Blockchain technology is well on its way to expanding financial access. Pioneered by Ethereum, smart contracts are a breakthrough innovation in computer science that treats finance in a permissionless and non-custodial manner. At the same time, Bitcoin’s durability is demonstrating that a money system outside of central banking is possible.
Yet blockchain technology can also be used in a permissioned manner. That means a central authority controls the protocol and makes important decisions on its operations. This includes holding your private keys. This is the essential difference between centralized finance (CeFi) and decentralized finance (DeFi).
What Makes a Financial Service Decentralized?
Developed as a peer-to-peer (P2P) electronic payment system, Bitcoin is the world’s first decentralized financial service. It has no board of directors to decide Bitcoin allocation or forbid anyone from accessing the Bitcoin network. Even the cryptocurrency’s creator, the pseudonymous Satoshi Nakamoto, is an unknown entity.
Most importantly, anyone can pitch in and make Bitcoin work. By becoming a miner and running a network node, they make it possible to exchange and store value without any bank or company involved. Presently, there are 14,185 Bitcoin nodes that verify and execute Bitcoin transactions, largely concentrated in North America and Europe.
However, Bitcoin was just the decentralized beginning, the vanguard of new thinking about money. In 2015, the Ethereum network introduced a new type of blockchain technology. Unlike Bitcoin, which focuses on de-banking and storing value, Ethereum is a general-purpose blockchain that enables users to create and support decentralized applications, or dApps.
Ethereum also enables users to set up and use smart contracts, which are computer programs that automate agreements. The idea is that Ethereum would provide the tools to replicate the traditional financial ecosystem. That encompasses cryptocurrency trading, lending, borrowing, insurance, payments, prediction markets, launchpads, derivatives, marketplaces, and even play-to-earn (P2E) games.
Instead of relying on intermediaries, the Ethereum network hosts dApps that perform the same functions. Smart contracts replace CEOs, brokers, custodians, and clearing firms leaving users with a permissionless barrier of entry.
Ethereum spawned a generation of other smart contract networks with their own dApp ecosystems, including Avalanche (AVAX), Algorand (ALGO), Solana (SOL), Cardano (ADA), Binance Smart Chain (BSC), Tron (TRON), and various Ethereum scalability sidechains like Polygon, Optimism, and Arbitrum.
An Example of a Working dApp
DApps are at the heart of the DeFi model. So how do they work? Let’s look at the example of market makers. In the traditional financial world, these institutions lubricate the capital markets by buying and selling securities in anticipation of sales by their customers. They inject much-needed liquidity — cash — to make the markets operate as smoothly as possible.
Without market makers and their liquidity, trading would grind to a halt. Likewise, banks also need to have deep liquidity to facilitate the exchange of money and offer loans.
The elegant simplicity of DeFi is that all of these vital functions are performed by users themselves.
Case in point, Uniswap pioneered an Automated Market Maker (AMM) protocol that facilitates transactions between users:
- User A wants to become a liquidity provider in order to generate yields — annualized interest rate, typically expressed as APY (annual percentage yield). To do so, user A adds tokens into liquidity pools, which are just smart contracts that collect and issue cryptocurrencies.
- User B wants to exchange one cryptocurrency for another. To do so, user B taps into a liquidity pool contributed by user A. When user B does this, user A gets a cut on the transaction.
This way, user A and user B create a decentralized ecosystem without actually interacting with each other. They only tap into smart contracts on either side of the equation — supply and demand. And all of this is done in a permissionless manner.
The same principle of liquidity providing (LP) applies to borrowing and lending as well. A liquidity provider pours liquidity into a lending smart contract. When the borrower taps into it, they pay the LP an interest rate.
These are the cornerstones of any monetary system, known since age immemorial. Here are the top 10 lending dApps available across blockchain networks (chains).
With the entire financial system recreated in a decentralized way, why would we even talk of centralized finance (CeFi)? Isn’t that just traditional finance, like banks? Not quite, as CeFi are much leaner operations aimed at simplifying the user experience.
Centralized finance (CeFi) orbits around blockchain technology in a permissioned manner. Unfortunately, we have all seen what this entails in collapses like Celsius Network..
Both platforms had digital assets that could interact with other blockchain networks. However, their token allocation was governed largely by the companies that launched them, not users themselves. Both could engage in risky practices — usually lending — the same way banks do.
Celsius Network offered its double-digit annual percentage yield gains by overleveraging and overextending its balance sheet. Based on its bankruptcy court filing, Celsius had $5.5 billion in liabilities while holding only $4.3 billion worth of crypto assets.
In a bull market, Celsius could get away by offering up to 18% APY. After the Federal Reserve started raising interest rates, investors dumped risky assets like stocks and crypto, which undermined Celsius’ CEL utility token.
That triggered a domino effect of toppling debt loads, forcing the company into bankruptcy. In the end, those who invested their crypto funds into Celsius gave away their private keys to a company. This effectively means they transferred away their ownership, without that company insuring those funds in case of a financial calamity.
Even one month before Celsius officially declared bankruptcy, the lending platform suspended all account withdrawals and transfers.
Does That Mean That DeFi Is Superior?
When accessing DeFi dApps, one typically does it through a non-custodial wallet like MetaMask. Non-custodial is the same as self-custody, so no one controls your money except yourself because only you hold the private keys that unlock access to a particular blockchain network.
This cannot be said of either traditional banks or CeFi platforms.
Whether one goes to Celsius, Binance, Coinbase, Nexo, or Gemini…all of their accounts are custodial wallets. They are essentially digital banks, but without government-backed deposit insurance.
If they go down due to bad business practices, your life savings may go down with them. With DeFi dApps, one is in control of their funds at any given time. Of course, DeFi hacks and exploits can happen, but they also happen on CeFi platforms in equal measure.
When all is said and done, a few extra APY percentages and conveniences are not worth the risk. After all, one day, you may wake up and find out that you are locked out of your account due to “extreme market conditions.” Just ask Celsius and Voyager Digital users.
This series article is intended for general guidance and information purposes only for beginners participating in cryptocurrencies and DeFi. The contents of this article are not to be construed as legal, business, investment, or tax advice. You should consult with your advisors for all legal, business, investment, and tax implications and advice. The Defiant is not responsible for any lost funds. Please use your best judgment and practice due diligence before interacting with smart contracts.