CeFi, or centralized finance, represents financial services for crypto such as centralized exchanges (CEXs), lending/borrowing, spending, or earning interest. While traditional finance typically refers to financial institutions such as using Charles Schwab for trading securities or getting a mortgage loan from Bank of America, CeFi deals directly with crypto related services. Some CeFi examples include Coinbase, Kraken, or Blockfi. These companies provide crypto related services and have a central authority able to control or restrict access to their financial services. In addition, CeFi companies often enforce KYC/AML regulations and are regulated by government entities.
The centralization and regulation of CeFi in most cases is no different than stringent regulation of traditional finance. But CeFi does offer some unique benefits in relation to crypto.
- Yield — One of the big appeals of CeFi is earning interest on your holdings. For example, you could give your ADA or USD stablecoin to CeFi firms such as Coinbase or Abra, who in turn could promise you an APY from 2–10%. The CeFi firm could be doing various activities, such as staking on a proof of stake protocol or lending out your cryptocurrency for yield. The CeFi firm attempts to profit from the difference between the yield they make with your money and the APY promised to you. These returns can be much higher than what is offered in a savings account from a traditional bank.
- Borrow against your cryptocurrency — You could also put your crypto up as a collateral for a loan. For example, if you have $2,000 worth of ADA and you want to take a loan out, but do not want to liquidate your ADA and be subject to potential taxes. You can go to a CeFi firm who is advertising crypto loans with a 50% LTV (Loan to value) ratio. After depositing your ADA, you receive $1,000 in USDT. You’ll have to pay back the $1,000 USDT loan in the stipulated time frame with interest that you agreed to.
What about DeFi?
DeFi, or decentralized finance, allows peer-to-peer financial transactions such as lending/borrowing or exchanging digital assets without the need of intermediaries. Instead of an intermediary, conditions of transactions are determined by smart contracts with all details recorded using blockchain technology. Below we'll compare CeFi with DeFi.
Benefits of CeFi
- Higher Interest Rates — When compared to some DeFi platforms such as AAVE, some interest rates offered on platforms such as Blockfi, Celsius, Abra, or Coinbase could be higher for your cryptocurrency. However, due to arbitrage, any significant yield differences might not persist.
- Fiat Conversion — Conversions between fiat and cryptocurrencies for most people typically happen via a a CeFi exchanges such as Binance, which allows you to buy cryptocurrencies in over 20 different currencies. While you can use P2P trading as a fiat ramp, the liquidity could be lower for less well-known cryptocurrencies. In addition, the spread of prices on P2P platforms and CEXs are sometimes significant, hurting the potential returns of users. DEXs, or decentralized exchanges, don’t offer this optionality because the use of fiat currency is heavily regulated and most DEXs are permissionless and non-KYC compliant.
- Cross-Chain Services — CeFi exchanges allow you to trade coins or tokens from different blockchains easily. For example, you can easily trade BTC (Bitcoin) for SOL (Solana) or ADA (Cardano), even though all three cryptocurrencies trade on different blockchains. While there are projects that allow people to trade cryptocurrencies for others on different blockchains through bridges in a decentralized manner, the ease of using a CEX like Binance or Kraken is still much easier and simpler to understand for most crypto users.
- Customer Service—While usage of DeFi applications requires extensive individual research before using, many CeFi firms have customer service departments which can help you with any tasks or issues.
Drawbacks and Risks of CeFi
- Pseudonymity — Unlike DeFi applications, CeFi firms typically follow KYC/AML regulations. You might have to provide very private details such as your passport number, tax ID, and residential address to use their service. DeFi is permissionless, meaning applications can be used by anyone with a personal crypto wallet with cryptocurrencies.
- Non-custodial — “Not your Keys, Not Your Coins” have become a popular phrase in the crypto community. It means that CeFi firms like Coinbase or Kraken maintain custody of your cryptocurrencies. They have the keys to your cryptocurrencies, giving them the ability to freeze your funds, sell them, or send them to another wallet. To use DeFi applications, however, one must use a personal wallet such as Eternl or MetaMask, in which the user maintains the private keys to the wallet.
- Transactions costs — CeFi firms can offer lower fees or some services for free to users. In DeFi, fees are needed to avoid spamming or DDOS attacks. In addition, fees are needed to entice liquidity providers to dApps such as DEXs or decentralized lending.
- Transparency — One of the benefits of a public blockchain is that they provide transparency of transaction history, allowing a verifiable audit trail. In CeFi, some firms commingle user funds such as CEXs. By commingling users' funds, the source of funds after cryptocurrencies have been sent out may be hard to properly track without the help of the CEX utilized in the transaction. In a DeFi application like a DEX, all transactions are publicly posted to the blockchain, meaning transparency remains.
CeFi and DeFi both have pros and cons. Due to the heavy regulation of fiat money and the current low usage of cryptocurrency for daily transactions such as buying groceries or shopping online, CeFi has structural advantages over DeFi. However, DeFi has opened financial tools and services to hundreds of millions of people who previously lacked access due to nationality. DeFi continues to evolve, with many blockchains like Cardano moving forward with interoperability, scalability, and functionality. Below is a scorecard comparing CeFi with DeFi.