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Technology and innovation are rapidly changing the global landscape, and the financial industry is one such example of radical innovation. The introduction of cryptocurrencies and blockchain technology has significantly altered the traditional financial system. Two alternatives have emerged out of the blockchain revolution: Decentralized Finance (DeFi) and Centralized Finance (CeFi).
In this article, you’ll learn about DeFi and CeFi, what makes them different, and how those differences affect consumers. If you care about finance and want to know where the industry is headed in 2024 and beyond, you’ll want to stick around.
If you’ve read a finance or tech blog in the last 5 years, you’ve likely read the words “DeFi” and “CeFi” before. You may have already deduced that they were short for “decentralized” and “centralized” finance, but what do they mean?
What is DeFi?
Decentralized Finance (DeFi) Is a financial system rooted in the blockchain network, providing users with access to financial services. DeFi is an open and transparent financial system that operates on a peer-to-peer basis, allowing users to interact directly using smart contracts, a self-executing program that automates the process.
One of the key features of DeFi is its titular quality: decentralization. “Decentralized” means that it’s not controlled by any one entity, making it more resilient and secure against cyberattacks and bad actors. By using blockchain technology, DeFi ensures that transactions are immutable, transparent, and secure.
What is CeFi?
The counterpart to Decentralized Finance is Centralized Finance (or CeFi), a financial system that operates on a centralized network. Sound familiar? CeFi is the traditional financial system that most people are aware of—a system where banks and other financial institutions act as intermediaries in financial transactions.
CeFi gives users access to a range of financial services like loans, savings accounts, and trading, but these services come at a cost. In CeFi, users pay fees to banks and other financial institutions, and the centrality of the network makes it an alluring target for cybercriminals.
What is the Difference between DeFi and CeFi?
You may have already noticed that the “Fi” stays the same, so it’s the “De” and “Ce” that change. The biggest and most important difference between DeFi and CeFi is that DeFi is decentralized, while CeFi is centralized. While that may seem obvious, the implications of this distinction are critical.
Advantages of DeFi
DeFi operates on a peer-to-peer network which allows users to interact with each other directly. That means that DeFi is less vulnerable to attacks and is more transparent and reliable than CeFi, but critically, DeFi also circumvents the financial institutions that were acting as intermediaries in CeFi, cutting them out of the process entirely.
A major advantage of DeFi is that decentralized platforms don’t subject customers to a thorough vetting process or ask them to provide the level of personal information that centralized institutions may require. As a result, DeFi platforms are frequently more accessible to more users, an advantage for users who value their privacy.
Advantages of CeFi
Traditional banks typically require a certain amount of personal information to even open an account, but why is that?
It’s not because financial institutions are cruel or demanding, but rather due to the regulatory requirements that financial institutions are subject to. Regulations like AML (Anti-Money Laundering) and KYC (Know Your Customer) require financial institutions to collect and verify a variety of personal information from their customers.
While this increased scrutiny makes CeFi less appealing to consumers who value privacy and anonymity, it also provides more stability.
Recently, events like the failure of Signature Bank have thrust CeFi vs. DeFi into the public eye. COVID-19 and government intervention into the banking industry shone a spotlight onto the risks associated with centralized finance. The high-profile bailout of many banks in 2008, ATMs running out of cash during the height of the COVID-19 pandemic, and the recent public awareness of ongoing interest rate hikes have made DeFi more relevant today than ever before.
The most recent key event that has shaped public awareness of DeFi and CeFi is the collapse of Silicon Valley Bank. Following interest rate hikes that triggered a bank run, Silicon Valley Bank—the bank of choice for nearly half of all venture-backed tech startups—collapsed. To salvage the institution, California’s Department of Financial Protection and Innovation (DFPI) seized and closed the failing bank. In the court of public opinion, this failure is a major strike against CeFi and the fractional-reserve banking system as a whole.
While many organizations were affected by the failure of Silicon Valley Bank, Signature Bank’s recent seizure by the government affected many more.
It’s worth noting that in the big picture, DeFi is still a relatively new concept. While DeFi has many potential upsides, it isn’t perfect either. Risks like smart contract bugs, hackers, and exploits (as well as the fact that DeFi is largely unregulated) are all major downsides to DeFi, but the potential upsides are attracting more and more people to the space.
Where do I Go from Here?
While there are many wrong ways, there’s no one right way to invest your money. The choice between DeFi and CeFi ultimately comes down to your priorities, your unique needs, and your risk tolerance.
Regardless of which option you choose, it’s important that you do your due diligence and research the risks and rewards of any financial platform before investing your hard-earned money.
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