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What is DeFi? & Difference Between DeFi vs CeFi

The DeFi Narrative

Removing third parties is the core principle of cryptocurrency—with the community rallying behind slogans like "not your keys, not your coins" , and "don't trust, verify!" But as the ecosystem sprung up around cryptocurrency, this original ethos has weakened. Most buying and selling takes place through secondary software on third party exchanges or wallet services, and most cryptocurrency is stored with third party custodians.

This discrepancy between placing trust in code, and placing trust in third parties, has opened an ideological chasm at the heart of the cryptocurrency space. Now with the explosion of Decentralized Finance (DeFi) protocols and Centralized Finance (CeFi) platforms that facilitate borrowing, lending and trading of cryptocurrency, the two ideologies are directly pitted against each other.

These two branches of blockchain-based finance share the same goal of liberation from the limitations of legacy banking, but each has a unique set of pros and cons.

What Is DeFi?  - Decentralized Finance

DeFi protocols  are typically open source, with all financial processes facilitated by a system of smart contracts hosted on a blockchain. 

Instead of a bank clerk shuffling funds around, or a centralized database, the smart contracts moving money are secured by decentralized consensus, typically on Ethereum, EOS, or Tron.

With all operations taking place on the public blockchain, full transparency is possible. Transactions can be verified with Blockchain Explorers, and smart contracts verified by specialist auditors.

With no gatekeepers to the system, those who wish to remain anonymous are able to, and do not need to surrender valuable passports or ID documents through KYC processes that can put sensitive information at risk. This permissionless freedom, along with an open source development culture, has transformed the strictly regimented world of traditional finance. With DeFi, innovators are free from regulations and can use smart contracts like "lego pieces" to create new forms of financial plumbing.

How Does DeFi Work? 

Interoperability is central to DeFi, and each project, of which there are over 200 listed on DeFi Prime, can be linked with others through smart contracts to create something new. This makes collaboration simple, and incentivizes the sharing of resources because each project benefits from the additional liquidity that each new success brings into the space—a stark contrast to the increasingly fragmented liquidity of the centralized exchange landscape. 

The success of this approach has made DeFi responsible for a long list of innovations supercharging the functions of traditional finance. These include new types of assets like wrapped BTC, new governance experiments like Compound's COMP, and complex forms of lending like flash loans

On the flipside, this complexity makes Defi a daunting prospect for newcomers. But while the learning curve might be long, at the end there are lucrative opportunities with new esoteric money making schemes like liquidity mining (aka yield farming), and interest rates that blow anything traditional banking can offer out the water.

The opportunities provided by these new protocols have incentivized the fast flow of new money into DeFi, which has doubled to more than $2 billion in just two months.

Difference Between DeFi vs CeFi

The downside of DeFi is that it is still very experimental, and while there might not be a custodial risk, there is the possibility of smart contract hacks with faulty code creating vulnerabilities.

This risk is what CeFi platforms aim to eliminate. Instead of removing trust by replacing third parties with code, CeFi adds more third parties in the form of auditors and certifications to replicate the functions of traditional finance with familiar reassurances like insurance and regulation.

CeFi platforms—including Nexo and BlockFi—typically benefit from a friendlier UX, and the same familiar sign-up processes as any centralized exchange, but have the same drawbacks of traditional finance like KYC processes that can put information at risk, and custodial services that represent an attractive target for hackers.

As regulated entities, CeFi platforms also tend to offer more possibilities for holding fiat in custodial wallets, and converting fiat to cryptocurrency and vice versa via a fiat gateway. These fiat gateways have helped CeFi services like attract hordes of new users, and make CeFi platforms an easy entry point into the ecosystem, even if funds are later moved to more decentralized regions. 

This scenario, which involves points of centralization with fiat gateways in an otherwise decentralized ecosystem, is what DeFi pioneers like Maker's Rune Christensen envisage as the next stage of evolution of DeFi and CeFi.

As Christensen told CoinTelegraph, “it is still the very early days” for DeFi, and eventually it is likely to merge with Centralized Finance: "What's currently known as CIFi will become the front end and sort of the access points to the various DeFI protocols (...) You will have a custodian that you trust and then that custodian interacts with the DeFi protocols for you.”

Guest Post

Kieran Smith

Content Strategist

Kieran Smith provides content strategy and copywriting services for cryptocurrency companies at Bitcopy.

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