Have a look at our previous post regarding Decentralized Finance (DeFi) and traditional financial services 👈

What are DeFi and CeFi?

Crypto-assets currently have a market capitalization of around $350 billion, with Bitcoin forming nearly $200 billion of that. In the future, these digital assets will be investable, bankable, fungible, and accessible to the entire regulated finance industry.

Major players within the digital asset industry can be grouped into two broad categories: Centralized Finance (CeFi) or Decentralized Finance (DeFi) solutions. Although most of the buzz in 2020 can be accredited to DeFi, it is not the only alternative to traditional finance: CeFi is another branch of blockchain-based finance disrupting the financial and banking industry.

As digital assets such as Bitcoin (BTC), Ethereum (ETH), and Tether (USDT) have enabled a new wave of financial solutions that empower both fiat and digital asset users, CeFi and DeFi have seen enormous growth.

  • CeFi provides centralized platforms that connect the legacy finance platforms with the new digital asset economy, by providing financial services to digital assets and often fiat currency users. CeFi mimics the legacy financial industry by allowing people to earn interest or get loans, whereby they use their cryptocurrencies as a form of collateral. CeFi corporations such as exchange platforms (Coinbase, or Binance) or payment solutions (Crypto.com, or Bitwala) act as lenders and bear custody of their clients’ funds/assets while they put them to use to provide interest for the lenders.
  • DeFi refers to the decentralized protocols, platforms, and applications that offer a parallel to traditional financial infrastructures like banks and state-run financial institutions. These financial instruments are removing the need for users to trust a middleman or corporation. Users trust a protocol rather than a corporation or human, i.e. they trust codes to deliver on any human or entity’s behalf.

The best illustration of the difference between these two models is exchange platforms. Historically, crypto-asset investors were interacting with centralized exchange platforms, like Binance or Coinbase, who manage the custody of crypto-assets for their users. For a few months now, investors have been increasingly more willing to use decentralized exchanges, like Uniswap, to interact with emerging tokens, as new projects are able to bring liquidity on their own on these platforms, avoiding the high listing fees and the sometimes long listing procedure from centralized platforms.

Source: Coinmarketcap

Pros and cons

Despite both sides having different benefits and tradeoffs, DeFi and CeFi represent a brand new paradigm in finance and spur innovation in the sector. They both have the chance to side with the depositor, to create a utility that always acts in the best interest of the people, generating sustainable long-term value with the users depositing the assets instead of maximizing profits for financial middlemen. Whether they are a success and can overtake traditional finance is yet to be seen, but the rapid development of alternative finance is a long-term trend.

For CeFi, one of the most important benefits is risk-transference. Just like legacy banking services, where banks and lending institutions insure depositors’ funds, CeFi corporations guarantee both safety and returns for their users. The obvious reason here is because they bear custody.

Further, CeFi platforms usually come with a highly intuitive and easy-to-use interface. Newbies can easily onboard onto these platforms to enjoy their services. The goal is to expose cryptocurrencies to as many people as possible.

But for CeFi, the biggest disadvantage or risk associated with these platforms is custody. The most considerable potential risk is getting hacked, a situation that could compromise any centralized system. If someone penetrates the custodian's wallets, users’ funds would not be secured anymore and they would need to rely on the platform to compensate them. Some of the most notable examples include the Binance hack in 2019 where more than $40 million worth of cryptocurrencies were stolen, as well as the most recent KuCoin hack with a stolen value of at least $150 million. This shows that even big CeFi institutions are prone to security risks.

DeFi, on the other hand, is all about empowering users to manage their own money without relying on banks or other financial institutions - self-custody. Though this can be liberating in many cases, it can represent a severe risk, since there are no chargeback features or protection mechanisms in place to prevent users from losing money.

Non-custodial finance means you are responsible for your risk. While anyone may argue this is a necessary principle for personal finance, newbies who may not know the underlying risks behind a protocol may be burnt in the event of a bug. Users have to be aware of the core development team integrity, the security of the code, and even the correct operation to avoid losing their funds due to a misclick.

Within CeFi, corporate management is responsible for decision making in terms of both the current and future state of the company. In the case of DeFi, the communities — consisting of platform governance token holders — are responsible for the management.

Building a bridge between traditional finance, CeFi, and DeFi

With regard to the pros and cons, the DeFi industry would benefit by incorporating certain aspects of the traditional financial world into its business model. That’s where the combination of CeFi and DeFi comes into play. Centralized and decentralized apps can be combined to create new types of economies and to encourage more people to use DeFi.

For months and years, new trends are appearing on this matter:

  • Traditional finance to CeFi: PayPal will allow customers to hold bitcoin and other virtual coins in its online wallet and shop using cryptocurrencies at the 26 million merchants on its network. The company hopes the service will encourage global use of virtual coins and prepare its network for new digital currencies that central banks and companies may develop
  • Traditional finance to DeFi: Revolut, the London-based fintech firm, has enlisted crypto-security firm Fireblocks to lay the foundation for new crypto products. Fireblocks’ core product is a secure infrastructure for moving, storing, and issuing digital assets. They will provide Revolut with the infrastructure needed for securing the payment railways for digital asset transfers and to introduce new product lines and retail-facing capabilities.
  • CeFi to traditional finance: Crypto exchange Gemini has received FCA approval, granting the company a path into the UK through an Electronic Money License. UK customers can make GBP deposits to fund their Gemini account via Faster Payments, CHAPS, and SWIFT wire transfers.
  • CeFi to DeFi: Back in September, the Binance Founder announced a $100 million investment fund to build better bridges between DeFi and CeFi. It will be used to support projects that expand the Decentralized Finance (DeFi) ecosystem and, in particular, that drive collaboration with Centralized Finance (CeFi).
  • DeFi to traditional finance: Non-custodial lending and borrowing protocol Aave's UK business entity has been issued an Electronic Money Institution (EMI) license in late August. Such an authorization allows the recipient to offer services such as issuing digital cash alternatives and providing payment services.

Regulation as a catalyzer for CeFi and DeFi to attract institutions

One of the main reasons for building a bridge between CeFi and DeFi can be related to regulations. Capital market participants face heavy restrictions that make it almost impossible for them to participate in DeFi. Different countries have different regulations, and there is no common standard or code of conduct for the creation and management of tokenized assets. To adhere to regulatory compliance, CeFi services are needed to attract these heavily regulated institutions to DeFi.

In the CeFi and DeFi space, stablecoins are a key piece to these two different puzzles. Stablecoins are widely considered to potentially bring significant benefits as a digital method of payment, providing for greater financial inclusion and a more efficient method of transferring funds. But from traditional finance’s perspective, they are also viewed as a potential risk to financial stability and integrity and could dilute the effectiveness of monetary policy.

The rise of DeFi protocols and the demand for tokens in liquidity pools has contributed to a huge surge in the supply of stablecoins in 2020:

  • Tether market cap increased almost 4x to $15 billion.
  • The USDC stablecoin’s market cap has grown 250% from $500 million to around $2 billion.

This highlights a significant acceleration in growth over the last two months. Bank regulators have no doubt observed that, although the asset class in the context of the traditional payments space remains relatively small, stablecoins have the potential to have a huge impact on regulated banks and payments incumbents.

In Europe, the “Regulation on Markets in Crypto-assets” (MiCA) represents a new proposal put forth by the European Commission. From the report, it’s apparent that stablecoins have been squarely at the top of European lawmakers’ minds: MiCA singles out this asset class and affords it a bespoke regulatory framework. It is bound to go through a lengthy legislative process before it becomes law, meaning that it might take years before the new rules to kick in.

However, as stablecoins largely power the DeFi space, the requirement for all crypto-asset service providers seeking authorization to operate in the EU will affect the DeFi industry at a certain point. They will need to be legal entities with an office in one of the member states. A framework will be required for institutions to develop compliant DeFi instruments that work within their jurisdictions.

For now, MiCA becoming a law is still far away. The DeFi landscape has time to evolve to integrate its expectations for DeFi projects to operate in the EU. We believe this requires better integration between traditional finance, CeFi and DeFi.

Will China also lead the race here?

Chinese startups are currently playing a crucial role in the DeFi boom. China often has a reputation for adapting Western products to local markets. While Chinese companies localize foreign products/projects, they are innovating and developing new ideas and features. That is what makes DeFi products so popular in the country.

Binance, Huobi, and KuCoin, three centralized exchange giants born in China, have made efforts to get into the DeFi space. Even though Asia was behind in the first wave of DeFi from the US, developers in China caught up quickly and might lead the future of DeFi - the way they have led CeFi.

Together with the country’s current progress on the Digital Yuan CBDC, we might see the first example of what DeFi and Cefi can bring to the traditional financial world.

CeFi vs CeFi: A coopetition story

DeFi will complement CeFi once it builds real bridges to the centralized financial world, bringing in more fiat and assets from new users in all countries. Instead of seeing these as competing segments of financial services, it’s important to consider how DeFi can be used to create sustainable long term value in the most essential areas, including stablecoins.

DeFi can start achieving real utility...

...with a more customer-centric balance between financial utility and decentralized protocol by fixing the fundamental problems of traditional finance. DeFi has to find ways to make investors feel safe onboarding into these assets.

...by not ignoring the benefits of centralized finance. CeFi solutions can provide a positive balance between retail and institutional focus that is better than the arguments for open protocols. CeFi can provide things like company-wide financial audits and create a familiar and user-friendly framework without imposing the same kind of risky systems that work against retail users.

CeFi can offer DeFi lessons in utility over protocol with semi-centralized solutions to help create stable fintech solutions. In that way, many more institutions would be comfortable to be involved in the DeFi space than they are today.

There’s a rare opportunity to redefine how capital markets operate, and with it, to enable capital inflows on a scale that DeFi is currently achieving just a fraction of. The DeFi industry has grown at a staggering pace in recent years and new, ever more innovative, and appealing DeFi platforms are appearing regularly, closing the gap between CeFi and DeFi capabilities each time.

Sources:

DeFi vs CeFi: How DeFi Measures Up - Ledger; Aug 10, 2020 [1]

Utility Over Decentralized Finance: DeFi vs. CeFi - Nasdaq; Sept 1, 2020 [2]

DeFi vs CeFi - SwissBorg; Sept 7, 2020 [3]

Tether market cap increases almost 4X in 2020 to $15 billion - Cointelegraph; Sept 18, 2020 [4]

The battle between DeFi, CeFi and the old guard - Cointelegraph; Sept 20, 2020 [5]

DeFi adoption 2020: A Definitive Guide to Entering the Industry - Cointelegraph; Sept 21, 2020 [6]

UK digital bank Revolut partners with Fireblocks to develop new crypto products - TheBlock; Oct 8, 2020 [7]

AllianceBlock is Bridging Traditional Finance and DeFi with Globally Compliant Decentralized Capital Market - TechBullion; Oct 9, 2020 [8]

How the DeFi Craze Made Its Way to China - Coindesk; Oct 15, 2020 [9]

Record-high Bakkt Bitcoin delivery exposes institutional frenzy for BTC - Cointelegraph; Oct 16, 2020 [10]

Chasing the hottest trends in crypto, the EU works to rein in stablecoins and DeFi - Cointelegraph; Oct 19, 2020 [11]

PayPal to open up network to cryptocurrencies - Reuters; Oct 21, 2020 [12]