The Significant Differences in Cryptocurrency CeFi vs DeFi vs DiFi
All the Myths and confusion these days revolve around centralised finance — CeFi — and decentralised finance — DeFi, but what is it really about? And have you heard about Difi — distributed finance? Let’s take a look at all three.
Centralised vs Decentralised vs Disitributed
Remember this illustration? This simple image essentially explains the three types of networks that all applications on the internet run on:
When it comes to finance, these three types of networks are translated into three types of finance platforms:
- With CeFi — Centralized Finance — users trust the people and institutions storing funds to ethically manage these funds and execute on services the business is offering.
- With DeFi — Decentralized Finance — users trust that the technology will function as intended to execute on services being offered.
- With DiFi — Distributed Finance — users trust that the technology will function as intended to execute on services offered, and that the institutions holding funds to ethically manage these funds.
CeFi — Centralised Finance
The main benefit of using CeFi services is that there is a higher degree of flexibility. Some advantages derived from this flexibility include fiat conversions, cross-chain exchange, and the ability to get help from customer service. In a nutshell:
Users benefit from the convenience of others holding and securing their keys
Users can exchange assets with typically higher liquidity
Users can easily move in and out of cryptocurrency
Verification
CeFi service providers need to follow KYC (Know Your Customer) and AML (Anti Money Laundering) regulations similar to banks and other financial institutions. Because of that, users are asked for personal information to verify that the user is legit, and to confirm where the deposits are coming from.
Custodial
A custodial wallet is a wallet where a user’s private keys are kept by the service provider. Custodials strive to provide users with the most convenient way to store cryptocurrency, giving users the option for a secure and customer-friendly solution, where users can get access to their assets with the touch of a button.
While funds are on the platform, they are stored outside of users’ custody and are therefore vulnerable to threats in the event that the security measures put in place by the exchange fail. Because of this, centralized exchanges have been the target of numerous attacks.
Centralised exchange (CEX)
When using a centralised cryptocurrency exchange — such as Binance, Coinbase, or Kraken — users send funds to the exchange to manage them within an internal account.
Many exchanges are dedicated solely to providing cryptocurrency trading functionality, but larger ones like Coinbase and Binance support borrowing, lending, margin trading, OTC, and more. This enables these exchanges to satisfy a wide range of customers’ needs through a single account. Many of these customers do not mind giving up their personal information or placing funds into the custody of these service providers because they are considered trustworthy entities.
Additionally, large exchanges have entire departments with customer service teams providing assistance to customers, should a problem or frustration occur. This high level of customer support offers customers a certain level of comfort, reinforcing the feeling that their funds are in good hands.
Trustful
When a user signs up to a CeFi service, the user needs to put a great deal of trust in the people behind, their code of conduct and their ability to prevent hackers from accessing the funds deposited.
Cross-Chain Services
CeFi services commonly support trading of BTC, LTC, XRP, and other popular coins issued on independent blockchains. Due to the complexity and latency of performing atomic cross-chain swaps, DeFi services typically do not support these tokens. CeFi services overcome this issue by taking custody of funds from multiple chains (whereas decentralized services require that tokens follow for example the Ethereum token standards to achieve interoperability). This is a big advantage for CeFi because many of the highest-market-cap and most frequently traded coins exist on independent blockchains and don’t follow interoperability standards.
Fiat On- and Off-Ramp
Centralized services commonly demonstrate more flexibility, as compared to decentralized services, when it comes to converting fiat to cryptocurrency and vice versa. To date, conversion between fiat and cryptocurrency has required a centralized entity so most DeFi services do not provide fiat on-ramps.
DeFi — Decentralised Finance
The benefit of using DeFi financial services is that you do not need to give up personal information or custody of your funds. This greatly reduces the risk of your information being used without your consent, or having your funds stolen. DeFi empowers people to independently manage their funds without missing out on any of the services available in CeFi and beyond. In a nutshell:
Users can hold their own private keys
Users can confirm transactions on a blockchain
Users don’t need to trust any third-party service
No Verification
Users do not need to request permission to use DeFi. With CeFi, users are frequently required to complete a KYC process to access services, which means that they have to provide personal information or deposit money, prior to being given access to services. With DeFi, users can connect directly to services using just a wallet and without divulging personal information or depositing funds. This is because DeFi is designed to be openly accessible to all parties, without any discrimination or barriers. This design has the additional benefit of mitigating the ability of companies to use or profit from your personal information.
Additionally, individuals or groups who decide to build on top of a decentralized protocol can do so freely. This offers a high degree of accessibility and promotes collaboration within the community. Products built within the DeFi ecosystem are designed to interact and benefit from each other; this is why DeFi products are commonly referred to as money legos.
Non-custodial
A non-custodial wallet is a decentralized wallet, where the user holds their own private keys. The user gets a file with private keys and needs to write down a mnemonic phrase with which they will be able to restore their funds. Having private keys means that you have full control over the funds. With full comes responsibility, and if one loses the private key the funds will be lost forever.
Decentralized exchange (DEX)
Decentralized exchange is facilitated by a system of smart contracts hosted on a decentralized protocol, like Ethereum. The smart contracts are encoded with a set of instructions with the sole purpose of autonomously fulfilling exchange orders. This means that only the exchange’s users, and smart contracts are involved in executing swaps. Users can make trade requests without needing to move funds outside their wallet; the funds are only transferred when the trade executes successfully on the exchange smart contract.
Trustless
A big advantage of using DeFi services is that you do not need to trust that the service will perform as advertised. Users can verify that DeFi services are operating as intended by auditing their code and using external tools like Etherscan to determine if a transaction was properly executed. Professional services such as Quantstamp, an organization of smart contract experts, will also assess and verify that smart contracts have been properly built to securely execute services.
Rapid Innovation
Another noteworthy advantage of DeFi is its rapid rate of innovation. The DeFi space is constantly building upon current capabilities and experimenting with new ones. The build-centric ethos of the space has transpired into a rich ecosystem filled with ground-breaking financial services.
In areas where centralized services have thrived, such as cross-chain exchange, DeFi has been working to deliver alternatives. For example, to compensate for DeFi’s inability to facilitate the transfer of incompatible cryptocurrencies like BTC, solutions such as WBTC and tBTC, which are compatible with decentralized protocols, fill the gap by acting as tokens pegged to the value of BTC. This allows DeFi users to access BTC through DeFi without needing to directly use the token.
Entirely new assets have been invented in DeFi as well. Users can passively earn interest by holding a token that represents the interest on funds lent out in a lending market. Compound pioneered this new asset with cTokens. These types of innovations only recently began to appear, and variants are already beginning to pop up.
DiFi — Distributed Finance
Distributed Finance — DiFi — is kind of like a middle way between DeFi and CeFi, taking the best of both worlds:
Users benefit from the convenience of others holding and securing their assets
Users can hold their private keys
Users can confirm transactions on a blockchain
Users can exchange assets with typically higher liquidity
Users know that other users are verified and hence legit
Verification
Similar to CeFi, users will need to verify themselves when signing up to comply to various KYC and AML regulations.
Multi-custodial
Similar to CeFi, funds are stored somewhere, however with DiFi the user can choose to store on a custodial wallet that the user trusts.
Similar to DeFi, users hold their own private keys and unique passphrase to unlock their account and access funds, stored on their trusted custodial wallets. The reason users need to access funds using a passphrase is because all transactions are logged on a blockchain, but contrary to DeFi, the same blockchain is used to log all transactions, regardless of the cryptocurrency, hence there are no atomic swaps used.
Decentralized exchange (DEX)
Similar to DeFi, transactions between users happen peer-to-peer in a decentralised way, logging all transfers and trades on a distributed ledger (blockchain).
Contrary to DeFi platforms, a DiFi platform typically has more liquidity due to it’s ability to separate core assets and IOUs. An IOU is a token, issued on the blockchain that the DiFi platform operates on, which represents the same value as the underlying asset. For example, 1 BLOCKBASIS.BTC is equal to 1 BTC. The 1 BLOCKBASIS.BTC tokens runs on Bitshares, while the 1 BTC is powered by the Bitcoin blockchain. When multiple cryptocurrencies come together on a DiFi platform, the total liquidity on the DEX increases.
Trustworthy
Similar to DeFi, by holding your own private keys and having all transactions logged on a distributed ledger, the need for trust is almost removed on DiFi platforms for any given user as they can easily move on to another service with their funds using their private keys.
Contrary to DeFi, on a DiFi platform the underlying asset will be stored on a custodial wallet, which the user will have to trust.
Conclusion
Time will tell which type of platform will win the “war for future of finance”,