Robert Steinadler, 6 months ago

What is CeFi?

There are two big sectors in the crypto industry that are not necessarily competing but complement each other. One is DeFi which is the abbreviation for decentralized finance, and the other is CeFi which stands for centralized finance. With both playing an essential role in crypto, we like to introduce you to CeFi with this article.

What is centralized finance, how is it different from DeFi, and what has it to offer?

What is centralized finance all about?

Per definition, CeFi combines elements of DeFi technology and services them as financial products through centralized entities. CeFi products typically offer to earn some type of interest on savings, borrowing or lending money but also include use cases where crypto is spent through debit cards.

Crypto was originally based on the idea that all financial applications should be decentralized. The benefit is that people across the world can transact and interact with each other without the need for a middleman or other centralized entities. Decentralized finance is the concept that supports this idea by empowering an ecosystem of decentralized financial applications that are run on top of blockchain technology using smart contracts. DeFi users can lend or borrow money and even trade with each other on decentralized exchanges.

These benefits of DeFi come with risks since many protocols and applications are still in the experimental phase of their development. Users also need to be tech-savvy and have specific knowledge to navigate this space and make full use of all the options that it has to offer. This creates a hurdle for many investors who lack the time, ability, or willingness to learn.

CeFi, on the other hand, is a term used for financial products that try to make the benefits of DeFi accessible through a company that offers related financial services. The idea is that customers can benefit from DeFi opportunities while making them safe and accessible by providing a service based on that technology.

How is yield earned through CeFi?

Centralized finance offers the option to earn yield by opening up an account with a service provider. This is very similar to a traditional bank account, but instead of money, customers transfer their crypto assets to that service provider. It is worth mentioning that, unlike a bank, these service providers are not offering the same security of funds, e.g., investor protection for bank customers within the EU.

This risk is often rewarded with a higher return when compared to a savings account with a bank. Crypto assets that are accepted by the service providers vary but usually include Bitcoin, Ethereum as well as the three biggest stablecoin solutions.

Once the CeFi account is funded with crypto, customers can earn yield with different products. The yield is usually generated through different methods. Service providers can hand down their customer’s assets to DeFi protocols and share the generated yields with them, but there are also other options possible. Such as creating a market for credits. While some customers choose to lend out their money for a fixed interest rate, others borrow it and pay an even higher interest rate. The difference is usually kept by the service provider and generates revenue for them.

How do CeFi lending and borrowing work?

As already described above, the service provider is usually creating a marketplace to bring borrowers and lenders together. However, unlike a credit with a bank, many CeFi platforms require collateral from borrowers.

While a bank customer is most of the time borrowing money against his future income, a CeFi customer funds his account with collateral which is either a crypto asset or a fiat currency. He then borrows against that collateral at a fixed or floating interest rate and can choose to receive his loan either in crypto or fiat.

What are the risks of CeFi?

DeFi carries specific risks, and so does CeFi, even though some might be different. Please note that we are only giving very general examples, and in case you like to use a CeFi product, you should do your own due diligence on what kind of risks are involved with the specific service provider of your choice.

  • Each service provider and his CeFi products are unique and can involve higher or lower risks. The risks involved can depend on the legal jurisdiction of the service provider as well as how it generates the yields that are promised.
  • Crypto deposits are not eligible for government-backed insurance or investor protection in most jurisdictions. Should the service provider fail as a business, customer funds are at risk.
  • Some CeFi products involve a lock-up period of funds. This is important because once the agreement is entered, customers cannot access their money for a certain period. It is worth keeping that in mind since, even in a case of a financial emergency, those funds are not accessible. So it is generally advisable to only lock-up assets you 100% won't need in that period. 
  • The crypto assets used to fund CeFi accounts and using these products also carry a risk. They might fall in value, or the underlying technology might face difficulties. Another factor comes into play when a crypto asset is backed by another asset. One example of such a crypto asset is stablecoins. Should the stablecoin in question depeg for some reason, then the Dollar value of the CeFi account changes, which can affect interest rates and the availability of the CeFi product.
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