There’s no shortage of acronyms in crypto. But two very important ones to understand are DeFi (decentralized finance) and CeFi(centralized finance). So in this guide you’ll learn about each of these, and see how they stack up against each other. From that, you might decide which is better for you.
DeFi aims for a blockchain-based financial system, which would make financial products like lending, borrowing, and trading more open to the world while cutting out the middleman. With DeFi, financial transactions happen automatically in a decentralized way – that is, without banks or financial institutions processing them behind the scenes. You can find out more about how blockchains do that in this guide.
There are two kinds of transactions that you can do on a blockchain. There are simple transactions, like sending crypto from A to B – say to your friend’s wallet. And there are complex transactions, like lending, borrowing, and trading crypto. DeFi focuses on the complex ones.
Smart contracts are programs stored on the blockchain that run automatically under certain conditions. These smart contracts have wallet addresses just like normal blockchain users. And if you send your crypto to a smart contract wallet address, it can automatically carry out complex transactions like lending, borrowing, or trading.
CeFi is a blend between the new world of DeFi and the traditional centralized financial system including banks. With CeFi, all crypto transactions go through at least one middleman, such as a crypto exchange or a lending and borrowing platform.
For example, you might use a centralized crypto exchange to trade crypto. That exchange would be responsible for ensuring that your trade goes through as intended. The same would apply if you’re depositing your crypto on a lending and borrowing platform. Here, the platform would lend out your crypto to different borrowers, who would pay interest to the platform in return. Some of that interest would then be passed onto you after the platform takes its cut. There’s nothing new here – it’s pretty much the same as what banks do when you deposit your savings with them.
DeFi and CeFi each have pros and cons, so let’s look at their benefits and drawbacks in different areas…
DeFi and CeFi are both far more accessible than traditional finance, but DeFi comes out on top in this area because anyone can plug into the DeFi ecosystem regardless of their geographic location. Globally, there are almost 2 billion people without a bank account right now. That means they can’t invest, borrow, or lend money using the traditional financial system. With DeFi, they would only need an internet connection, a bit of crypto, and an understanding of DeFi to start putting their money to work.
Most CeFi platforms, meanwhile, have Anti-Money-Laundering and Know-Your-Customer requirements, so you’ll need to jump through a few more hoops before using their services. That said, these requirements are currently a lot less cumbersome than what you usually need to provide to open a bank account.
DeFi transactions are more transparent because all DeFi transactions are recorded on public blockchains. This might make the overall system less prone to major collapses. Look at 2008, hardly anyone knew ahead of time that big banks and mortgage lenders were about to implode. That’s because most of the issues were only visible on the centralized systems of those companies themselves. But since all DeFi transactions are on public blockchains, alarm bells can start to go off a lot earlier than with CeFi.
Of course, there’s a risk that DeFi smart contracts might not always execute properly, whereas CeFi has a central organization to help keep transactions running smoothly if something goes wrong.
CeFi platforms are a lot easier to use than DeFi protocols. They’re a lot more familiar and similar to traditional banks – they even have customer service departments. You can also send traditional currencies to CeFi platforms to buy crypto and vice versa. In the world of DeFi, traditional currencies don’t feature at all. And to actually make money through DeFi lending and borrowing platforms, you really need to know what you’re doing.
When it comes to security of funds, each has its own pros and cons. With DeFi, you are responsible for keeping your crypto safe because you interact directly with the blockchain through your own crypto wallet. This can be very secure and you have full control of your funds. But be aware: if you lose your password or key phrase to access your crypto wallet, there’s no company you can call on to regain access to your funds.
In CeFi, the platform takes custody of your crypto. And you can call on them if you forget your login credentials much like you can with a bank. That said, CeFi platforms are only as secure as the platform custodying your crypto. So make sure you use a trusted and regulated platform to look after your funds. Always read the terms and conditions of the platform, and make sure they seperate your crypto from their own company funds. That way, if they ever go bankrupt for some reason, your funds won’t be dished out to the company’s creditors.
Remember that DeFi is all about complex transactions – like lending out your crypto in exchange for interest a.k.a. income. You can still do those transactions on CeFi, but DeFi platforms give you the chance to earn more.
Why’s that? For starters, DeFi platforms don’t have any requirements to listing on them, so most new projects start out on DeFi first. And those new projects often offer incentives – like higher interest rates – for early users. That means that if you’re on DeFi platforms you can take advantage of being an early adopter and getting those incentives.
By the time those new projects list on centralized platforms, the incentives and earning potential have calmed down a bit. But unlike DeFi protocols, most CeFi platforms only list a token once they’ve done their due diligence on it. That can be a good thing because there’s less chance of losing money on a scam crypto project.
Keep in mind that DeFi fees can actually be higher than CeFi ones. With CeFi, you’re paying a fee directly to the exchange or lending platform rather than the fee required to secure your transaction on the blockchain – so CeFi fees can be a lot lower than DeFi fees. If you’re using an Ethereum-based DeFI application, for example, you could end up paying around $15 per transaction, depending on network demand at the time.
It all comes down to personal preference. If you’re deeply immersed in crypto and comfortable with keeping hold of your own coins, you’ll probably find DeFi more rewarding. But for most people, CeFi is a more convenient option, provided you’re using a reputable platform that you can trust.
This guide was produced by Finimize in partnership with Change Invest.
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