Decentralized finance (DeFi) and Centralized finance (CEX): What You Need to Know

DeFi is an open and global financial system built as an alternative to a system of the internet age that is tightly controlled, and held together by decades-old infrastructure and processes. DeFi gives exposure to global market and alternatives to local currency and banking options . It also gives control and visibility over funds.

DeFi product financial services is opened up to anyone with internet connection and they are largely owned and maintained by their users.

What is DeFi?

DeFi is an acronym that stands for Decentralized finance. Decentralized finance is a general term for a whole huge financial infrastructure that places an emphasis on decentralization.

Decentralization is the process whereby the activities of an organization especially activities that deals with making decisions and planning are distributed or delegated away from a central authoritative location or group and given to smaller fractions within it.

Decentralized finance (DeFi) also refers to the framework or ecosystem of financial applications built on Blockchain networks. It aim is to create an open-source, permission less and transparent financial service ecosystem through peer-to-peer(P2P), decentralized applications (DApps).

What is CEX?

CEX is an acronym that stands for Centralized Crypto Exchange, it is a platform for trading cryptocurrencies. It serves as an intermediary between buyers and sellers, matching trades in a centralized order book.

It is also a business' that provides buyers and sellers with multitude methods of services like a crypto trading platform, account services as well as customer support services.

CEX makes use of order book, that is a collection of buying and selling updated by the buyers and sellers even though it is owned and operated by a private company. Example of centralized exchanges are Bitcoin, Kucoin, Coinbase, Bybit, Gemini and Kraken.

How DeFi work

DeFi works through peer-to-peer financial networks which leaves room for security protocols, connectivity, software and hardware advancements. With this system , intermediaries like banks and other financial service companies that charge businesses and customers for their service are eliminated, thereby reducing the need for these intermediaries.

How does CEX work?

CEX makes use of a funded account on a centralized exchange, exchange such as buying and selling of crypto which is similar to buying and selling of stock on a stock exchange. Therefore, to start trading on a centralized exchange, an account that is signed up and funded with national fiat currency like dollar and euro must be put into place.

Factors to consider when choosing a centralized exchange platform —

• Live market prices for all supported currencies.

• High liquidity and efficient markets.

• Low costs and fees.

• Active trading platform.

• Supported currencies.

• Security history and reputation.

• User friend.

Differences Between DeFi and CEX

The major difference between DeFi and CEX is that DeFi ( Decentralized Finance) uses peer -to- peer financial networks which eliminates intermediaries like banks and other financial service companies that charge customers for their services while CEX is a trading platform that serves as an intermediary between buyers and sellers and in the process keeps the record of selling and buying activities on the platform.

Moreover, DeFi delegates and distributes the activities that has to do with making decisions and planning to smaller fractions within it, on the other hand, CEX is owned and operated by a private company .

DeFi Application

DeFi applications are designed to communicate with Blockchain , allowing people to use their money for purchases, loans, gifts, trading or any other way they want without a third party. These applications are programs installed on a device like personal computer, tablets or smartphone that makes it easier to use. Some popular DeFi applications include lending platforms like Compound and Aave, decentralized exchanges like Uniswap and SushiSwap, and yield farming platforms like Yearn Finance. These applications aim to provide financial services in a decentralized and transparent manner.

FUNCTIONS

• Accessibility: Anyone with an internet connection can access a DeFi platform, and transactions occur without geographic restrictions.

• Low fees and high interest rates: DeFi enables any two parties to negotiate interest rates directly and lend cryptocurrency or money via DeFi networks.

• Security and Transparency: Smart contracts published on a blockchain and records of completed transactions are available for anyone to review. Blockchains are immutable, which means that they cannot be changed.

• Autonomy: DeFi platforms don't rely on centralized financial institutions. The decentralized nature of DeFi protocols mitigates the need for and costs of administering financial services.

Advantages of DeFi

• Borrowing and lending

Decentralized borrowing and lending have many advantages over the traditional credit system. These include instant transaction settlement, no credit checks, and the ability to collateralize digital assets. Also, since these lending services are built on public blockchains, they minimize the amount of trust required and have the assurance of cryptographic verification methods. Lending marketplaces on the blockchain reduce counterparty risk and make borrowing and lending cheaper, faster, and available to more people.

• Monetary banking services

DeFi applications are financial applications, therefore , they make use of monetary banking services .These can include the issuance of stablecoins, mortgages, and insurance. As the blockchain industry matures, there's an increased focus on creating stablecoins. They are crypto assets usually pegged to real-world assets that are easily digitally transferable. As cryptocurrency prices can fluctuate rapidly at times, decentralized stablecoins could be adopted for everyday use as digital currencies that are not issued and monitored by a central authority and with smart contracts, underwriting and legal fees could be reduced significantly.

Insurance on the blockchain could eliminate the need for intermediaries and allow the distribution of risk between many participants. This could result in lower premiums with the same quality of service.

• Decentralized marketplaces

Decentralized Exchanges (DEXs), are some of the most popular DeFi applications, an example is the Binance DEX. These platforms allow users to trade digital assets without needing a trusted intermediary (the exchange) to hold their funds. The trades are made directly between user wallets with the help of smart contracts.

Some exchanges, known as Automated Market Makers (AMMs), use liquidity pools to facilitate trading without directly needing a counterparty to match your trade. Uniswap and Pancake Swap are two of the best-known examples. Since they require less maintenance work and managing, decentralized exchanges typically have lower trading fees than centralized exchanges.

Blockchain technology may also be used to issue and allow ownership of a wide range of conventional financial instruments. These applications would work in a decentralized way that cuts out custodians and eliminates single points of failure.

Security token issuance platforms, for example, may provide the tools and resources for issuers to launch tokenized securities on the blockchain with customizable parameters.

• Yield optimization

DeFi DApps can be used to automate and optimize the compound of yield gained from staking, reward pools, and other interest-bearing products. Yield optimization can also be referred to as yield farming. For example, a business might receive regular rewards from Bitcoin mining, delegating BNB, or providing liquidity. A smart contract can take your rewards, purchase more of the underlying asset, and reinvest it. This process will compound the business interest, often significantly raising their returns. Funds are usually pooled together with other users’, using smart contract, meaning that gas fees are shared across all members of the yield optimizing smart contract and this saves time and optimizes compounding.

Advantages of CEX Exchange

• Fast Transactions

Speed is one of the main reasons why centralized exchanges are so popular among investors. The quick transactions will allow complex trade types to take place but will also improve the experience of the users.

• Protection Against Scandals

Cryptocurrencies are used with Internet access. A lot of complicated jargon is usually associated with centralized exchanges and so many beginner investors are quite afraid to start the crypto trading.

Without a centralized agency, the transactions can be quite risky. Many scandals had to be endured by crypto investors, so conservative investors want to make sure that they work with a reputable company to protect them from such scandals. Therefore, centralized exchanges are the saviors in this situation because they are regulated by the government and have a physical location.

• Easier to Use

It is much easier to use a centralized exchange, especially as a new investor. This is because the transactions are entrusted to a company. Even though they need to pay a small fee for this sometimes, people can get tools to monitor their assets and gain easy access to their money.

• Safety Insurance

Just like any other crypto exchange, centralized exchanges are also susceptible to digital attacks. Hackers may target them at any point, looking to put their hands on the crypto assets. But centralized exchanges are insured for a small extra fee. This way, investors can rest assured that they will be protected in case a digital attack happen.

Potential Risks and Disadvantages of DeFi

• Counterparty Risk

Refusal to repay debt after a crypto loan or any kind of lending leads to a risk of the counterparty .

• Regulatory Risk

The legality of certain services and projects can be difficult to ascertain , that is, funds can be at risk when a business invest in a smart contract that is subsequently shut down due to regulatory problems

• Token Risk

Assets have different risk levels affected by their liquidity, trustworthiness, token smart contract security, and associated project and team. As the DeFi pace has many low market-cap tokens, token risk can be particularly high.

• Software Risk

Code vulnerabilities can undermine the security of smart contracts a business is invested in. wallet could also be compromised due to connecting to DeFi DApps and giving them certain permissions.

• Impermanent Loss

There is high risk of losing some tokens deposited in the pool when staking in liquidity pool.

Disadvantages of CEX Exchange

• Security Risks

Centralized exchanges are susceptible to hacking and security breaches. Centralized exchanges hold custody of users’ funds, making them attractive targets for hackers. An example is the High-profile incidents in the past, such as the Mt. Gox hack, have resulted in significant loss by the users.

• Lack of Control

Users entrust their funds to the centralized exchange, relinquishing control over their assets. This centralized control contradicts the ethos of decentralization that underpins cryptocurrencies.

Centralized exchanges like FTX often lack transparency, leaving users in the dark about how trades are executed or how funds are managed behind the scenes.

• Regulatory Vulnerability

Centralized exchanges are subject to government regulations and may face compliance issues, leading to disruptions in service or even closure. This regulatory uncertainty can negatively impact users’ ability to trade and access their funds.

• Lack of Transparency

Transparency can be lacking in centralized exchanges, leading to concerns about market manipulation, insider trading, and lack of accountability. The users may not have full visibility into how trades are executed or how funds are managed.

• Central Point of Failure

Centralized exchanges represent a single point of failure in the cryptocurrency ecosystem. If a centralized exchange experiences downtime or operational issues, users may be unable to access their funds or execute trades, leading to potential financial losses.

Role of Smart Contract in DeFi

Most of the existing and potential applications of decentralized finance involve creating and executing smart contracts. While a usual contract uses legal terminology to specify the terms of the relationship between the entities entering the contract, a smart contract uses computer code. Since their terms are written in computer code, smart contracts have the unique ability to enforce those terms in an automated manner. This enables the reliable execution and automation of many business processes that currently require manual supervision.

Using smart contracts is faster, easier, and reduces the risk for both parties. On the other hand, smart contracts also introduce new types of risks. As computer code is prone to have bugs and vulnerabilities, the value and confidential information locked in smart contracts are at risk.