As cryptocurrencies and digital assets have become more well-known, the term “DeFi,” or decentralized finance, has started to pick up in online conversations. Of course, the natural extension to DeFi is CeFi, or centralized finance.
Ironically, bitcoin, the first cryptocurrency, was developed with decentralization in mind. However, the crypto ecosystem is becoming increasingly centralized — and the average investor might have no idea this is happening. To understand why this is happening, investors must learn what makes certain corners of the crypto ecosystem are considered DeFi while others are essentially CeFi.
Q3 2022 hedge fund letters, conferences and more
Ruadhan, founder of the Ethereum-based Seasonal Tokens crypto ecosystem, makes the difference between DeFi and CeFi easy to understand, even for investors entirely unfamiliar with cryptocurrency.
"CeFi is where you give your money to someone and trust them not to steal or gamble it, and DeFi is where you use smart contracts instead of people, theoretically eliminating the need for trust," he explained.
What Are DeFi And CeFi?
When most people think of centralized finance, the natural instinct is to look at the traditional financial ecosystem. It's easy to understand because we've been transacting within it since the days of ancient Mesopotamia, where it was originally developed. Since those days, we've used everything from livestock to gold and even certain kinds of shells before eventually developing fiat currencies.
Centralized finance is marked by numerous rules and regulations governing financial assets of all kinds, which can range from commodities to currencies, securities, and more. In traditional finance, regulatory bodies like the Securities and Exchange Commission and Commodity Futures Trading Commission oversee trades and transactions in the many different kinds of assets that exist.
Despite that oversight, those who transact within a centralized financial structure must trust that policymakers, banks, and those they transact with won't do anything to jeopardize their assets.
On the other hand, decentralized finance does not require parties to trust each other because the distributed ledger technology backing it prevents them from ripping each other off. While money passes through a bank that acts as an intermediary between two transactors in CeFi, there are no such intermediaries in DeFi. Instead, the parties use smart contracts to keep each other honest.
How CeFi Works In The Crypto Ecosystem
With bitcoin and some other cryptocurrencies having their roots in DeFi, it might be challenging to see how they can be used within a centralized infrastructure. However, the interplay between bitcoin and a centralized platform like a crypto exchange has more to do with the rules governing the platform than with those overseeing bitcoin and other DeFi cryptocurrencies.
For example, centralized platforms allow users to borrow money against their bitcoin the same way traditional assets can be used for collateral on a bank loan. Centralized exchanges like Coinbase or the now-bankrupt FTX support trades of bitcoin and other cryptocurrencies, but they require regulations to do so.
However, some exchanges are decentralized, so it's now always easy to tell whether you're dealing with a DeFi or CeFi situation within the crypto ecosystem. Some examples of decentralized exchanges include Uniswap and PancakeSwap.
How To Distinguish DeFi From CeFi In Crypto Assets
DeFi is set apart by three critical characteristics: accessibility, control and transparency. For example, DeFi users always have easy access to the rules governing the platform they're using, whether it's a smart contract or cryptocurrency, because such vehicles eliminate private agreements or other deals that make CeFi opaque at times.
Additionally, DeFi users always retain control over their assets, meaning that an outside entity like the SEC or a bank can't freeze their accounts. This issue is of great concern to regulators concerned about money laundering or other nefarious activities because they can't freeze the crypto assets owned by suspects or convicted criminals.
Finally, DeFi users can always access their crypto assets as long as they have a reliable, secure internet connection and the knowledge of how to use them.
The Risks Of DeFi Versus CeFi
While DeFi might sound like the perfect solution to every problem created by centralized finance, there are some issues to be aware of. Ruadhan noted that the smart contracts commonly used in DeFi are still created by humans — leaving them prone to error from time to time.
"With DeFi, there's still a risk that the smart contract code could have a bug that allows a hacker to steal money, so it's important to make sure that the code has been audited by reputable security experts," he explained. "Once the code is known to be secure, DeFi is the safer option, because the funds are never in the control of another person who could accidentally or deliberately misallocate them."
On the other hand, the risks associated with CeFi are much more numerous and include everything from basic fraud or money laundering to pyramid schemes or other complex scams. In the world of crypto, we've seen plenty of new ways CeFi can go wrong.
Why More And More Centralized Crypto Firms Are Collapsing
It's important to point out that decentralized exchanges, which remain true to the original, decentralized purpose of bitcoin, remain unscathed as more and more centralized crypto firms collapse.
Thus, it makes sense to question why CeFi appears to be harmful to the crypto ecosystem — particularly when the centralization of crypto exchanges and other entities within the ecosystem is exactly what has made many institutional investors more comfortable with cryptocurrency.
At this point, we've seen a wide array of crypto players file for bankruptcy. Crypto exchange FTX, its connected hedge fund, Alameda Research, and lender BlockFi are three of the latest to do so. Other noteworthy failures within the crypto ecosystem include the hedge fund Three Arrows Capital, the Terra stablecoin and its connected token, Luna, lender Celsius, and brokerage Voyager Digital.
Upon closer examination of these failures, we discover a few factors that led to these firms' downfalls, of which the primary is leverage. When crypto prices are soaring, it may seem like leverage is unimportant because they will keep climbing higher and higher, but the current crypto winter shows that isn't always the case.
For example, Three Arrows Capital borrowed more and more cryptocurrency without any collateral and then used it to make more and more trades. Eventually, the hedge fund was caught with so much leverage amid plummeting crypto prices that it simply collapsed because it couldn't pay its debts.
Other common issues that have led to crypto firms' collapses include unsustainably high yields and a lack of transparency. Lender Celsius offered sizable yields to users in exchange for being able to lend their cryptocurrency to others, but it buckled when plunging crypto prices made it unable to maintain those massive yields.
It All Boils Down To One Thing
At the end of the day, the root of all these issues is trust — or the lack of it.
"A large CeFi crypto firm like FTX can make billions of dollars by funneling customer deposits into a proprietary trading operation," Ruadhan explained. "It's naive to think that a large, trusted firm would never do such a thing.
The more trusted they are, the more they can make by violating that trust. Companies that gamble with customer funds this way are vulnerable to sudden collapses when the customers realize that the company doesn't have enough money to cover withdrawals."
Investors need only look at bitcoin's origin story to see why DeFi crypto firms continue to work, while a growing number of CeFi firms are going bust. The cryptocurrency was forged in the wake of the Great Financial Crisis in 2009 with the goal of fixing the problems with the traditional, centralized financial system.
Then, to hook institutional investors, centralization grew in importance because these big whales tend to feel better with more regulations in place. However, the centralized crypto firms are the ones folding, while decentralized firms remain unscathed despite the plummeting prices. It's as if crypto has highlighted the many problems with centralization all over again — only in fast-forward this time.
Share your thoughts on DeFi versus CeFi in the comments section below.
