synergy possibilities.

CeFi’s stress testing might be very instructive for CeFi, even thoughCeFi and Defi have different procedures and user behaviors. Defi appears to have avoided such interruptions thus far, which could help CeFi better understand its limits. Whereas CeFi relies on circuit breakers to control excessive asset fluctuation (markets stop trading when volatility reaches predetermined levels), Defi may be able to learn more about its limitations.