The Rise of DeFi: A Challenge for Traditional Finance

In this blog, we’re diving into what DeFi is all about. To keep things clear, I’ll start with CeFi, so you’ll have a solid foundation before we jump into DeFi. I’ll also walk you through the main services DeFi offers and break down the key differences between CeFi and DeFi. And don’t worry, I’ll keep everything super simple!

What is Centralized Finance (CeFi)

To put it simply, CeFi is when financial services provided are managed by a central authority, like a bank or a company, which controls your money and handles transactions for you. 

However, CeFi is not just limited to banks or traditional institutions. We have CeFi in the crypto space as well. For example, Binance, Kraken and Coinbase, all these are centralized platforms who provide financial services in crypto to individuals, since they are central authorities who manage peoples’ money, they also fall under CeFi. 

What is DeFI (Decentralized Finance)

In simple terms, DeFi is a system that provides all the financial services like lending, borrowing, trading, and saving through blockchain technology without involving banks or other middlemen. 

To say it in a more casual way, DeFi is like having your own bank that runs on blockchain technology managed by smart contracts. Fascinating, isn’t it? But don’t think your regular banks are involved here - they’re not! 

Instead, DeFi services are provided by decentralized applications (DApps) driven by smart contracts, where no single entity has control, these apps are commonly governed by a community of users and developers making DeFi a truly open and democratic financial system. 

How DeFi Operates without any Intermediaries

To offer financial services and make sure no one gets cheated, we really need a system of control. In today’s world, banks and financial institutions help ensure everything runs smoothly with minimal errors. But when it comes to blockchain technology, a lot of what banks and financial institutions do can be replaced. That’s where smart contracts come in.

These smart contracts act like automated agreements, ensuring that all financial activities happen smoothly, so that no party ends up being cheated. They have the rules written right into the code, which means technology is in charge of how financial transactions work. 

However, smart contracts alone won’t make DeFi a reality. They need the support of users, who are rewarded for their participation. This is similar to how banks work: banks can’t provide loans unless people deposit money with them. 

Just like banks rely on your deposits to earn income, to offer interest payments for savings and provide better banking services, DeFi platforms rely on users’ cryptocurrencies to offer their services.

In the conventional financial world, we have banks and financial institutions managing people’s money. In the world of DeFi, we have smart contracts managing users’ cryptocurrencies. 

Meanwhile, CeFi still plays a significant role in the crypto space, functioning like traditional banks by providing services such as trading, lending, and borrowing, but in a centralized manner, where users rely on a company to manage their funds.

For example, when you lend your crypto on a DeFi platform like Aave, you’re providing the funds that others can borrow. In return, you earn interest, just like a bank would. This teamwork between technology and users creates a financial system that’s open, transparent, and efficient. So, in the end, it’s all about working together to make finance accessible to everyone.

 

Key Services offered By DeFi

Lending and Borrowing: DeFi lending platforms like MakerDAO, compound and Aave allow users to lend their crypto to others and earn an interest paid by the borrowers. Borrowers can access stable coin denominated loans by locking up their crypto assets as collateral.

Smart contracts manage the whole process here, from managing interest payments and collateral to repayments and cutting out any need for intermediaries. To put it simply, the smart contract acts as the bank here.

Trading and Decentralized Exchanges (DEXs): DEXs like Uniswap and PancakeSwap let users trade their digital assets directly with other users without any involvement of a trusted intermediary such as a Centralized Exchange (CEX) like Binance or Coinbase to hold their assets. 

These platforms use Automated Market Makers (AMMs) and liquidity pools to facilitate peer to peer trading directly using user’s wallets. For example, assume you want to sell Ethereum and get USDC (dollar pegged stable coin).

To do that, you only have to connect your wallet to Uniswap or any DEX, select the amount of Ethereum you want to swap with USDC and confirm the transaction. The transaction will be handled by a smart contract, and when it is successful, you will receive USDC in your wallet.

Stablecoins: Stablecoins such as USDT, USDC and DAI are digital currencies in the realm of crypto pegged to physical currencies like the US dollar. For example, 1 USDT OR USDC is equal to 1 US dollar. Stablecoins are crucial in DeFi, allowing users to transact and store value without worrying about the wild price swings of cryptocurrencies like Bitcoin or Ethereum. 

For example, users can lend using stablecoins and earn interest without having to worry about the wild price swings. Borrowers also prefer to borrow stable coins instead of volatile cryptocurrencies as they provide predictable repayment amounts. 

Yield Farming and Staking: Yield farming and staking are other services that DeFi offers for users to earn additional income. In DeFi, staking is locking up your crypto to support operations of a blockchain network, particularly a blockchain that uses Proof of Stake (PoS) as their consensus mechanism, such as Ethereum.

In return for their participation, users earn staking rewards in the form of additional coins or tokens. Yield farming, on the other hand, is about providing your cryptocurrencies to the liquidity pools to support the operations of certain DeFi platforms. And in return, you earn rewards often in the form of transaction fees or additional tokens.

Lending platforms like Aave and Compound, yield Aggregators like Yearn Finance and Harvest Finance, and decentralized exchanges like Uniswap and PancakeSwap, rely heavily on yield farming. 

While some DeFi platforms, such as asset management platforms like Zapper and insurance platforms like Nexus Mutual, offer yield farming as an optional feature.

Derivatives and Synthetic Assets: These are financial products which mimic the real value of underlying assets like stocks, cryptocurrencies, commodities or gold. There are a lot of financial activities that could be done in the DeFi ecosystem using these financial products. 

For example, users can speculate on future price movements of these financial products to profit, buy or trade digital versions of gold or other commodities, use these products for hedging against sudden price volatility, and more

The above-mentioned services represent the core of Decentralized Finance and offer almost every traditional financial service such as lending, borrowing, saving, trading and asset management. 

Nice! Since now you have a good understanding about the services that DeFi offers and real-world examples of DeFi platforms, let's take a look at the key differences between CeFi and DeFi.

CeFi vs. DeFi: What Sets Them Apart

Control: In CeFi, Financial institutions control our money. For example, when we deposit money in a bank, the bank is in control of our money. 

 

Same thing happens in crypto space. If we want to buy crypto, we deposit funds to a centralized exchange (CEX) like Binance to buy cryptocurrencies, in all these scenarios, we trust an intermediary or a central entity to manage our money. 

In the case of DeFi, we nearly maintain complete control over our money. For example, if we want to buy crypto in a DEX, we don't have to deposit funds, rather we can connect our wallet directly to a DEX like Uniswap and do a peer-to-peer transaction.

In DeFi lending platforms, we trust the smart contract which runs in a decentralized, secure and tamper proof way to control our crypto, not a central authority like in CeFi. 

Transparency: Activities of CeFi, such as managing users' funds and handling users' personal data are sometimes hidden. For example, FTX, a popular centralized exchange, collapsed in 2022 due to misuse of customers' funds. 

In mid-2022, CeFi crypto lending platform Celsius Network filed for bankruptcy due to mismanagement of users' funds by investing in high-risk ventures.

Since actions of CeFi are not transparent, users rely on the security and openness of these institutions through audits and regulatory control.  

But in DeFi, everything is transparent. Smart contracts are open source, meaning anyone can check the rules written into the code and make sure everything is fairly conducted. All DeFi transactions carried out through smart contracts in public blockchains like Ethereum are also transparent and irreversible. 

Access: In CeFi, accessing services can be challenging due to strict regulations. Centralized institutions require users to complete KYC (Know Your Customer) verification, which can limit access based on identity and geographic location.

In contrast, DeFi offers broad accessibility. These decentralized platforms operate without a central authority, allowing anyone with internet access to use their services without revealing personal information. This makes DeFi a more inclusive option for users around the globe​.

Security: Centralized Financial platforms like banks and crypto exchanges all implement robust security measures to protect users’ funds. But these security systems are not 100% security guaranteed and therefore are still vulnerable to hacks and data breaches.

Centralized exchanges like Binance, Mt. Gox, KuCoin, and Bitfinex have experienced security breaches over the years. Since these platforms handle billions of dollars, they are prime targets for hackers.

When it comes to DeFi, it is no exception. Since smart contracts are open source, hackers can explore vulnerabilities in the code and steal users’ cryptocurrencies. Obviously, hackers cannot change the code in smart contracts, but still, they can explore for any flaws in the code that enable them to steal cryptocurrencies from DeFi platforms. The DAO hack in 2016 is a perfect example of this. 

Final Thoughts

In my opinion, the battle between CeFi and DeFi does not have a clear winner. Both satisfy different needs and preferences. Individuals seeking control and responsibility over their crypto can turn to DeFi, while those desiring a more regulated environment for financial services may prefer CeFi.

Ultimately, the choice depends on your technical skills, beliefs, and risk tolerance. Using DeFi typically requires a good understanding of blockchains and the crypto space, as it often lacks the user-friendly interfaces found in CeFi. And always remember, if you opt for DeFi, you are 100% responsible for managing your cryptocurrencies.

So, what's your choice? CeFi or DeFi? It’s always wise to be knowledgeable about both, just in case.

Disclaimer: The contents of this article are for informational purposes only and are not financial advice. The views here are just the author’s opinions. The crypto market is volatile, so be sure to do your own research before investing.