What is Centralized Finance (CeFi)?

Note: in this article, we’ll consider Centralized Finance (CeFi) in the context of digital asset and cryptocurrency investing. There are other types of CeFi organizations, however, like stock brokers and Traditional Finance (TradFi) institutions.

At their core, centralized cryptocurrency exchanges — much like a centralized stock broker or traditional banking institution — serves as a middleman between buyers and sellers of cryptocurrencies or tokenized assets.

Generally speaking, Centralized Finance (CeFi) organizations, in the context of cryptocurrency investing, intend to offer some aspects of Decentralized Finance (DeFi) with the benefits of Traditional Finance (TradFi) products and services, such as ease of use, additional security features, and customer support systems. Through CeFi organizations, users can expect to:

• buy and sell digital / tokenized assets
• exchange assets to fiat currency, and vice versa
• deposit / withdraw fiat to and from their bank accounts
• count on the centralized exchange to hold their funds securely
• expect some level of customer support, identity verification, and account security

While Decentralized Finance is permissionless and requires no verification, Centralized Finance often requires users to complete registration via a standardized sign-up process, email verification and usually imposes additional steps for KYC/AML and user identification.

Like Traditional Finance (TradFi) banking services, CeFi organizations are known to offer consumers additional ways to generate yield on their investments. Typically, in the context of cryptocurrency investing, CeFi organizations may leverage Decentralized Finance (DeFi) investment strategies and return some of the profits to their customers. Since the CeFi organization is acting as a custodian and middleman in these operations, the return on investment (ROI) may be lower for CeFi users than if they had participated in DeFi themselves.

For new or inexperienced users, though, the hands-off approach of CeFi income may be appealing. While this is changing over time, CeFi applications typically serve as the gateway, or on-ramp to DeFi applications.

Generally, CeFi organizations eliminate a great deal of burden for their users. This burden may be access, cost, or process-related. We can understand Centralized Finance organizations as applications that:

• serve as a gateway to digital asset ownership and DeFi for newer users
• easily connect to standard bank accounts or debit cards
• typically offer a wide range of cryptocurrencies or tokens and $USD pairs for trading
• can offer users opportunities to earn on their digital assets (example: Coinbase Earn)
• may offer additional features like credit or debit rewards card, etc. (example: Gemini Credit Card)
• can offer lending and borrowing services (example: BlockFi)
• can offer easy cross-chain transfers of digital assets
• offer a range of investment and more advanced trading features (example: options or leverage)
  • It’s worth noting, however, that several protocols are working to bring these offerings to mainstream DeFi.
• typically have higher numbers of users and, subsequently, more trade volume
• lower fees and fewer steps for buying or selling asset
• potential for users to recover funds if stolen / black swan event, etc.

Popular CeFi organizations include Coinbase, Kraken, Binance, among others.

As CeFi is typically controlled by a small group of leadership, the organization has the power to make immediate choices that can impact the operations and/or offerings of the company without the need for decision-making user-communication processes.

Critics of CeFi typically argue that these shortcomings:

• put too much power in the hands of few
• leave no real power or asset control with the user
• open doors to widespread corruption or fraud
• make access to information limited / unverifiable
• could leave users without access to their account without warning

2022 has been a very eventful year with regards to Centralized Finance (CeFi). Cryptocurrency investors have experienced a number of events related to leadership’s misuse of funds, fraud, loss of access to personal assets, etc. Two major examples of this include:

• Celsius
• FTX

And the fallout is usually not simply the sole Centralized Finance organization. As the industry is continuing to discover, many CeFi organizations have equity in, or assets stored within, each other’s organizations — when a major company like Celsius or FTX have problems, it’s reasonable to expect various impacts to other organizations and their balance sheets.

It’s important that all investors research centralized organizations before depositing funds. Reading an organization’s Terms of Service, or Privacy Policy, for example, are good ways in which a user can better understand how a cryptocurrency exchange may use or custody an investor’s funds.

Additionally, investors who are new to cryptocurrency should be aware that, generally speaking, digital assets like cryptocurrencies on centralized exchanges are not FDIC insured, so they do not have the same protections as fiat in traditional finance (TradFi) and banks enjoy.

• It’s worth noting, though, that some centralized exchanges may offer certain guarantees for specific products. For example, Coinbase offers a guarantee on principal amounts within their lending program.

Centralized Finance organizations indeed have value, utility, cost-saving and, and, in the context of supporting new or inexperienced users, can offer tremendous convenience, reassurance, and easier access to yield-earning resources. For more experienced users, or those who believe in using more permissionless, decentralized means of buying, selling, loaning, or staking assets, DeFi products will likely remain the product of choice.

Additionally, as DeFi products continue to build, grow, and evolve, the industry may begin to notice that popular, well-built Decentralized Finance applications pull users and market share away from some mainstream CeFi organizations.