Contents

Cefi vs DeFi

Overview

From DeFi skeptic to believer in ten minutes.

Prerequisites:

  • Basic independent understandings of CeFi and DeFi.

Objectives:

  • The point of this post is to better understand how CeFi and DeFi relate to one another, and how this relationship will shape the future.

Epistemic Status:

  • This post stemmed from my search for why DeFi matters outside of building tools for speculation. I am no crypto expert. Please feel free to ask any follow-up questions in the comments below.

Cefi vs DeFi

Level 1 Differences (Technical Differences)

These are the technical differences that don’t accomplish much in and of themselves, but which lay the groundwork for more applicable differences to build off of.

  • Transparency
    • In CeFi, users never really know what is being run on the backend. Users don’t have access to any of the backend information, and the code can be changed at any time without the users knowing.
    • In DeFi, all serious projects make their code open source. Everyone can read the code, see all on-chain interactions, and validate that the code is being run properly.
  • Trustless
    • In CeFi only the centralized party has the authority to decide the truth. Users have no real authority and at the end of the day, the centralized party makes the decision. If the centralized party wanted to, it would have the power to declare that 2 + 2 = 5.
    • In DeFi there are mechanisms in place by which all parties in the system can reach a consensus on what the canonical truth is. As long as the majority of people are good actors, users don’t have to worry about others claiming something false to be true.
  • Permissionless
    • In CeFi it is often required that you give personal identification information to a centralized party to use their software.
    • In DeFi anyone can use services with anonymity and without KYC.
  • Censorship and manipulation
    • In CeFi the government can coerce the centralized party to act in a certain way and censor certain users.
    • In DeFi, applications cannot be as easily censored or manipulated. It is being run by computers all over the world. There doesn’t exist a centralized party to coerce.

Level 2 Differences (Functional Differences)

These functional differences are a bit higher level and implied by the level 1 differences.

  • Trust
    • In CeFi the users have to rely on their trust for the centralized party to tell the truth and run the code properly.
    • In DeFi the users don’t have to rely on their trust for any centralized party. Because of DeFi’s transparency and trustlessness, users can verify the applications and their executions to their heart’s content.
  • Security
    • In CeFi you must rely on the centralized party to ensure the security of the applications. The security of the applications cannot be verified by users, and in practice can easily be overlooked by the centralized party.
    • In DeFi there are much higher standards of security because all the code for DeFi is out in the open. CeFi could technically reach the same levels of security in its applications but in practice, it doesn’t happen.
  • Regulations
    • In CeFi there are lots of regulations imposed by the government. Many of these regulations are necessary because of the lack of transparency. If users aren’t able to inspect the code and its execution themselves, the government must step in and do it for them.
    • In DeFi, the native transparency of operations allows for anyone to inspect the code and its execution; this allows for weaker regulations because users can take more responsibility in the auditing process instead of relying on the government.
  • Barriers to entry
    • In CeFi there are extreme barriers to entry due to code being closed source, and the intense regulations on financial applications. This leads to inefficient monopolies.
    • In DeFi there are much smaller barriers to entry because all of the code is open which means that if the community doesn’t like the decisions developers are making concerning an application, they can fork the project in another direction.
  • Conflicts of interest
    • In CeFi there are conflicts of interest where the centralized party is incentivized to nickel and dime their users. Users aren’t given the transparency to see what is going on, and competition can’t enter the industry because of barriers to entry.
    • In DeFi you can’t force someone to use your app. If the community doesn’t like the decisions you are making someone can fork your project in another direction. This requires developers to align their interests with users.

Level 3 Differences (Application Differences)

So we’ve now gone over technical and functional differences between CeFi and DeFi, but how do these differences reveal themselves in the applications themselves?

A common misconception is that the power of DeFi stems from the applications made technically possible on DeFi that were not technically possible with CeFi. In reality, all applications built on DeFi can technically be built and deployed on CeFi.

The real difference lies in the applications that while previously technically possible with CeFi, were are only made usable with DeFi due to the higher levels of trust users are willing to place in DeFi applications. Being technically able to build something is not all that matters; the type of relationship that is established between software and its users is important to the ways that software will be used.

Let’s look at what these trust differences enable in currency, organizations, and banking.

Currency

Due to higher levels of trust, cryptocurrencies have the chance to become the world’s first digital global currencies. Bitcoin for example can be saved and spent anywhere with internet access while avoiding the problems of a centralized party being able to manipulate its price. This will make the international transfer of wealth easier than ever.

Organizations

The trust afforded by DeFi allows for organizations to become credibly neutral in a way that was not possible with CeFi.

This means for example that they can manage large sums of money while maintaining trust with their members. Gitcoin introduced its GTC Gitcoin governance token for this exact reason: https://unstoppabledomains.com/blog/daos-vs-traditional-organizations

Banking

There is a bit of a chicken and egg problem with banking and KYC.

There are 1 billion people with access to the internet who do not have access to banking services. They don’t have access to banking because they do not have enough information to identify themselves for the banking KYC process and therefore cannot use regulated banks.

They are left with the option to use unregulated centralized banks, but this is problematic because there isn’t much stopping the bank from running away with the user’s money given their lack of regulation.

This is where the trust of DeFi makes a difference. You can trust unregulated DeFi software more than regulated CeFi software by exploring the code of the application yourself, thereby allowing for a trusted bank on a phone for anyone with access to the internet.

The Greatest Benefit of DeFi

The greatest benefit of DeFi is its native openness. DeFi is going to win because it’s open: “In a world of tinkers, of experimenters, of makers, open wins”.

Think back to Linux and Wikipedia; they were able to take IBM and Britannica by storm by using the power of the open-source community. Similarly, by enabling anyone to build on top of DeFi, an incredible ecosystem comes together.

This will allow for DeFi to become what CeFi should have been. This means taking existing applications on CeFi and improving them with trust, security, and user aligned interests. There are tons of unknown, unknown improvements and innovations to be made, but rest assured they are coming. DeFi is unleashing a Cambrian explosion of financial applications.

The Future

It is helpful to try and picture the future with DeFi fully adopted, and compare it to the present. Imagine a world where crypto is used for everything, international money exchange is trivial, everyone with access to the internet has full access to banking services, and the interests of finance are aligned with those of the people. That is the world I want to live in.

The Limitations of DeFi

No comparison of CeFi and DeFi would be complete without looking at the limitations DeFi has with respect to CeFi.

Miner Extracted Value

While DeFi helps to remove the conflict of interest between software designers and their users, it does introduce a conflict of interest between software executors (the miners) and their users.

This conflict of interest is known as miner extracted value (https://coinmarketcap.com/alexandria/glossary/miner-extractable-value-mev) which is “a measure of the profit a miner (or validator, sequencer, etc.) can make through their ability to arbitrarily include, exclude, or re-order transactions within the blocks they produce”. While MEV is worth considering, its negative effects on DeFi users are not nearly as significant as the negative effect profit-seeking has on CeFi users.

Scalability

Currently, the cost of a transaction on CeFi applications is a tiny fraction of the cost of an equivalent transaction on DeFi applications. This is due mainly to the burden on DeFi to reach consensus between thousands of computers around the world while preventing malicious actors from interfering.

While most blockchains aren’t capable of serving the world’s demands in their current states, there are roadmaps in place to bring blockchains up to speed at which point scalability will not be as much of an issue.

Conclusion

I hope this post helped clear up the differences between CeFi and DeFi. If you have any questions or feedback, please let me know! :)