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By the end of this article you will understand:
1. What Centralised Finance (CeFi) is
2. What’s wrong with the centralised banking system
3. How scarcity gives money value
4. The difference between CeFi & DeFi?
What is CeFi?
CeFi is an abbreviation for Centralised Finance, which describes those services that overlap the traditional payment system and the decentralised cryptocurrency ecosystem.
A cryptocurrency exchange (often abbreviated to CEX) is an example of a CeFi service. Popular exchanges include Coinbase and Kraken.
CEX operations are centralised; they have a traditional business setup with customer registration requirements, known as KYC (know your customer). Despite their centralised systems, they enable users to buy, sell and hold decentralised assets, like crypto or NFTs.
Why do we need CeFi?
CeFi provides a connection between two payment networks that otherwise have no means to connect because they operate separate settlement layers.
How funds move in and out of CeFi services is often described as on and off-ramping because they function like motorway on/off ramps.
CeFi provides a gateway to decentralised financial services (DeFi), such as crypto borrowing, lending or yield generation. These decentralised services don’t rely on a central point of control or management, with all transactions processed on a blockchain.
Benefits of CeFi
The benefits of using CeFi services come from their position straddling traditional finance and blockchain-based decentralised services, and can be summarised into two main categories:
- on/off ramp function between TradFi & DeFi
- simplified crypto financial services
On & off ramp movement
Using a cryptocurrency exchange as an example CeFi service, we can look at the main on and off-ramp services they provide.
Fiat on ramp – CEX customers can move money from the traditional financial system (such as a bank account) using the platform to buy cryptocurrency and store it in a crypto wallet built into their account.
Fiat off ramp – CEX customers can convert crypto back to fiat and withdraw the proceeds to their bank account; this includes crypto deposited from an external crypto wallet.
Crypto off ramp – Once a customer buys crypto on a CEX, they can withdraw it to their own crypto wallet rather than leave it in the platform’s built-in wallet. This gives them control of the private keys that grant access to their cryptocurrency.
Crypto on ramp –A CEX customer can deposit crypto held in a wallet they control and then trade it for another crypto or exchange it for fiat. They can then off ramp the funds back to their bank account.
Access to simplified crypto financial services
DeFi has been one of the of the biggest areas of growth within the crypto ecosystem over the last three years. According to DeFi metric services like DefiLama, there is over $50bn locked in decentralised financial services, down from a high of triple that TVL (total value locked) in November 2021.
DeFi services commonly include borrowing against crypto holdings, lending crypto to earn interest, staking crypto or applying yield generating strategies, described as yield farming.
The problem with DeFi is that it can seem complex for newcomers and due to its decentralised nature, there are no guardrails. This is where CeFi steps in.
CeFi offers many of the financial services of DeFi, but within a more familiar and reassuring centralised platform with the fallback of customer support. CeFi services will engage with DeFi providers, offering you slightly less attractive returns or loan APR for the convenience of not having to deal directly with the DeFi protocols.
The disadvantages of CeFi
Though the benefits of CeFi flow from its ability to straddle between the established regulatory system of TradFi and the permissionless world of DeFi, this unique hybrid position also presents a number of disadvantages.
Higher transaction costs
CeFi services, like exchanges, operate as middlemen profiting from inflating transaction fees and costs for withdrawals. This means that users are getting a poorer deal than if they were to deal directly with decentralised services.
Regulatory grey area
CeFi services such as exchanges have grown quickly, especially during periods known as bull markets, where prices rise dramatically. Regulation hasn’t, however, kept pace, so most CeFi services operate within a regulatory grey area and without full oversight from government bodies.
This also means that the normal deposit protections that customers of regulated banks and financial services enjoy do not apply, so if and when something goes wrong customers can lose everything.
In 2022, several high-profile CeFi services went bankrupt, locking users out of their funds. The aftermath is still being felt with the individual circumstances being slowly untangled in the courts.
Lack of transparency
One of the benefits of cryptocurrency is its transparency. Anyone with an internet connection can review transaction flows and the logic behind DeFi services by reviewing the Smart Contract logic that drives them.
CeFi is opaque by comparison. Often described as a ‘black box’, it’s hard to verify claims that CeFi services make about their solvency, how they generate returns or whether the yields offered are sustainable.
TradFi may also lack transparency, but this shortcoming is counterbalanced by greater regulation and credibility gained from businesses that in some cases have operated for decades.
There have been calls for exchanges to show audited Proof of Reserves to provide greater transparency going forward.
Not your keys, not your coins
The absence of protective regulation is even more problematic because CeFi still requires users to trust the service with their personal information, fiat money and most importantly, the private keys of their crypto.
The crypto community summarises this pitfall in the mantra ‘not your keys, not your coins’. Crypto purists argue that crypto should be stored in a wallet where you control the keys, not on an exchange.
Yet, many of us naturally favour default options, especially when self-custody (looking after your keys yourself) requires a level of technical know-how.
What is CeFi? A recap
CeFi is an abbreviation for Centralised Finance. An example of a CeFi service is a cryptocurrency exchange (often abbreviated to CEX).
Why do we need CeFi?
CeFi provides an essential connection between the traditional financial system (TradFi) and the decentralised financial system (DeFi) made possible by cryptocurrencies and the blockchains that support them.
The benefits of CeFi
- Provides a bridge between TradFi and DeFi described as on/off ramping.
- Simplifies DeFi services, such as borrowing, lending and yield generation.
The disadvantages of CeFi
- Higher transaction costs and withdrawal fees
- Lack of clear regulations and deposit insurance
- Lack of transparencycan lead to false claims about security or proof of reserves.
- Contradicts the key philosophy of self-determination - Not your keys, not your coins