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How Do DeFi and CeFi co-exist in the Crypto Industry?

As a difficult 2022 fades into the rear-view mirror, anybody investing in a crypto-related financial product today will still need to choose between CeFi and DeFi - or some combination of the two. Here Finoa’s Marius Smith evaluates the pros and cons of both, and the roles they are currently playing in the evolution of the crypto finance sector.

On paper, centralised finance (CeFi) was the ideal entry point into crypto for both institutional and retail investors; offering simple to understand financial products that facilitated access to some of the benefits of decentralised finance (DeFi). However, the collapse of FTX – as well as a number of other high profile exchanges in 2022 – has significantly reduced confidence in CeFi. While outflows of assets from exchanges has now slowed, there is still a lack of trust in those parties that cannot adequately prove that customer assets are backed 1:1 and prove that they are not using customer assets in yield-generating activities.

The crypto industry is still relatively small in size (when compared to traditional finance) and so investors are also struggling to differentiate where relationships between different exchanges and other crypto providers begin and end. While some institutional investors see low confidence – and therefore prices – as the perfect time to enter the crypto markets, others are less relaxed, and this additional due diligence is adding sizable delays for potential new crypto participants.

The role of DeFi

DeFi offers more autonomy for holders of crypto, but there are still some potential challenges that many retail investors are not aware of. Smart contracts are the backbone of DeFi, but they are also vulnerable to bugs and errors; one mistake in the code of a smart contract could very easily result in the loss of funds for an investor. DeFi is also susceptible to liquidity risk; many DeFi protocols rely on liquidity pools and, if these dry up, then the value of the assets in these pools will decrease. The value of DeFi assets are highly volatile, and can be affected by wider market conditions too.

Then there is the problem of governance and regulation in DeFi. Many DeFi protocols are governed by their users, which can lead to changes in the protocol that are not in the best interest of all users. The regulatory environment for DeFi is also still evolving, and there is a risk that governments could take actions that negatively impact the DeFi space. Finally, as there are multiple parties involved in DeFi transactions, there is a risk that one of the parties might default or not fulfil their commitments.

There has also been evidence that other decentralised apps (dApps) have promoted non-collateralized lending which has resulted in loan defaults. Any investors into DeFi need to have proper due diligence in place before participating, especially considering the potential risks.

However, DeFi does have plenty of benefits. For one, there is full transparency over transactions that are verified on-chain. These transactions are also able to be processed (and verified) at lightning speed and can be automated, and so it’s an effective way for the blockchain to be deployed for day-to-day activity without incurring larger fees. While potentially more complex, DeFi does also remove the barriers for investors and opens up opportunities otherwise only accessible to financial institutions in the traditional system. The expansion of the tokenisation of real-world assets is just one example of this, offering a more secure and accessible investment opportunity for those that cannot hold the physical assets.

While still in its infancy, DeFi continues to prove its promise of eliminating intermediaries, reducing costs, and increasing accessibility to financial services for all.

The role of CeFi

There will always be investors, typically those who are less familiar with crypto or who have regulatory requirements, who will seek out trusted intermediaries to engage with DeFi and blockchain-enabled innovation. CeFi in many cases lowers the barrier to entry, as investors can participate through seamless and easy to use interfaces, perhaps offered through banks or service providers they are already familiar with. These intermediaries are especially important for institutional participation in DeFi because they provide a secure way for institutions to store and manage their digital assets. Custodians, or regulated exchanges, may also provide compliance and regulatory support, which is crucial for institutions that are subject to strict rules and regulations, and is a prerequisite for participation in the first place.

CeFi crypto providers need to demonstrate that they are operating financially sound businesses that protect their users and the assets that they deposit on their platforms. There needs to be a benchmark of transparency on crypto asset operations, thorough third-party audits of wallet security infrastructure and proof of reserves, as well as a drive towards regulatory sign-off in trusted jurisdictions that ideally nurture crypto with progressive regulation. The latter is particularly important, as we should expect to see the timeline for regulatory initiatives accelerated in the wake of the FTX collapse.

It’s very convenient to position DeFi versus CeFi, but there is certainly a balance to strike between the two, and both are integral to the future of the crypto industry. For CeFi crypto providers, enabling DeFi access in an intuitive way will pave the wave for more widespread adoption of crypto in the longer term; albeit they may be at the mercy of the regulators in the short term if the financial products they create are too user friendly for non-crypto native investors. Permissioned access will pave the way for risk-averse investors, and CeFi providers will curate where investors can deploy capital, facilitate institutional on-ramp, and enable access to gated DeFi offerings and markets.

DeFi will also have its place, offering better usability for both wallets and interfaces. The crypto market is still very fragmented, and CeFi struggles to keep up with innovation, always lagging behind. For investors seeking exposure to long-tail assets and the newest protocols, DeFi-native applications will continue to be the only option for them to explore and access the newest innovations. That being said, any innovation needs capital and liquidity to really grow, and CeFi will be the magnet which attracts those bigger investors into the crypto space to facilitate this growth.

About The Author

Marius Smith Marius Smith is Director of Strategy and Growth at Finoa. Born and raised in Denmark, Marius completed both his Bachelor’s and Master’s at Copenhagen Business School, with exchange trips to Hong Kong and Wisconsin, USA. He previously has worked for Google and N26.

Editorial Note: This sponsored article is made possible by MVPR. Opinions expressed are solely those of the sponsor and readers should conduct their own due diligence before taking any action based on information presented in this article.


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