Decentralization is one of the fundamental concepts of cryptography. DeFi (decentralized finance) explores a new system of finance not dependent on central parties. It's a complete ecosystem of applications driven by smart contracts that enable financial services like lending, saving, trading, and more without intermediaries.
However, DeFi is still in its infancy. DeFi navigation calls for a fair amount of technical expertise and a degree of comfort, with the possibility of losing some or all investments due to faulty programming, malicious hackers, or even simple user mistakes.
So what is CeFi? It’s a framework that seeks to provide cryptocurrency investment options that combine some advantages of DeFi with the usability and security of conventional financial instruments.
What is CeFi?
CeFi (centralized finance) is a process where users can acquire loans, earn interest, and buy and sell cryptocurrencies using a centralized institution. This is usually a centralized exchange (CEX), but can be institutions that offer users yield on crypto.
It aims to make financial services as effective and economical as possible while maintaining fair exchanges during crypto transactions. CeFi allows users to borrow money, trade cryptocurrency, use a crypto debit card to make purchases, receive awards, and more.
CeFi vs. DeFi
The fundamental difference between CeFi and DeFi is the buying-and-selling process. CeFi uses centralized institutions to oversee the system. DeFi, however, relies on blockchain technology. Prominent CeFi exchanges like Binance and Coinbase have offered crypto-financial services for many years now, while decentralized exchanges (DEXs) operate on blockchains like Ethereum (ETH).
Because CEXs participate in CeFi, they’re responsible for protecting users' funds. A user's risk lies with the exchange, whereas DeFi eliminates these intermediaries. Instead, two parties buy and sell cryptocurrency by putting their faith in smart contracts, which are digital agreements that automatically activate when a predetermined set of conditions are met.
CeFi facilitates cross-chain solutions and fiat currency to cryptocurrency transfers. If required, CeFi can move money to help customers or stop trading in the case of an event like a cyberattack. CeFi can restrict users and prevent transactions, whereas DeFi can’t. DeFi is considered more open and unobtrusive because there are fewer barriers to entry and all terms are fully transparent. Instead, users create crypto wallets with public and private keys that enable them to trade crypto anonymously.
In CeFi, a KYC (know-your-customer) procedure is often required before a user can start transacting on CEXs. This procedure confirms a user's identity by proving they are who they claim to be. KYC in cryptocurrency aims to prevent unlawful actions––including money laundering, terrorist funding, and tax evasion––by authenticating a user’s identity.
Customers can open an account on some CEXs before going through a KYC procedure. Still, these accounts often restrict users from availing all CeFi services and facilities until the authentication process is over. For example, many CEXs won't let a consumer withdraw money or buy cryptocurrency if their identification isn't confirmed. Some exchanges set a cap on deposits.
The way each CEX handles KYC will vary. However, the usual process involves sharing your full name, date of birth, and address. After this, the exchange may request photo identification, like a passport or driver's license. CEXs use this data to confirm a user’s identity and give access to the full range of services.
Centralized exchanges (CEXs)
A CEX offers two parties a neutral platform to conduct a cryptocurrency transaction. Centralized organizations generally run CEXs.
In CEXs, users' crypto assets are often maintained as a database record and don't interact with blockchains like in DeFi. Although consumer traffic is gradually moving to DEXs, most cryptocurrency transactions still occur on CEXs.
CEXs are generally easier to use with interfaces similar to conventional financial apps. Transaction costs can be lower—depending on the CEX—since there’s no interaction between transactions and the blockchain. Transaction costs tend to be lower on CEXs as fees are purely for profit and don’t involve potentially high gas fees.
However, this can also go the other way—since fees are purely for profit, CEXs may decide to impose high transaction charges. Moreover, because users don't have custody of their money, they’re susceptible to censorship and asset confiscation.
CEXs often have the most footfall with the majority of user traffic. At the time of writing, these are the largest CEXs on CoinMarketCap as per Exchange Score, which takes into account trading volume, weekly visits, and average liquidity:
- Coinbase Exchange
- Huobi Global
Advantages of CeFi
DeFi is slowly becoming the preferred finance in the crypto community, but CEXs still hold most of the traffic due CeFi’s many advantages. Here’s a list of CeFi’s benefits and the advantages it offers over DeFi:
- User experience: Interacting with centralized institutions will be more similar to what users are used to. Transactions occur faster, and the interfaces can be far simpler, requiring less technical expertise.
- Fiat-to-crypto conversions: With so many exchanges and trading volumes, CeFi offers the most extensive fiat-to-crypto conversions for cryptocurrencies. These facilities help crypto's growth by enabling individual and institutional investors to inject significant amounts of capital into the market, providing ample liquidity for prominent cryptocurrencies like bitcoin (BTC) and ether (ETH).
- Cross-chain exchanges: With CEXs, converting cryptos on one blockchain to those on another are more straightforward because individuals many times don’t actually own the crypto, with transactions represented in a SQL DB. Some cross-chain DEXs exist such as Thorchain.
- Customer support: DeFi operates using smart contracts on top of a blockchain. In the event of a negative occurrence like theft or a cyberattack, users can’t report to a supervisory or regulatory body. CEXs in CeFi, on the other hand, operate like regular banks, offering round-the-clock customer care. CEXs are responsible for your cryptocurrency, necessitating their assistance should something go wrong.
- Liquidity: At the time of writing, CeFi offers more trading and exchange options than DeFi. CEXs have far more liquidity as they control which cryptocurrencies become listed on exchanges. These are generally in-demand cryptocurrencies or crypto assets with some use cases, making them sellable.
Are there any downsides to CeFI?
CeFi attempts to address DeFi’s limitations, but that doesn’t mean it’s flawless. Here are a few disadvantages that come with CeFi:
- Hacking risks: One of the main drawbacks of CeFi is that cybercriminals are constantly drawn to centralized systems. They try to benefit from the high liquidity of CEXs and use illicit techniques to hack important data, enabling them to steal money from customers.
- High transaction fees: Transaction costs naturally rise in CeFi due to several intermediaries. Higher transaction fees are making people gravitate toward DeFi.
- Lack of transparency: CeFi is a regulated financial system. However, a lack of transparency exists due to users' inability to check a ledger to verify transactions. DeFi operates on smart contracts, which provide complete transparency and assurance to both parties involved in the transaction.
- Need to trust: Centralized institutions aren't as transparent as decentralized systems, so users must place their trust in CeFi with the hope that their services are competent with the ability to manage risk. Centralized cryptocurrency lending company Celsius fell into bankruptcy in July 2022 when its assets fell from over $25 billion to $167 million, resulting in a $1.2 billion hole in its balance sheet. Celsius claims it has enough cash on hand for a restructuring process, but its failure to manage risk caused users to lose millions of dollars in digital assets.
Generating income through CeFi
CeFi allows users to earn yield through crypto accounts comparable to a traditional bank account—crypto potentially provides much greater yields. However, it's worth noting that crypto-based investments aren't covered by government-backed insurance, although some CEXs like Coinbase give a guarantee on any USD Coin (USDC) deposited for lending.
Since the government doesn’t back crypto investments, all digital assets on CeFi are at the discretion of the entity that owns and operates the CEX. The entity can freeze or take money away since they claim ownership over the assets.
CeFi and DeFi are financial concepts that are relatively new to the crypto landscape. DeFi aims to democratize finance and put the power back into the hands of the people, while CeFi’s objective is to improve in areas where DeFi falls short.
Both have pros and cons—with CeFi’s major criticism being its lack of transparency, accountability, and anonymity. However, plenty of new crypto opportunities take these factors into account when offering digital financial-services products.
One of these companies is Worldcoin, a next-gen crypto company that aims to put a free share of its cryptocurrency in the hands of every individual on the planet. We prioritize your privacy, keep you anonymous, and encourage crypto participation in what is a growing digital economy. Subscribe to our blog to know more and stay updated on all the news in the cryptocurrency market.