Decentralized Finance vs. Centralized Finance Explained | Project Serum
Decentralization is one of the cryptocurrency industry's core principles and was one of the critical features laid out by Satoshi Nakamoto in the Bitcoin whitepaper. Decentralized finance, or DeFi, is an extension of this principle: the democratization of an ever-expanding suite of traditionally exclusive financial services made available to anyone with an internet connection.
But what advantages do decentralized financial services bring, and why are developers working around the clock to build this parallel financial system? This guide will explore the differences between decentralized and centralized financial services and provide an overview of what this rapidly-evolving industry looks like today.
What is Centralized Finance (CeFi)?
Before we dive into decentralized finance, let's first explore what DeFi seeks to replace: centralized finance or CeFi.
Centralized finance is a broad term used to describe the traditional financial system you're already familiar with and any financial service in which a central authority oversees transactions. Centralized authorities can take the form of governments, in the case of fiat currency, central banks, like The US Federal Reserve, or corporations, in the case of remittances and traditional investments. These are all familiar entities, but where did they come from, and why do they dominate our financial lives today?
A Brief History of Centralized Finance
You probably use some aspect of the centralized financial system every day. Still, this system can be traced back to the agricultural revolution in the late Neolithic period. As humans moved from hunting and gathering to a more settled, agrarian lifestyle, this newfound stability allowed for the accumulation of surpluses and the beginnings of trade.
But while bartering was a significant step forward for society, it was far from perfect. As trade became more widespread and complex, the need arose for a system in which goods could be exchanged without the need for a double coincidence of wants.
In other words, people needed a way to trade without having to find someone who not only had what they wanted but also wanted what they had to offer.
The solution was money: a universally accepted medium of exchange that could be used to purchase any good or service. Money allowed people to specialize in producing a particular good or service, safe in the knowledge that they could sell their wares and buy whatever else they needed.
Fast-forward to today, and you have the modern financial system. Centralized financial institutions like banks and investment firms have replaced bartering as the primary means of exchange, and government-issued fiat currency has become the standard unit of account in nearly every society around the globe.
If you've ever used a bank, sent money overseas, or taken out a loan, you've used centralized finance. Some common examples of CeFi services include:
Central Banks (The US Federal Reserve, European Central Bank, Bank of England)
Retail and investment banks (Citi Group, Merrill Lynch, Goldman Sachs)
Payment processors (Visa, MasterCard, Paypal)
Traditional investments ( stocks, bonds)
Fiat currency (e.g., USD, EUR, JPY)
Loans and lending platforms (e.g., SoFi, Lending Club)
The majority of the world's commerce currently depends on centralized finance. And while the status quo may offer the comfort of familiarity, the global financial system wasn't built to benefit everyone; our system's current level of centralization has both advantages and disadvantages.
Advantages of Centralized Finance
There are several advantages to the centralized financial system that we currently use. Still, these advantages are not shared equally amongst the individuals and societies the system was built to serve.
Those residing in developed nations have greater access to services like loans and traditional investments. In contrast, those living in developing countries and members of the 1.7 billion "unbanked" population are often left out of the financial system altogether.
Nonetheless, for those whom the system does serve, some advantages of centralized finance include:
Convenience: Centralized financial services are relatively easy to use and widely available. If you live in a developed nation, then you likely have access to several different CeFi services, like retail banks, investment firms, and payment processors.
Accessibility: Centralized financial institutions are regulated by government bodies tasked with holding these institutions accountable and ensuring they’re accessible to large swaths of society. In theory, anyone who meets the requirements should be able to open a bank account, take out a loan, or make an investment.
Liquidity: Centralized financial institutions are typically large and well-established, allowing them to provide liquidity to their customers. This means that you can usually get your money out of a CeFi service when you need it without worrying about the service being unable to meet your withdrawal request.
Scalability: Centralized financial institutions are designed to handle large amounts of transactions without issue. This is important for processing payroll or making international payments, which requires processing a high volume of transactions quickly and efficiently. Centralized institutions often have the resources and infrastructure necessary to support a high volume of users without compromising on the quality of service.
Disadvantages of Centralized Finance
Despite the advantages centralized finance offers, several disadvantages have become increasingly apparent in recent years.
Often touted as a benefit, recent history has shown that unlimited, opaque power in the hands of centralized authorities can lead to problems. Central banks, like the US Federal Reserve, regularly engage in market-manipulating practices like quantitative easing (QE), which can lead to inflation and erode the purchasing power of citizens' savings.
The irresponsible actions of centralized financial institutions partly caused the 2008 financial crisis. While regulations were put in place to prevent a repeat of the crisis, it's become apparent that these regulations are not enough to protect us from the greed and recklessness of the financial elite.
Other disadvantages of CeFi include:
Inequality: The centralized financial system is designed to provide the most benefits to those who are already wealthy and have access to traditional financial services. This creates a vicious cycle of inequality, as power, capital, and access are increasingly concentrated in an ever-shrinking pool of individuals and institutions.
Lack of privacy: Centralized financial institutions acquire a great deal of personal information about their customers, which can often be mishandled or sold to third parties. High-profile security breaches highlight exploitable weaknesses within centralized databases, and increasing encroachment from world governments under the guise of national security further erodes citizens' rights to privacy.
High fees: Whether overseas remittances, overdraft fees, ATM charges, or currency conversion fees, users of centralized financial services are frequently nickeled and dimed by the institutions they entrust with their money. These fees add up over time and often disproportionately impact those who can least afford them.
Restrictions: Centralized financial institutions have the sole discretion to restrict their services and can limit access to users' money or how they'd like to use it. For example, banks can freeze customer funds at any time and often put restrictions on things like international payments or cryptocurrency purchases.
What is Decentralized Finance (DeFi)?
Decentralized finance, also known as "DeFi," is a growing ecosystem of financial protocols and decentralized applications designed to provide an open and permissionless way to access financial services without intermediaries.
Anyone with an Internet connection can use DeFi services without going through a traditional financial institution. Additionally, as the name suggests, DeFi protocols eschew centralized control in favor of decentralized governance mechanisms.
The DeFi ecosystem is still in its early stages, but it has already grown to encompass a wide range of services, including lending, borrowing, trading, remittances, and more.
Advantages of Decentralized Finance
DeFi protocols were created in response to longstanding shortcomings of the traditional financial system, bringing various advantages over centralized financial services. One of the most significant advantages of DeFi is that it is open and accessible to anyone with an Internet connection.
Decentralization entails that DeFi protocols are controlled by the users who use them rather than by central authorities. This decentralized governance model makes it much more difficult for DeFi protocols to be manipulated or censored by outside parties.
Other advantages of DeFi include the following:
Increased privacy: DeFi protocols offer increased privacy compared to traditional financial services. For example, many DeFi protocols allow you to trade without going through Know Your Customer (KYC) or Anti-Money Laundering (AML) processes.
No restrictions: DeFi protocols are based on code, which means that users can use these services without restrictions in most cases. For example, you can trade any asset on a decentralized exchange and borrow or lend any amount of money on a decentralized lending platform, so long as the platform has the liquidity to support your transaction.
Decentralized governance: DeFi protocols are often governed by decentralized autonomous organizations (DAOs), which means that the community controls them. This allows for more transparent and decentralized governance compared to traditional financial institutions.
Disadvantages of Decentralized Finance
While DeFi protocols offer several advantages over traditional financial services, the industry is still in its infancy and has some challenges to consider. As a relatively new industry, many concepts and ideas are still experimental and have yet to be proven effective on the same scale as their centralized counterparts.
Some challenges facing the DeFi space are:
Lack of regulation: The decentralized nature of DeFi protocols means that they are subject to different rules and regulations than traditional financial institutions. This lack of regulation may make some people hesitant to use DeFi services, as there is no guarantee that their money will be safe.
Complexity: The complexity of decentralized protocols may make them difficult to use for some people. Most decentralized services require users to have a basic understanding of blockchain to use them effectively, but the technical barriers to entry are continually lowered as time passes.