How DeFi and CeFi Can Work Together
Centralized finance or CeFi and Decentralized finance or DeFi are often pitted against each other as challengers. Yet a minute examination of both these paradigms shows that they could have easily complemented each other.
To understand why it would rather be a better idea to advocate collaboration between DeFi & CeFi, we need to delve deeper into what these two finance-systems imply and what some of their defining features are.
What is Centralized Finance?
Centralized finance implies a service where all orders are controlled by one central exchange with no other competing parties. The only price available for traders are those that are quoted by the central exchange itself. The users of a centralized exchange show absolute trust in the people who run the exchange. People trust them to manage their funds professionally and legally and execute the services of the business. The broad objective of a centralized finance system is to facilitate fair trades and boost more transactions.
What is Decentralized Finance?
As the name suggests, decentralized finance is free from the clutches of a central authority managing every aspect of the trade. It operates through a decentralized blockchain run by the participants of the blockchain network themselves. It effectively cuts out the intermediaries and regulatory authorities and makes the system purely a peer-to-peer one.
The primary and broad objective of decentralized finance is to encourage financial inclusion and make the financial world more accessible to the people who suffer from a lack of opportunity. It expands the systems of lending and borrowing, stock-trading, asset storage, and insurance. It offers total autonomy, increased tradability, and enhanced transparency.
Features of a Centralized Finance System
- Although centralized exchanges have often been subjected to cyber threats and hackings, people show trust in them because they come with a sustained legacy of conducting fair trades. Large centralized exchanges have full-fledged customer service teams for each of their departments. A high level of support translates into high comfort levels for users who believe that their funds are in good hands. Resultantly, they don’t mind sharing their information or giving up the custody of their funds.
- Centralized exchanges offer more flexibility in terms of fiat to crypto conversions. A lot of mainstream investors prefer to join the CeFi bandwagon because it allows them to leverage their fiat currency funds and take payouts in fiat currency as well. It makes onboarding easy and convenient for newcomers. Conversion of fiat to crypto requires a centralized entity, DeFi services often lack this aspect.
- Centralized exchanges offer cross-chain services. They support the trading of LTC, XRP, BTC, and many other coins issued on independent blockchains. Issues relating to latency and the complexity of performing cross-chain swaps often make DeFi systems lack severely in this aspect. On the other hand, since CeFi gets the custody of funds from multiple chains, they can easily offer this feature.
On the other hand, DeFi has some unique features that make it more accommodative and inclusive. Let’s have a quick look at those enticing features of a decentralized finance ecosystem.
Features of a Decentralized Finance System
- One of the most enticing features of a decentralized financial system is that it is permissionless. What it means is that unlike a CeFi system, users of DeFi do not need to complete a KYC process to access its services. Users are free to access the DeFi system using their wallet — without providing any personal information or depositing money. Moreover, a decentralized system supports customization. Individuals with the appropriate knowledge of how things work in a decentralized financial system can build on it. It makes a DeFi system more collaborative. Communities can easily channel a DeFi system’s inherent benefits to their advantage.
- Since a DeFi system does not take custody of its users’ funds, there is no need to trust what the platform claims about its performance. Users are free to authenticate whether the service is performing as intended. They can do it either by scanning the code or leveraging external tools such as Etherscan to check whether a transaction was executed successfully or not.
- As we have already noted, a DeFi system encourages people to innovate. It has a build-centric nature perfectly conducive for developers to innovate on ground-breaking financial services that fit the exact needs of a set of beneficiaries.
CeFi and DeFi: Filling Up Each Other’s Gaps
Centralized finance exchanges attract a lot more trade. However, since it is regulated by a central authority, it requires people to provide personal information before they can start trading. Complying with KYC requirements is a mandatory requirement. This acts as a major barrier for centralized finance exchanges to become inclusive. To understand how acute this problem relating to personal identification is, let us have a look at some numbers:
KYC is a Barrier in CeFi
According to the latest available global data, there are as many as 1 billion people in the world who struggle to prove who they are. Of these 1 billion people who do not possess any discernible official proof of identity, more than 80% live in Sub-Saharan Africa and South Asia. 47% of these people are below their national ID age. It indicates a severe lack of birth registration efforts.
Most importantly, the majority of these people who do not have official proof of identity are the ones who need access to finance the most. 63% of people who do not have an ID-proof live in lower-middle economies, and 28% live in low-income economies. To have to undergo a compulsory KYC process is counter-intuitive in these economies for any financial system to prove its worth.
DeFi can work wonders to compensate for this lack of CeFi. In DeFi, the mechanism is peer-to-peer. One can easily access the benefits of a DeFi lending or borrowing platform, during the hours of crisis, without first having to prove who they are. The lender directly lends the borrower with an auto-executing smart contract acting as the instrument of trust between them.
CeFi is Expensive
Despite CeFi having superior services, is an expensive system for the same reason that makes it non-inclusive. The involvement of intermediaries makes it costlier. For people who need to access the financial system, especially as a borrower, a CeFi system becomes counter-productive as they need to shell out more money to access the service than a DeFi service.
CeFi and DeFi: Coming Together
Experts predict that it is out of mutual interest that these two finance systems will embrace each other. While facilities of fiat conversions, exposure to a wide range of crypto assets, and due diligence conducted by the platform would work in favor of the CeFi, the DeFi system will become preferred for its inclusivity, cheaper transactions, and relatively high yields.
These mutually complementing aspects make experts hopeful that the lines between CeFi and DeFi will blur. Systems of centralized finance will leverage DeFi to empower the back-end and improve user experiences. Developing on the building blocks of DeFi will also ensure that no hacker or external malicious entity would be able to ruin the protocol. While, when it would come to the improvement of the protocol, anyone participating in the network would be able to contribute to the collective upgrading of the network.
The Road Ahead
To ensure that systems emerge that make the most out of the positive aspects of CeFi and DeFi, developers will have to stress upon these following aspects:
- Risks associated with DeFi would have to be reduced. This can be done by offering insurance, introducing much vigorous testing and auditing processes, and ensuring that misleading adverse information about DeFi is curbed.
- One of the reasons why people still move towards CeFi, despite the system being restrictive and stringent, is that there is not enough information on DeFi protocols. An increase in DeFi education would help DeFi to merge with the mainstream.
- Finally, all stakeholders involved in the world of decentralized finance will have to make sure that reputable DeFi communities are built.
Looking at the benefits of DeFi, many centralized exchanges are allocating funds to drive collaboration. CeFi players are providing liquidity support to DeFi projects that these systems often lack due to less volume of transactions. These centralized exchanges would also conduct audits and due diligence on their chosen DeFi protocols. In exchange, the DeFi projects will gain access to the centralized exchange’s customer base, media information and knowledge reserves, and its financial management protocols.
With all these developments taking place, we can reasonably assume that a well-defined and structured symbiotic relationship between the CeFi and DeFi ecosystems would help make world finance more accessible, inclusive, and efficient.
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