The downfall of FTX at the end of last year has made the crypto industry review the power well-known crypto moguls and enthusiasts have over the industry in general and some projects in particular. Moreover, it once again sparked conversations about the downsides of centralized finance (CeFi), which regrettably has an infrastructure that can enable such systemic failures.
While centralized platforms and services have certain advantages (such as adequate liquidity and accessibility) that contribute to their popularity among users, serious security breaches or mismanagement associated with some of them may outweigh the benefits and gradually destroy user trust in the long run. This is where decentralized finance (DeFi) comes in.
From a blockchain perspective, decentralization involves transferring control and decision-making from a centralized entity to a distributed network, thereby reducing the amount of trust users place in a service-providing organization. Therefore, it enables individuals to retain financial autonomy without relying on intermediaries.
So, what are the main differences between DeFi and CeFi? Let's compare the two based on such factors as trust, transparency, anonymity, and points of weakness.
When using centralized services, users have to entrust third-party organizations with the storage and management of their funds. This is similar to the traditional banking system, where corporations have decision-making power over people's assets. While centralized services help many users start their crypto journey without needing to study blockchain and related technologies, they also gain the power to dictate their own terms and modify them without user input. Unfortunately, such imbalanced relationships may sometimes lead to unwise decisions on the organization's side, often without user knowledge.
Decentralized networks allow users to have complete control over the safety of their assets without having to trust any single organization. However, this also means that users have more responsibilities when managing their assets, which requires a higher level of knowledge and experience.
The next factor, transparency, follows the previous one. When using crypto apps and services, users take a major risk by trusting a company or a particular person. Many scandals related to the crypto industry, including the previously mentioned FTX collapse, confirm the significance of distributing influence and responsibility within a project.
Therefore, many decentralized projects are now establishing decentralized autonomous organizations (DAOs) to ensure complete transparency and equality in decision-making. DAOs enable companies to bring together like-minded individuals working towards a common mission or project without entrusting any individual or group with financial, organizational, or other decisions. As a result, decentralized projects eliminate the possibility of manipulations within the company that can damage people's trust and lead to irreversible consequences, including the loss of funds.
Many people cannot access banking services due to lack of documentation, distance from financial institutions, high fees, etc. This restricts their participation in the economy and access to services like loans. Similarly, centralized crypto services also impose strict authentication requirements, which again can restrict access for certain users, but in the Web3 space. Although KYC can prevent illegal activity, it also leads to loss of anonymity, which conflicts with the privacy-focused ethos of many crypto users who seek greater privacy and freedom.
While centralized services are often pressured by some central authority (for instance, the company’s board or some financial regulator) to demand some form of verification, decentralized companies allow their clients to preserve anonymity. Moreover, some DeFi projects acknowledge the problems a lack of verification may bring and are currently working on creating authentication procedures that still protect user identity, including solutions based on zero-knowledge technology (This technology enables verification of information without revealing it).
Centralized platforms and services are often more user-friendly, and many new users feel more secure knowing that a company is responsible for their assets. A key risk of centralized networks is the presence of single points of failure, which can be exploited by attackers or lead to systemic breakdowns. Hackers only need to target one central point to gain access to the entire system, making them more vulnerable to attacks. Furthermore, even without attacks, such networks are more susceptible to systemic failures because a malfunction in one part of the centralized system can significantly affect the overall performance. Decentralized systems can reduce centralized vulnerabilities, though they may introduce new risks, such as code exploits or governance manipulations.
The crypto industry has two competing approaches — centralized and decentralized projects. While some believe that centralized projects will always have their prominent place, others bet on decentralized services to become the industry's driving force. Both approaches have their advantages and disadvantages, and only time will tell which approach will be the most successful in the long run. So far, DeFi and CeFi are actively contributing to the growth and adoption of crypto products and services.
