What is centralized finance?

Centralized finance (CeFi) refers to the financial services and platforms that are provided by centralized entities, such as financial institutions, banks, or exchanges. The fact that these service or platform providers are controlled by a single entity or organization is what makes them centralized. For example, traditional banking institutions are CeFi entities as the transactions and services offered are managed and controlled by a central authority. This is in contrast to decentralized entities which operate on a blockchain network and promote peer-to-peer transactions without relying on an intermediary.

Another example of a centralized entity is a centralized crypto exchange, often abbreviated to CEX. The operations of a CEX follow a more traditional setup when it comes to a user registering and providing personal details in order to complete the Know Your Customer (KYC) process. However, as we outline in our article, What is Decentralized Finance (DeFi), assets such as crypto and NFTs are decentralized. What a CEX enables a user to do is to buy, sell, and hold a mix of these decentralized assets on a centralized platform.

In this sense, CeFi is providing connectivity between two payment networks that otherwise wouldn’t have been able to connect as they operate on different settlement layers. The CeFi platforms are offering users a pathway into DeFi services, essentially acting as a bridge for those who want access to DeFi but feel more familiar with interacting with a more traditional centralized platform. Once the user has created an account with a CEX for example, they can access various products and services that DeFi protocols offer, such as crypto borrowing, yield farming and lending to name a few. 

Unlike CeFi services, DeFi transactions operate on a decentralized network and have no reliance on a centralized authority for control of management. Instead, a smart contract or decentralized protocol facilitates the transactions and provides the services. 

A CeFi platform is typically controlled by a central authority or entity, where they exercise control in the form of managing user accounts, executing transactions, and holding custody of consumers' assets. Below highlights the key ways in which a CeFi platform operates.
User Registration: To use a CeFi platform, a user is typically required to register for an account. This process usually involves the provision of personal information, completing the KYC process, identity verification procedures, and agreeing to the platform's terms of service.

• Custodial Services: When a user chooses to deposit funds or assets into their accounts, they’re trusting the CeFi platform with the custody management of their assets.
• Transaction Processing: When a user initiates a transaction, such as sending funds to another user, the platform processes the transaction without involving a blockchain or decentralized network.
• Risk Management and Compliance: CeFi platforms are subject to regulatory requirements, meaning they’re required to implement measures for risk management, security, and compliance.
• Fee Revenues: For CeFi platforms to generate revenue, fees are attached to certain transaction types. For example, trading fees, withdrawal fees, and interest on deposits.

Advantages

The main advantages of CeFi can be split into two key categories; the on and off ramp functionality between Traditional Finance (TradFi) and DeFi, and, the simplification of crypto financial services.

First, let’s consider how CEX’s offer a variety of on and off ramp solutions:

• Fiat on ramp: A user can move money on a CEX away from a TradFi service, for example their bank account, and buy cryptocurrency. 
• Fiat off ramp: A user who has purchased crypto on a CEX can convert their balance back to fiat and withdraw back to a TradFi service, for example their bank account.
• Crypto off ramp: A user who has purchased crypto on a CEX can withdraw their balance to an external crypto wallet, as opposed to holding their balance within the platform’s wallet offering. 
• Crypto on ramp: A user can deposit crypto held in an external crypto wallet and bring onto the platform, either to trade for another cryptocurrency or exchange to fiat.

Second, when we look at the simplification of access to crypto financial services, DeFi is often perceived as complex for newcomers. Given there are no guardrails in the instance something goes wrong, many newcomers are hesitant to participate. In these cases, CeFi offers these individuals access to DeFi services within a platform more similar to TradFi services, and often has the safety net of customer support and familiar UX. These CeFi platforms engage with the DeFi providers to offer the same services, but the return for the individual is slightly less as there is a cost attached to have access to the convenience of not dealing directly with the DeFi protocol.

Disadvantages

Much like TradFi, CeFi services serve as middlemen and profit from charging fees on transactions. Meaning, a user engaging with a CeFi platform is getting a weaker deal than if they chose to transact and deal directly with the DeFi services.

From a regulatory perspective, the pace at which CeFi services such as CEX’s have grown has meant that regulations haven’t kept the same pace. Many CEXs can operate without a full oversight from government bodies, and in these cases it can mean the typical ways in which consumers are protected may not apply, so, if something goes wrong the customer could lose everything. 

Similarly, CeFi requires a user to trust their platform with personal information, as required by the KYC process. Plus, in addition to this information the CEX holds the users fiat money and the private keys to their crypto. In this regard, as coined by the crypto community, if it’s not your keys it’s not your crypto. The lack of control and risk factor here is a concern for many users.