- Introduction
- What are CeFi and DeFi, and how are they different?
- The lapse of trust in CeFi
- DeFi vs. CeFi
- Conclusion
Introduction
Ever since the emergence of cryptocurrencies and the encompassing ecosystem, there has been a consistent debate regarding the optimal degree of decentralization. Decentralization is among the most fundamental tenets of blockchain technology, but achieving a highly secure and scalable system is difficult as advocated by the blockchain trilemma. Various projects within a similar domain provided significant differentiated experiences based on the varying intensity of decentralization. This is distinctively evident in the crypto-based financial products and services industry, where a division has developed and segmented the space into CeFi and DeFi. In this article, CeFi and DeFi will be compared, along with their benefits and disadvantages, and current events will be highlighted that demonstrate why DeFi is the future of the crypto ecosystem.
What are CeFi and DeFi, and how are they different?
In Centralized finance (CeFi), all cryptocurrency trading orders are processed through a central exchange, and the people in charge of that exchange are responsible for maintaining your funds. Private keys to your crypto assets would be sent to your preferred third-party wallets to carry out your desired payments and coin orders. Additionally, users can choose the coins offered on the exchange according to their preferences, and transaction fees must be paid when trading on CeFi. In summary, when you purchase or sell cryptocurrencies through a centralized exchange, you don’t directly own them, as the exchanges serve as the custodians holding the assets and private keys on behalf of the customer. Additionally, all users must abide by the guidelines of the central exchange. CeFi is an attractive option for users new to the crypto ecosystem. Popular CEXs maintain huge customer support teams, and since central authority maintains the custody of the assets, accessing mainstream financial services is much easier for the customers. CEXs also support convenient fiat exchange and offer efficient cross-chain services.
Decentralized finance (DeFi), on the other hand, can be considered a modern financial paradigm true to the promise of the blockchain technology it is built upon. DeFi presents a threat to the current traditional financial system and is an attractive alternative for crypto users who are wary of CeFi projects. DeFi refers to all products and financial services that are open to anyone without the involvement of an intermediary or a centralized exchange. DeFi offers a variety of services, including borrowing, yield farming, cryptocurrency lending, asset storage, and more which you can utilize without a bank account or the internet. It also develops a fair and open financial system, and you have complete control over your assets since you own the key pair to your wallet.
The lapse of trust in CeFi
In CeFi, users must have faith in the cryptocurrency exchanges, which are in charge of protecting users’ funds. However, numerous times, there have been frauds in which users and investors have lost billions of dollars due to rampant mismanagement and maleficence. A critical divergence in the cryptocurrency industry—between CeFi and DeFi —was brought to light by the collapse of the cryptocurrency market in late 2022. CeFi has long been in the spotlight due to a lack of transparency, and while several cracks appeared in the ecosystem, the FTX disaster finally broke the camel’s neck.
In November 2022, the crypto exchange FTX experienced a crash with catastrophic repercussions for the entire industry. A string of incidents that started in late October 2022 exposed the vulnerabilities in the exchange’s operations and resulted in the platform’s inability to meet the demand for customer withdrawals. Concerns initially emerged from CEO Sam Bankman Fried’s crypto trading arm Alameda Research. On 2nd November, a report released by Coindesk showed that a significant chunk of Alameda’s balance sheet was composed of $FTT tokens, the currency issued by sister corporation FTX. As a result of the claims, Zhao, the CEO of Binance, declared that the firm would liquidate its position in FTT that FTX had given Binance in 2021 as part of a deal that saw FTX buy back Binance’s shareholding in FTX. Customers of FTX were concerned about the price decline in $FTT as a result of this action, and thus the number of assets being withdrawn from FTX increased. Since FTX was unable to keep up with the demand for customer withdrawals as FTT’s prices dropped precipitously, FTX, Alameda Research, and more than 100 affiliated organizations filed for bankruptcy on 11th November. Further reports emerged from Reuters stating over $1 billion of client funds went missing.
A similar incident occurred in 2021 when Three Arrows Capital (3AC), a well-known crypto exchange firm that managed over $10 billion of assets, declared bankruptcy and defaulted on investor loans totaling $270 million from Blockchain.com and $670 million from Voyager Digital, among others. The collapse of 3AC can be linked to Terra Luna and other risky investments, and the firm was further distressed by continued hacking, which resulted in losses of $678 million in the second quarter of 2022. The collapse of Terra Luna set off a chain reaction that caused Three Arrow Capital, which had substantially invested in Terra Luna, to fall into line.
Due to numerous crypto exchanges defaulting on debts, declaring bankruptcy, and other factors, 2022 has been a challenging year for cryptocurrencies as well as crypto investors. The cryptocurrency lender Celsius Network started the bankruptcy proceedings after battling insolvency concerns for several months. Trouble began in April 2022 when Celsius Network announced that it would hold non-accredited users’ cryptocurrencies in custody, preventing them from adding more currencies to their portfolios and receiving rewards on the Celsius Earn platform. While Celsius was collaborating with the authorities to find a solution, the cryptocurrency market was shaken by the sudden failure of algorithmic stable cryptocurrency TerraUST and TerraLuna, which collapsed with $300 billion in losses across the crypto market. When the company banned withdrawals, swaps, and transfers, citing an unstable market environment as justification, reports began to circulate that the company had become seriously insolvent. In July, KeyFi’s CEO Jason Stone accused Celsius of misleading about its investment plan and management. The following day, KeyFi filed a complaint against Celsius in the New York Supreme Court, accusing Celsius of participating in market manipulation and failing to secure customer funds. Celsius soon filed for Chapter 11 bankruptcy protection in the US. A court filing by Celsius’s advising partner revealed that the company had a $1.2 billion hole in its balance sheet.The FTX-caused outbreak claimed Blockfi as one of its most prominent victims. Earlier, a liquidity issue emerged at Blockfi resulting from the insolvency of Three Arrows Capital in June 2022. Upon liquidating 3AC, it sustained significant losses. After this situation, Sam Bankman Fried proposed a bailout to the sinking BlockFi, who accepted the $400 million bailout plan to get the struggling cryptocurrency exchange through the liquidity crisis. But as soon as FTX crashed in November, BlockFi also declared bankruptcy after only having about $275 million left in cash. According to firm executives, the company has over 100,000 creditors and between $1 billion and $10 billion in assets and liabilities, respectively. In the midst of this, BlockFi said that withdrawals would be suspended, citing the fact that it had several assets put on FTX and was still owing some of the credit FTX had extended. Even the cryptocurrencies were significantly impacted by this, with Bitcoin hitting a two-year low.
DeFi vs. CeFi
Defi and CeFi are far more accessible than traditional finance, and both work around the same financial services – trading, payments, insurance, lending, staking, asset management, and more. However, several crucial distinctions vastly differentiate the two paradigms of blockchain-based financing. The fundamental differences and subsequent divergence in user experience and performance between CeFi and DeFi is well-known, but the year 2022 so far has been a cautionary tale of a lack of decentralization and its effects.
With the FTX disaster and its massive political coverage, it is difficult not to draw comparisons to the 2008 financial crisis, with large institutions taking precarious positions and, ultimately, jeopardizing users’ funds. The only difference is the assets are now cryptocurrencies. Both DeFi and CeFi seek the same goal, which is to provide access to crypto-based finance products and services, but DeFi achieves this through the creation of a permissionless, trustless ecosystem that takes asset custody and responsibility back to users. While this results in a steeper learning curve for new users and thus can hinder mass adoption, it ultimately creates a more reliable industry.
A person using DeFi could also earn more than a person using CeFi, where a user would only be able to buy tokens when the cryptocurrency exchange lists them. Many new projects first get listed on DeFi, and since they are fresh, they frequently provide incentives like higher user rates for early birds. The DeFi ecosystem also provides a much superior avenue for innovation. The introduction of Ethereum paved the path for leveraging DeFi’s potential inside the financial sector, inspiring companies, and enterprises to develop and implement ingenious solutions. The benefits of DeFi are not limited to its users. For example, market liquidity can be improved and fraud risk reduced. DeFi has the potential to increase the crypto market’s security and prestige over time.
The FTX disaster has kickstarted the transition to DeFi. Major DeFi protocols, including MakerDAO, Aave, and Compound, have witnessed a significant jump in user activity. DEXs registered substantial volume and transaction statistics after the crash, with Uniswap clocking record 24-hour trading volume on 9th November, more than quadrupling the figure from two days earlier. Curve is another DEX that enjoyed tremendous growth, almost hitting $3 billion in daily trading volume for a measly $170 million from before the disaster. Specialized DEXs offering perpetuals and other crypto-derivatives also had their best day since the Terra disaster, with over $5 billion in daily trading volume. Derivatives DEXs are especially primed for explosive growth, given the FTX was the industry leader within the sub domain. Trading volumes on decentralized exchanges (DEXs) exceeded $32 billion over the week the FTX fell.
Wallets and related services are also joining the bandwagon as users move to take control of their assets, as displayed by an increased outflow from centralized exchanges (CEXes) to personal wallets. The number of Cardano wallets has recently increased by well over 30,000 weekly, rising from roughly 3.638 million to 3.671 million.
Conclusion
With the current state of CeFi and the long-term advantages offered by DeFi, it is easy to say that the future of the crypto-based financial industry is decentralized. But the transition wouldn’t be so simple. As promising as DeFi is, it is not a panacea and comes with a distinct set of problems, with cracks in infrastructure often resulting in hacks and loss of user funds every now and then. This development provides renewed stimulus for the revaluation of the industry infrastructure as the crypto community moves forward.