DeFi vs. CeFi in Crypto

Many people think of crypto as a single-faceted industry revolving around cryptocurrencies. But scratch the surface a little, and you will find plenty of fragmentations within the industry that often contrast with each other.

The cryptocurrency market crash of spring 2022 brought to the fore a key distinction in the crypto industry: that of centralized finance (CeFi) and decentralized finance (DeFi).

In this piece, we’ll explore the characteristics of CeFi and DeFi.

DeFi vs CeFi: points of difference

DeFi is short for “decentralized finance,” an umbrella term for a variety of financial applications built on the blockchain. These applications or platforms are typically built using smart contracts, which are pieces of code that determine the rules a DeFi protocol operates under.

Users who interact with DeFi smart contracts do similar things that they would do in traditional finance (or centralized crypto finance), such as borrow money, make loans or trade assets. The only difference is that all of that takes place without intermediaries, and the entire operation runs on code.

DeFi protocols include but aren't limited to spot exchanges like Uniswap, derivatives trading platforms like GMX, options trading platforms like Opyn and lending platforms like Aave. The DeFi industry commanded $69 billion in assets as of August 2022, according to DefiLlama, a site that tracks the amount locked in DeFi. That’s up from less than $1 billion at the start of 2020.

Most DeFi protocols coordinate through decentralized autonomous organizations, or DAOs, where holders of governance tokens (such as UNI for Uniswap) decide matters, like treasury allocations or changes to tokenomics. Decision-making and transactions through the protocol are transparent through public blockchain explorers, such as Etherscan.

CeFi is different. On the surface, CeFi looks like traditional finance businesses. CeFi firms are private companies that deal primarily with blockchain assets like cryptocurrencies or NFTs (non-fungible tokens). There are no open-source smart contracts underpinning their operations (they aren’t built in the blockchain after all), and they make their own rules behind closed doors, just as other private companies do. Users interacting with them are essentially paying customers.

CeFi is not to be confused with TradFi, or traditional finance, which comprises centuries-old legacy institutions like J.P. Morgan Chase or BNY Mellon. Outside of crypto, TradFi is simply known as the financial sector.

CeFi businesses include lending platforms like BlockFi and exchanges like FTX.

DeFi is permissionless, meaning anyone can make use of financial applications available on the blockchain. CeFi businesses use DeFi protocols. In fact, Celsius Network was also one of the largest players in the DeFi markets before the company went bust in June 2022.

How things can go wrong with CeFi

The collapse of Terra in May 2022 showed how an entire ecosystem can blow up as a result of unsustainable design in DeFi. It also had a domino effect on CeFi via crypto hedge fund Three Arrows Capital (also known as 3AC), which was heavily invested in Terra and had borrowed billions of dollars in cryptocurrencies from CeFi lenders to make such investments and pursue other risky strategies across the crypto industry.

The founders of 3AC cited Terra as one of the two major factors in its demise. The other were investments in the Grayscale Bitcoin Trust (Grayscale Investments is owned by Digital Currency Group, which also owns CoinDesk).

The CeFi lenders were overconfident in 3AC and lent those funds without securing sufficient collateral. When the crypto market crashed, 3AC failed to pay back the loans. Investors claim that the defunct fund owes them $2.8 billion.

Three main causes explain the collapse of major CeFi lenders:

• Unsustainable yields – CeFi lenders offered high yields. They achieved that by investing customer funds in risky DeFi protocols like Terra. When those protocols collapsed, CeFi lenders couldn’t keep paying high yields.
• Lack of transparency – CeFi lenders are structured as private companies with business operations and balance sheets away from prying eyes. DeFi protocols operate through public smart contracts and governance forums.
• Under-collateralized lending – CeFi lenders offer customized lending terms, which in the case of 3AC, meant under-collateralized and even non-collateralized lending, exposing them to high financial risks. Borrowing in DeFi is typically over-collateralized.

Although high yields tend to raise eyebrows, they aren’t necessarily problematic as long as they are backed by a legitimate money market where rates are dynamically determined by supply and demand. Alas, that wasn’t the case in this instance.

Read Also: DeFi Lending: 3 Major Risks to Know