Since the fall of Terra (Luna), the (un)stablecoin UST and the falling crypto prices, many problems have come to light in the crypto market. Crypto banks such as Celsius and Voyager experienced liquidity problems and the major cryptocurrency hedge fund Three Arrows Capital (3AC) had to be liquidated. The ability to withdraw funds from the crypto banks was paused. Until now, it is unclear whether users of these crypto banks can get their coins back or what the plan is going forward.
Since then, the debate between CeFi and DeFi has continued to heat up. Some swear by using DeFi, while others prefer to use the services that CeFi has to offer. But what exactly are CeFi and DeFi? And what are the pros and cons of CeFi and DeFi?
Table of Contents
What is CeFi?
In the world of cryptocurrencies, centralized finance (CeFi) often refers to a central party such as an exchange or a crypto bank like Celsius and Voyager. CeFi is defined as the management of money. Centralized finance includes activities such as borrowing, lending, investing, and saving. Traditionally, finance was done through banks and/or capital markets. Banks collect money through savers, which they then lend to parties who want to borrow – for example through private and business loans or mortgages.
When using CeFi, you do not have the cryptocurrency in your own custody. To use exchanges such as Binance or Coinbase, one has to send the coins to these exchanges. Unfortunately, in this case (and therefore also with Celsius and Voyager) the old principle of ‘not your keys, not your crypto’ applies. When using a crypto bank, one can get returns on the deposited coins. However, these are then in the possession of the crypto bank.
What is DeFi?
Decentralized Finance (DeFi) are financial services without a central authority. This means that the transactions are peer-to-peer. DeFi is about decentralizing financial services that could replace CeFi. DeFi can exist because some cryptocurrencies can be programmed for automatic activities such as Ethereum or Cardano. Because of this programmability, there are all kinds of possible functions that DeFi can take over from CeFi through decentralized apps ( DApps). Exchanges such as Uniswap and GMX have been set up, lending protocols have been created like Aave and Compound, and decentralized stablecoins came in circulation such as DAI.
What are the pros and cons of CeFi and DeFi?
An important characteristic of DeFi is the fact that the services are accessible to everyone with an internet connection and a wallet. No one is excluded from using DeFi services. No bank account or government approval is required. This is a big advantage for many users, especially in less developed countries. Where in Europe almost everyone has a bank account, this is not the case in Africa. For example, according to Statista, there are only 456 million people with bank accounts in Africa, while a total of 1.3 billion people live on the continent. This means that approximately 65 % of the population is still unbanked. This prevents them from using financial services such as making daily payments or borrowing money.
Flexibility & Speed
Besides accessibility, the flexibility and speed of transactions are major advantages when using DeFi. A DeFi transaction can be made at any point, at any time – including weekends and after office hours. While international transactions between banks can sometimes take up to 5 business days, DeFi transactions are generally completed within seconds. This way, everyone on Compound can borrow and lend money at any time.
Banks and other financial institutions need to make money (and preferably make as much profit as possible) in order to survive and create value for their shareholders. The costs that users incur at a bank as a result can be high. For example, taking out a mortgage can cost thousands of euros and there are costs associated with having a simple bank account. All these costs incurred by financial institutions are eventually recovered from the users in one way or another. These costs are eliminated when using DeFi. The only costs incurred are the transaction costs of the network that is being used. There are no costs for operational staff, (mis)management, or CEOs.
If the fallen crypto banks Celsius and Voyager had been transparent about the risk they took to achieve returns, there would probably have been a lot fewer users. The users could then have noticed that the return on their coins was not as risk-free as was communicated. This (in)transparency is a disadvantage of CeFi and an advantage of DeFi. When using DeFi, everything is visible on the blockchain and can be validated. Therefore, the activities are very transparent. While in CeFi, everything takes places behind closed doors. If certain protocols are insolvent in DeFi, this can easily be found on the blockchain.
Hacks & Protocol risk
One major disadvantage when using DeFi, is the possibility that hacks occur. Money has been stolen from a large number of protocols during the last couple of years. This can happen due to errors in the code of smart contracts that are used or other bugs in the code. According to Messari Research, about 3 billion was stolen from DeFi protocls in the past year. Most of this amount came from bridges.
These exploits allow a hacker to transfer funds to his own wallet. The users of the hacked DeFi platforms often lose their money after these kinds of hacks. Subsequently, a user has little to fall back on as DeFi is not regulated. This, however, may be the case with regulated banks. For example, all European banks have a deposit guarantee scheme in some way: a guarantee for the protection of assets in the event of a bank failure. In the Netherlands for example, up to €100.000,- is guaranteed per bank, per person. This regulation can therefore be a major advantage when using CeFi. These kind of guarantees have also been set up in the crypto industry. For example, Binance has the Secure Asset Fund for Users (SAFU) with which they can protect users.
Hacks don’t just happen in the DeFi domain, though. Hacks also regularly take place within the CeFi domain. Numerous exchanges have been hacked and many coins have been stolen. Examples include MtGox for 740,000 Bitcoin in 2014 and BitFinex for $623 million in 2016. In some cases, exchange users lost their coins, while in other cases the exchanges eventually reimbursed the funds. The use of both DeFi and CeFi therefore carries the necessary risks. All in all, it is important to do your own research for the protocol or exchange that you are going to use. Both for Defi and CeFi platforms.
The fact that CeFi is scalable today is being shown by how easy transactions can be made in the current money system. However, the scalability of DeFi can be questioned on some networks. For example, during the bull market in 2021, simple transactions on the Ethereum network could only be done for a minimum of $70 on some days. This made DeFi unusable on the network for a lot of users. Now that the crypto market has cooled, and with it the use of the Ethereum network, transaction costs have dropped to about $0.40. So, it is now a lot more affordable to interact with the network. Other blockchains like Cardano or Atom have much lower transaction costs and are thus much more scalable.
Conclusion DeFi vs CeFi
DeFi has been developing strongly in recent years: more and more features and possibilities are being added every day. Around the globe, a lot of developers are working daily to make the financial revolution a reality through the use of DeFi. It offers users many advantages due to its accessibility, flexibility, speed and transparency. This is in contrast to CeFi, where transactions can be expensive and slow, where not everyone has or can get a bank account and where mismanagement is very common at crypto banks, for example. Although DeFi still entails a lot of risks and problems such as scalability and possible hacks, the future looks very promising.