DeFi vs CeFi: the Difference Between Decentralized and Centralized Finance
We all know our good old traditional financial system. Borrowing, lending, getting insurance, investing, trading, payments, and banking – all happening with the help of someone.
That someone could be your bank, let’s say the CitiBank, or your insurance company, maybe Allainz or AXA.
These institutions and companies operate our finances in the traditional way. Dealing with fiat money, i.e. regular currency, like e.g., the US dollar, and standing as the third party in each and every operation.
This is the traditional, centralized finance in a nutshell.
But! There’s a new player on the market. Fresh, young, and ready to revolutionize the old ways. That player is DeFi – decentralized finance.
In this article: DeFi vs CeFi, you’ll learn all about what DeFi is. How it is different from CeFi, its characteristics and features, why we even need it, and more!
1 Main Difference Between DeFi vs CeFi
The main difference between centralized and decentralized finance is quite simple.
DeFi (Decentralized Finance) is the financial system we know mentioned earlier, but established within a decentralized blockchain technology. Therefore, making DeFi not require an intermediary for any operation. So whether that’s lending, borrowing, investing, transferring, or exchanging money – DeFi works in a peer-to-peer system, meaning any person can complete financial operations directly with any other person.
CeFi (Centralized Finance) on the other hand, does require an intermediary for completing operations. The intermediary we’re speaking of is usually the bank.
Now, why would we need a mirror reflection of CeFi built on the blockchain technology?
Well. There are a few good reasons. But we’ll get into all the juicy details for anyone hungry for knowledge later on! First, let’s get us familiar with a few important facts about DeFi.
7 DeFi Facts and Characteristics
DeFi Is Transparent: our current banking system is not transparent, which may result in various frauds, scams, or simply human errors, for which in most cases pays the client. On many occasions, banks had to pay million dollar fines for their mistakes. DeFi is the transparent system because of the blockchain transparency. This system is there to help you complete the exact same financial operations, but without the unnecessary intermediaries and thick walls.
DeFi Is Less Expensive: Extracting the intermediaries and third-party institutions is also connected with lower costs of completing any financial operation. There’s no need for employees, physical locations for various institutions, or fixed costs of the place. All that’s needed is the developer who’s going to write the code for the DeFi application.
DeFi Is Inclusive: Decentralized Finance operates in the peer-to-peer system, meaning the transactions and operations are completed from person to person. This also means that anyone with access to the internet can access and take advantage of DeFi. This is contrary to the traditional system in which you have to open a bank account, for which you need to meet a fixed set of requirements. Banks may deny you to open an account and may also block the funds on your account at any moment if they find the reason to do so.
DeFi’s Market Cap Is Quite High: the market capitalization of all tokens from the DeFi sector comes up to 92,930,729,087 USD. Source: https://defimarketcap.io/. Date: 16th of October, 2022.
DeFi Is More Predictable: DeFi is more predictable and less prone to error since it relies on a written code instead of humans. Of course, the code is written by people, but it has to run smoothly to work. Whereas, in traditional finance we have to rely on people, which may result not only in costly errors, but also scams and frauds.
No Complicated Verification Procedures: DeFi does not require you to provide a copy of your ID or verify your account, which you do have to do in traditional finance.
All DeFi Tokens Can be Viewed Here: https://coinmarketcap.com/view/defi/.
Why Would We Need DeFi? CeFi vs DeFi Lending
Now let’s get straight into the real burning question we all have: why was DeFi invented?
Well, the answer is quite simple.
People got tired of the traditional system and its flaws.
Which, of course, at the beginning was all we knew, but with time came developed technology, and thanks to that, a new and improved system has been made possible.
DeFi is a system that doesn’t require us to rely on a centralized authority, eliminating the need for the third party in each transaction. In turn, it makes it possible to conduct transactions directly from person to person, with a little help of technology.
You may not be convinced just yet and that’s understandable. So to visualize this, let’s go over a few examples to better understand the concept and the need for DeFi.
Dave takes a loan
Dave is a 25 year old man who’d love to have his own home and move out of his rented apartment. He has some money saved, but not enough to buy a home without any kind of financial support. Dave is also working full-time as a backend developer, earning $100k per year and each month and saving a fixed amount of money in cryptocurrency.
He can be sure to receive the loan from a bank and will get the money he needs to buy his very first home.
But what would be better for him? Take the loan through Centralized Finance, aka a bank or through DeFi and take the loan without the intermediary?
Let’s compare these two situations.
Taking a loan with DeFi vs CeFi
With CeFi
If Dave decides to go with CeFi for taking his loan, he will have to deal with the fact that the interest rate of the loan is 10% of the whole amount he’s borrowing.
Banks earn money precisely by borrowing amounts from those that deposit the money in their institution, in turn, rewarding them with, let’s say a 3% interest rate. Then, the borrowed money from depositors gets lended to Dave, who took the loan with a 10% rate, making the bank winning a whole 7% of the transaction.
With DeFi
DeFi makes it possible for Dave to be both the borrower and the lender, whichever he chooses to be, without having to bother with banks and their procedures.
Of course, if Dave would not have any cryptocurrency prior to that moment and would have to start from scratch, borrowing in DeFi might have seemed scary or complicated to him. But it so happens that he knows a thing or two about crypto and smart contracts that are the base of DeFi lending, making it easy for him to choose this option instead.
Even if he didn’t know anything about crypto before, it just seems scary and complicated, but it actually isn’t. Why? Because in DeFi, there are no mounting paperwork for him to fill out before he files his written request for a loan, he won’t have to hire a credit advisor, he won’t have to wait weeks or months for approval, and he’ll skip all the helpline calls he would normally have to make to speak with the bank. Besides, just as we learned how to use the internet, we can definitely learn how to use DeFi.
Taking all that into consideration, the decision between DeFi vs CeFi in this case seems to be a no-brainer.
How Does Taking a Loan in DeFi Work?
Let’s elaborate a bit more on borrowing and lending in DeFi, because we think that’s quite revolutionary and interesting.
So, to get straight to the point.
You may be wondering how DeFi lending can be safe and how can both parties trust each other enough to even get involved in the process.
Well, the answer is simple: in decentralized finance, the trusting party consists of smart contracts.
They are the key to this whole venture.
We’ll craft a detailed article about smart contracts soon, but just to explain DeFi lending, we must briefly mention how they work.
A Bit About Smart Contracts
So, smart contracts or simpler – digital contracts are self-service applications written on the blockchain technology.
The best way to understand smart contracts is by thinking of a regular contract, e.g. the one you have with a bank when taking out a loan. That contract has certain terms of agreement between the two parties.
Smart contracts are those terms of agreement but written by a developer on the blockchain technology. Now, because the contract is digital and most importantly, coded, it means that the written application is automatically checking whether or not the terms of agreement are being respected by both parties. If not, the smart contract won’t finalize the transaction it’s been written for. Of course, it may be written in a bit more complicated way and still has to be validated by the blockchain users, but it takes out the main intermediary, which in traditional finance would be a bank.
The fact that the smart contract has to be coded by a developer is the only centralized factor to this method. We have to always take into consideration this fact, simply because it may contain human errors. So before getting involved with DeFi lending, we have to check the protocol in question.
And if we don’t know how to do that, it’s best to simply use the protocols that’ve been around on the market for a while and have been known to work well.
The most apps serving as smart contracts have so far been written on Ethereum’s blockchain, the second biggest cryptocurrency after Bitcoin.
Oh boy! That was something.
Now that we have this out of the way.
To actually use DeFi for borrowing money we have to do a few things. The first is having stablecoins or other cryptocurrency of a few times higher worth than what we want to borrow.
Let’s tackle this with an example.
We have 1ETH, which is worth $3,000.
So we can borrow $2,000 as collateral for the $3,000 that we have. If the ETH’s value drops, the smart contract will initiate its procedures and will start selling our collateral ETH to make sure that the lender has what he initially offered so that we could take the loan in the first place.
So #1 rule in DeFi borrowing is that we cannot borrow an amount higher than what we’ve set as our collateral.
This basically means that your collateral must be higher than what you want to borrow. Most of the time, the amount you can borrow sits between 70 to 80% of your collateral. The exact amount also depends on the size of your collateral and on the platform you’re using.
It’s worth noting that the protocols may work a bit differently here and there in between various platforms, but the main rules remain the same throughout them.
How Does DeFi Lending Work?
We can also be the ones lending money to others through DeFi, therefore becoming banks in some sense. If you’ve played Monopoly anytime in your life, you know the feeling of being the banker. DeFi lets you do just that, but in a bit more complicated way than just opening the game box.
So, what we have to do is place our money on a protocol of choice. The amount we place will be located there at a certain interest rate. The money we put in can again be stablecoins or other cryptocurrency.
Basically, the same way we put our money in a savings account in a bank. But this time around, there’s no intermediary taking his own percent in the whole process.
As a reward for lending our cryptocurrency, we get interest in stablecoins or cryptocurrency. Again, smart contracts watch over our safety.
Plus, as we already mentioned, the person borrowing the money has to put in collateral more money than they want to borrow, making sure that the amount we put forward is safe and will return to us.
Examples of the Decentralized Exchange Markets
Our three examples of the decentralized exchange markets are:
Feel free to check these out and look out for our article explaining DeFi exchange markets in more detail and comparing the available options!
Our Thoughts on DeFi vs CeFi
DeFi vs CeFi – a clash that just 20 years ago we wouldn’t even think would happen. But here we are!
We think DeFi will be just as revolutionary as the invention of the Internet was back when it came in to our lives and how it changed the traditional media. That’s most-likely how DeFi will impact CeFi.
Of course, it may be a bit more difficult, because banks and traditional financial institutions won’t be so eager to give up their control of the finances. But, even with that in mind, DeFi is still growing quite dynamically since it’s been first invented.