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Date: 2020-11-15 07:15:00
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There are two halves of the financial system from a crypto enthusiast's perspective — traditional finance and cryptocurrency finance. But the crypto space now has two subspaces — centralized finance (CeFi) and decentralized finance (DeFi). Here's how the divide happened.
One of the original ideas behind cryptocurrency is to have a wholly peer-to-peer network that doesn't need centralized intermediaries such as financial institutions. Events played out differently in reality, however.
First, there are two ways to own crypto. You either receive payments in crypto or exchange government-issued money, such as the dollar for it. Most people enter the market via fiat gateways, and that complicates things — at least concerning the idea of circumventing financial institutions. Most countries have anti-money laundering regulations, which makes financial service providers responsible for preventing the illicit use of their platforms.
Consequently, services that allow people to exchange fiat money for crypto became subject to existing regulations. There's a history of governments (China and Japan, for instance) cracking down on crypto exchange operations.
Second, in a world where crypto is entirely peer-to-peer, everyone would be responsible for managing their own risk since there wouldn't be any centralized institution in the middle. Users would have to safeguard their private key, which, if missing, can lead to irrecoverable loss of their digital assets.
That's unlike consumers' experience with traditional finance companies, where the money saved in the bank has insurance coverage. So a familiar setup became necessary.
These two challenges together steered the early development of the crypto space in the direction of CeFi.
As the crypto market grew to become a multibillion-dollar market, a section of the market that wanted greater flexibility and broader options started building financial services that rely on self-executing computer algorithms called smart contracts. In some cases, a decentralized community of entities or participants decides how the service runs. This is the basis of decentralized finance.
As the name centralized finance suggests, CeFi consists of a financial system in which users trust their funds to third-party entities. Users of CeFi services essentially trust the people managing the businesses to uphold high ethical standards. This same trust feature is an import from the traditional financial space. Also, it's worth noting that the term CeFi exists in the context of cryptocurrency, according to Pokket CEO Bill Dashdorj.
"CeFi is an extension of the existing financial model, but upgraded to the next level with crypto," said Dashdorj. "It alleviates one of the biggest pain points of the traditional financial system — accessibility but keeps the usability and simplicity as it's more familiar to most people."
The way Dashdorj sees it, "CeFi is the breaker of barriers for financial services, and it serves more immediate needs of people not satisfied or unable to access traditional financial services."
Examples of CeFi services include centralized exchanges like Coinbase and Binance. Stablecoins like the USDC from Coinbase and the proposed Facebook-led Libra stablecoin are also CeFi services. These stablecoins belong in the CeFi class because they are backed one-for-one by the US dollar, governed by a centralized government.
Crypto saving and lending services like BlockFi, Celsius and Pokket are also centralized finance companies. In general, CeFi is any service in which you're keeping custody of the private keys of the crypto assets you purportedly own.
The only decentralized part of CeFi is that these services build use cases for decentralized cryptocurrencies like bitcoin, ether and litecoin.
The core idea behind DeFi is to bring full decentralization to the crypto ecosystem, said Brian Kerr, CEO of Kava Labs, a DeFi platform.
"Unlike CeFi services, DeFi protocols and applications are open source and run in the cloud by numerous operators across the globe," Kerr said. "The software becomes open and accessible to anyone with internet access and requires no KYC or burdensome onboarding process akin to the traditional finance world."
In other words, DeFi services are permissionless and trustless.
Experts contend that the freedom that DeFi offers comes with users' responsibility to manage their own risks. As opposed to CeFi, users of DeFi applications are mostly in charge of their private keys.
Besides, DeFi services aren't foolproof. A recent report from crypto intelligence firm Ciphertrace shows that roughly $98 million worth of crypto was lost to hacks that targeted decentralized finance protocols between January and the end of October. The situation has gotten worse within the first half of November, with the DeFi service Akropolis losing over $2 million to a hack.
Examples of DeFi services include decentralized exchanges, such as Uniswap and dYdX. With these services, users connect their self-custodied crypto wallets to the exchange to make trades. There's no central entity that holds and manages users' assets. Algorithmic and autonomous lending services such as Compound and bZx also belong in the DeFi class.
There are also stablecoins in the DeFi half of the crypto universe. DeFi stablecoins are backed by decentralized crypto assets like ethereum, bitcoin, etc. — instead of government-issued money.
The DAI stablecoin, developed by the Maker Foundation, is about the most famous decentralized stablecoin. The DAI is algorithmically tied one-for-one to the US dollar using a collateralized debt position (CDP) monetary system. In a CDP system, any of the accepted collateral cryptocurrencies are deposited into a smart contract in exchange for newly minted stablecoin. Fundamentally, new DAI tokens are loans given against the crypto collateral in the smart contract.
Still, both CeFi and DeFi share some basic similarities.
“The most important real-life use case of DeFi and CeFi is the ability to generate yield from global pools of capital and liquidity that are accessible to nearly anyone as long as they have access to an internet connection,” said John Patrick Mullin, the cofounder of Mantra DAO, a community-governed DeFi platform for staking, lending and governance.
“These developments have allowed for users who may have previously been shut out from the financial system to access a range of financial products they’ve never had access to before,” Mullin added.
The difference is in how services in each subspace seek to provide access.
Despite the centralization features of CeFi, which is against cryptocurrency’s original idea, it does play an essential role in making crypto useable. Here's are some areas that experts believe CeFi is useful.
As mentioned earlier, certain aspects of CeFi has a somewhat similar design to the traditional financial space, which partly makes it easier to onboard new crypto users.
Cryptocurrency is already an esoteric topic, which must be simplified if it must go mainstream, and that is the work that CeFi does, said Katherine Deng, VP of global business at MXC Exchange.
"By design, CeFi businesses are able to attract and service new crypto users," Deng said. "These users are already familiar with the user experience from traditional finance, and it would be a big ask to expect them to make an abrupt jump to managing their own risks with DeFi."
Part of the familiar user experience is that CeFi services take custody of crypto assets for users just like financial institution does for its customers. This makes the learning curve for crypto adoption less steep.
There are a handful of cryptocurrencies in the market these days. The top names include bitcoin, ether, litecoin, ripple, zcash, etc. And it's common for crypto users to exchange one type for another — just as people exchange the US dollar for euro. However, the process of trading two cryptos from different blockchains isn't as simple as it is with different fiats.
You can't just deposit bitcoin on the ethereum blockchain to get ether (the native currency of the ethereum blockchain). The Bitcoin blockchain is different from Ethereum blockchain, and they are not interoperable, Adam O'Neill, the chief marketing officer of crypto exchange Bitrue, highlighted.
"CeFi allows for cross-chain trading, which means that, in theory, you can trade any two cryptocurrencies between each other," O'Neill said. "It also allows users to purchase cryptocurrencies with their fiat coins such as US dollars, giving them an easy way to get their hands-on digital currencies."
O'Neill added: "Cross-chain trading is difficult to achieve with DeFi because many decentralized protocols live on a blockchain and, consequently, are restricted to accepting only the crypto assets supported by the blockchain network in question. For instance, a DeFi protocol built on the ethereum blockchain is circumscribed to support only ether and other assets that were originally issued on the ethereum blockchain."
CeFi exchanges, on the other hand, maintain large order books, which make it easier to simulate cross-chain trading.
"CeFi, in principle, can be very efficient. You only execute once with no need for consensus," said Alex Batlin, CEO at wallet provider Trustology.
The superior efficiency here is possible, thanks to the fact that centralized financial services do not perform every single transaction on the blockchain. Most DeFi applications, on the other hand, must execute transactions on-chain. As a result, CeFi businesses can offer higher liquidity and faster transaction speed.
The lack of adequate transparency with traditional finance, particularly regarding how financial companies use client's funds, was one thing that crypto sought to fix. The CeFi model only brings a marginal improvement in transparency while DeFi redefines transparency.
“Defi creates autonomy for people by leveraging the transparency and accessibility of the decentralized blockchain; that autonomy is used to create financial opportunities,” noted Steven Becker, the president of the Maker Foundation.
In essence, DeFi offers better business operations transparency since decentralized protocols are mostly open-source and are available for anyone to audit. That's hardly the case with centralized services.
Kerr added: "As opposed to CeFi, where a singular business operator collects fees from users, any profits derived from DeFi applications are passed back to the participants. This creates market efficiencies that are hard to achieve with centralized models."
Rent-seeking is a concept in economics that happens when an entity pursues an increase in wealth without reciprocating with any meaningful contribution to productivity.
The idea came from the belief that entities earn income from one or a combination of wages, profit and rent. Of the three, rent is the easiest to acquire. Rent involves the maximization of owned resources, which can encourage monopolistic behaviors. And monopoly has been proven to inhibit innovation.
This issue doesn’t plague decentralized services, experts say.
“DeFi enables innovation in the financial solutions available as well as how each person can consume those options. But just as there is no freedom without obligation, the cost for the autonomy of DeFi is the responsibility of managing your own risk,” Becker said.
The core DeFi concepts are genuinely novel, but the products in the market at present are mostly unusable for the majority of the target market — the unbanked and underbanked people. For this, DeFi needs the user experience of CeFi.
"DeFi and CeFi complement each other. They provide more options for people and institutions to use their power and capability to create financial opportunities," Becker added.
However, Mullin cautions that many CeFi projects are “black boxes,” adding that many DeFi protocols are highly speculative.