CeFi vs. DeFi

How to compare Centralized and Decentralized Finance

What is finance? What is centralized, or even decentralized finance (DeFi)?

The community informally attributes the term “centralized” to traditional banking, brokers, stock exchanges, and assets alike. Yet, almost everything that remotely touches a blockchain is touted as DeFi.

In our recent paper on CeFi vs. DeFi, we attempt to demystify the differences between those two paradigms. To our surprise, we have not found a consistent definition of the differences between CeFi and DeFi, hence try to provide a decision tree that should help everyone clear that fog:

Possible decision tree to differentiate between CeFi and DeFi. The differences are not always as clear-cut as one would hope.

Let’s try to apply that decision tree to a few concrete examples.

Uni/Suhsi/Pancakeswap — CeFi or DeFi?

Automated Market Maker (AMM) exchanges (such as Uni/Suhsi/Pankakeswap), typically operate on permissionless blockchains, where the user retains full custody over the assets, allowing us to move to the second question of the decision tree. As long as no miner can single-handedly censor a transaction execution, and as long as the smart contract doesn’t grant anyone such ability, we can move forward to the third question of the decision tree. Again, if no miner or smart contract function can freeze the protocol execution, we are observing a DeFi protocol.

USDT or USDC — CeFi or DeFi?

Reserve-backed stablecoins have clearly boosted DeFi’s use-cases and helped tremendously by bringing stability to a rather volatile asset class:

The temporal comparison of 4 stablecoins, please mind the different scale on the y-axis.

Clearly, the reserve-backed stable coin examples here pivot much closer to 1 USD than their other counterparts. Yet, does this stability come at a cost?

Owning an ERC20 USDT or USDC token enables the user to remain custodian over the asset (passing the first test). Yet, both, the USDT and USDC smart contracts have built-in functionality to blacklist specific blockchain addresses, preventing these from sending those stablecoins (see code below). Even worse, the USDT smart contract retains the option to zero-out balances of black-listed accounts 🥺.

USDT code blacklist functionality.

Following our decision tree above, we conclude that USDT/USDC are governed by a CeFi intermediary while using DeFi settlements. The CeFi intermediary can censor transactions by blacklisting addresses. By crawling the Ethereum chain, we found that USDT blacklisted over 400 accounts, and nearly 44M USDT were zeroed out!

We invite the interested reader to check out our paper for further examples and details.

DeFi Bank run?

The above-highlighted power from CeFi onto DeFi can cause systematic risks in DeFi. If, for instance, a Curve or Aave pool containing USDT is suddenly black-listed by the USDT smart contract, the pool can no longer return USDT. We are hence likely to experience a similar situation as in a CeFi bank run shown below.

Because CeFi providers retain control over DeFi, a DeFi bank run is possible.

There are though interesting differences between a CeFi and a DeFi bank run:

• In a CeFi bank run, most bank clients do not receive any money or a constant minimum from their account.
• In a DeFi bank run, those who exit a liquidity pool first, are likely to lose little, while those that come later receive an increasingly worse price for their LP tokens. That is because liquidity pools typically penalize users for unbalancing the pool’s assets. Nifty traders are likely to build USDT blacklist detection bots to automatically exit an affected liquidity pool 🙃

Thank you for your interest in the above, looking forward to your constructive comments!