What is CeFi and how does it work?
This allowed for the control of trade and soon the Mesopotamian empire became the richest in the world Thousands of years ago, finance was invented in ancient Mesopotamia. This allowed for the control of trade and soon the Mesopotamian empire became the richest in the world. Since then, humans have used a variety of items as currency, including livestock, land, and cowrie shells, as well as precious metals (such as gold) and, more recently, fiat currencies.
A currency can be worth intrinsically, for example if it is backed by land, or it can be given a value by fiat, meaning that it is decreed to have value by a governing body. In every known instance, attempts to create a stable, everlasting currency have been based on the concept of a centralized institution such as a government. This government would support the financial worth of the currency and have a military force at its disposal. But, what does CeFi mean in crypto?
Centralized exchanges are the main source of trading orders for cryptocurrency. These exchanges are regulated by a central authority, which controls all aspects of the exchange. Examples of CeFi companies include Binance, Coinbase and Kraken. People create accounts on these exchanges and use them mainly to send and receive coins. This isn’t all, though. These exchanges offer a variety of services in addition to crypto trading, such as lending, borrowing, and margin trading.
Although the funds are kept on the exchange, users don’t have control over them and they could be in danger if the exchange’s security measures don’t work. Since centralized exchanges are easy targets for security attacks, many have been attacked. Most people who use centralized exchanges feel ok about sharing their personal information and letting the organization hold their money because they trust centralized exchanges.
In addition, major exchanges have departments with customer support staff who can help customers. The high quality of customer service reassures customers that their money is in good hands.
What is DeFi and how does it work?
Because of the way blockchains work, which is decentralized and does not require permission, new virtual currencies have been created. The ability to transfer and trade financial assets without the need for a third party is one of the most powerful features of blockchain technology. Decentralized finance is a new sub-field of blockchain technology that focuses on developing financial technology and services on top of ledgers with smart contracts.
DeFi services do not require intermediaries and can be accessed by using cryptocurrencies and smart contracts. Financial institutions act as transaction guarantors in the current financial world. Since your money goes through these institutions, they have a lot of power. In DeFi, a financial institution is not needed for a transaction because it is replaced by a smart contract.
DeFi can be used in conjunction with most CeFi products, such as asset exchanges, loans, leveraged trading, decentralized governance voting, and stablecoins. Although the number of goods available is constantly increasing, some of the most complicated products, such as options and derivatives, are also evolving quickly.
DeFi has three major benefits: transparency, control, and accessibility. In DeFi, a user can understand the rules that operate financial assets and goods. For example, DeFi aims to get rid of private agreements, back-deals, and centralization, which are all major obstacles to CeFi transparency.
By allowing users to remain the custodians of their assets, DeFi gives its users control so that no one can censor, move, or destroy their assets without their permission. With a little bit of knowledge and a decent computer, anyone can design and deploy DeFi products. The DeFi software is operated by the blockchain and its distributed network of miners.
DeFi vs. CeFi: Various properties compared
The table below compares the most prevalent properties of DeFi and CeFi.
Public verifiability
DeFi applications that are not open-source cannot be classified as non-custodial because their execution and bytecode is not publicly verifiable on a blockchain. Unlike CeFi, DeFi users can verify that state changes are being executed properly. The transparency of DeFi technology allows it to create trust in an unmatched way.
Atomicity
A blockchain transaction consists of a sequence of actions, which could include multiple financial transactions. Combining these two features can make transaction atomic, meaning it will either completely succeed with all activities, or fail entirely. This programmable atomicity attribute is not present in CeFi, so people would have to use slow and expensive legal agreements to enforce atomicity.
Anonymous development and deployment
Transactions made through centralized finance platforms provide users with less anonymity than those made through DeFi platforms. DeFi projects are often created and managed by anonymous teams. Even Bitcoin’s founder is unknown. Once the miners have installed the DeFi smart contracts, they operate them implicitly. DeFi applications that don’t have a front-end require users to interact directly with the smart contract.
Custody
DeFi allows you to control your assets directly, without having to wait for the bank to open. However, with such enormous power comes great responsibility. If insurance is not provided, users will have to pay for most of the damage caused by technology. Centralized exchanges, which are similar to traditional custodians, are popular for keeping cryptocurrency assets.
Trading of crypto assets
CEXs are similar to traditional counterparts. An off-chain record of outstanding orders that CEXs keep for traders is called a limit order book. Instead of having a centralized entity that acts as an intermediary in a trade, a DEX uses an automated market maker (AMM) protocol to match the counterparties in a transaction. The price of a security is determined by an automated market maker that relies on mathematical algorithms to take into account transaction volumes.
Execution order malleability
People who use blockchains that don’t require permission often share the details of the transactions they plan to do with others in a peer-to-peer network. This means that people can compete to be the ones who get to execute transactions, by bidding on transaction fees. Since there is no one central authority who always gets to execute transactions, this provides an opportunity for people to try to become the transaction executor. This flexibility has resulted in many different ways to manipulate markets, which are now routinely used on blockchains.
Organizations that regulate financial institutions in CeFi establish requirements that are much stricter than other institutions, for example in how transactions must be ordered. However, this is possible because of the way CeFi’s financial intermediaries are set up.
Transaction costs
Transaction fees help to avoid spam on DeFi platforms and blockchains in general. Financial institutions in Centralized Finance can choose to offer transaction services at no cost, because they can rely on Anti-Money Laundering verifications of their clients.
Non-stop market hours
CeFi markets are notorious for experiencing outages. The New York and Nasdaq Stock Exchanges are the two main trading venues in the United States. They are open from 9:30 am to 4:00 pm Eastern Time, Monday to Friday.
Since blockchains never stop, most, if not all, DeFi markets are always open. Since DeFi platforms are decentralized, there is no pre- or post-market trading, unlike CeFi where there is usually less liquidity for different assets during these times.
Privacy
DeFi can only be found on blockchains with smart contracts that do not preserve privacy. Pseudo-anonymity means that while a users’ identity is not directly attached to their transactions, it can be indirectly traced back to them. True anonymity would mean that a user’s identity can never be traced back to their transactions. Even though decentralized exchanges are becoming more popular, many people still use centralized exchanges to convert their money to cryptocurrency. These exchanges have the power to reveal address ownership to law enforcement if they are asked to.
Arbitrage risks
Preferably, an arbitrage should happen all at once to avoid the risk of prices going up and down. Arbitration on centralized and hybrid exchanges is only successful if the arbitrators are working with the exchanges to make sure that all trades are executed. If they are not, then the arbitrators are at risk of the market prices changing.
If transaction fees are ignored, arbitrage between two decentralized exchanges on the same blockchain is risk-free. This is because the blockchain’s atomicity characteristic allows traders to write a smart contract that performs the arbitrage and reverts if the arbitrage does not return a profit. When two decentralized exchanges (DEXs) on separate blockchains are arbitraged, the arbitrage risk is comparable to that of a centralized exchange (CEX) and a hybrid exchange.
Inflation
Inflation is caused by the depreciation of a currency when new currency is introduced. Inflation is the loss of a currency’s purchasing power, but the relationship between supply and inflation does not always reveal itself clearly; sometimes, the money supply increases without causing inflation.
In CeFi, or centralized finance, central banks have the authority to create fiat money, and inflation is often gauged against the value of a selection of common consumer goods, called a consumer price index.
This can be due to a number of reasons, but the main one is that many DeFi protocols are designed to be “Asset Pool” smart contracts. In the DeFi world, the asset supply of several cryptocurrencies can change for a number of reasons, with the primary one being that many DeFi protocols are designed as “Asset Pool” smart contracts. As Bitcoin’s supply is limited by its hard cap, and the economic activity it needs to sustain is not, this is likely to lead to a scarcity of the currency. Without a block reward to create new bitcoins, and therefore no inflation, blockchains may be less secure.
It is not yet known if BTC and other cryptocurrencies will have a big problem with income inequality because of the way fiat money is devalued over time. There is no reliable evidence that cryptocurrencies can solve this problem.
Cross-chain services
Bitcoin and other digital currencies created on separate blockchains are often traded through CeFi platforms. DeFi services have difficulty supporting these tokens because atomic cross-chain exchanges are complex and take a long time to complete.
This problem is solved by CeFi services by storing funds from several chains. With decentralized services, tokens must follow Ethereum token standards to achieve interoperability.
This is a significant advantage for CeFi because many of the highest-market-cap and most frequently traded coins exist on separate blockchains and do not adhere to interoperability rules.
Fiat conversion flexibility
When it comes to exchanging money for Bitcoin, or Bitcoin for money, centralized services are usually more flexible than decentralized services. Because conversion from fiat to cryptocurrency requires a centralized institution, most DeFi providers do not offer a way to convert fiat currency to cryptocurrency. This financial system also allows customers to be onboarded more quickly, which leads to a better experience for them.
Synergies between CeFi and DeFi
DeFi is currently in its early stages. The attributes of transparency, non-custody, and decentralization that are found in DeFi platforms are also shared by CeFi platforms due to the fact that they both utilize the blockchain settlement layer. However, the blockchain slows down DeFi’s transaction speed, confirmation time, and privacy.
While DeFi has made some progress in decentralizing finance, it still relies significantly on the long-standing financial system. The value of crypto-assets on DeFi is still primarily determined by fiat currency. Crypto-assets that are tied to fiat currency are called stablecoins. They are widely used because their value does not fluctuate as much as other crypto-assets. Only central banks are allowed to issue central bank money, as initially mentioned in this article.
DeFi’s use of fiat currency makes central banks unnecessary for the time being.
CeFi lending platforms provide a way for people to use their traditional money to invest in the crypto-asset market. Instead of using fiat-pegged stablecoins, those services allow users to borrow fiat money and use their crypto holdings as collateral.
The platforms are run by businesses that serve as counterparties to both depositing and borrowing customers. Because of this, businesses that deal with cryptocurrency are often called crypto banks.
Additionally, both DeFi and CeFi aim to offer excellent financial products and services to customers while also driving the economy. In conclusion, both DeFi and CeFi have their own advantages and disadvantages, and there is no easy way to combine the best of both worlds.
We believe that the two financial systems will both exist and help each other. A few ways that synergy can be achieved are highlighted in the section below.
Bridges
To make them more effective, financial organizations are connecting DeFi and CeFi. Chainlink and Synthetix allow users to trade CeFi financial instruments on the DeFi market, and Grayscale Bitcoin Trust allows users to trade Bitcoin on the CeFi over-the-counter market.
DeFi as an innovative addition to CeFi
DeFi protocols improve upon CeFi services by taking advantage of the unique aspects of blockchains. In the DeFi world, a new type of exchange called an AMM has taken on the role of the traditional CeFi exchange with its order-book architecture.
AMM is a smart contract that allows for the pooling of assets from liquidity providers. This means that when a trader wants to buy or sell, they do so with the AMM smart contract, which then matches them with the best liquidity provider. The design of the AMM involves fewer contacts with market makers than a CeFi order book, resulting in lower transaction costs.
CeFi, in turn, is adopting such developments. Centralized exchanges, such as Binance, began to provide market-making services following the AMM concept. There are some financial markets, like foreign exchanges, that have used a mix of the AMM model and human interaction. These markets are in a good position to start offering market-making services in the DeFi market, whereas existing DeFi markets are not. Some approaches used in centralized finance may be adopted by decentralized finance providers to decrease their clients’ exposure to arbitrageurs.
Lesson for CeFi: DeFi collapse
The cryptocurrency market suffered a crash on March 12th, 2020, with the price of ETH falling by more than 30% in less than 24 hours. The price of ETH fell sharply by more than 40% on May 19th, 2021. The Dow Jones Industrial Average fell sharply by 9.99% on Thursday, leading to the nickname “Black Thursday” in the world of traditional finance (but with less dramatic daily moves).
Both CeFi and DeFi were put under immense pressure during the crashes. Because there was a lot of trading activity, centralized exchange systems were not working well (for example, Coinbase stopped trading for almost an hour, and exchanges were closed for a short time after going over the amount they are allowed to move in a day). The price of gas on Ethereum (ETH) increased significantly to the point that a standard ETH transfer cost over a hundred dollars.
The high amount of activity on the network caused the MakerDAO liquidation bots to fail in February 2020, delaying the confirmation of users’ transactions. DeFi services are available all the time because blockchains are distributed, which is not the case for CeFi. DeFi systems tend to be more expensive for users in extreme scenarios. Since then, the fact that DeFi protocols are resilient has received greater attention.
Although CeFi and DeFi have different settlement processes and user behaviors, CeFi could learn a lot from DeFi’s stress tests. DeFi’s lack of circuit breakers appears to have helped it avoid disruptions, which could in turn assist CeFi in understanding its own boundaries.
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