This article will examine the differences between Decentralized Finance (DeFi) and Centralized Finance (CeFi) trading platforms, and factors that traders might consider when choosing between them.
Both the CeFi and DeFi ecosystems contain products and services that are designed to perform similar tasks. For instance, exchanges, lending services, derivatives trading platforms and payment services exist in both DeFi and CeFi systems.
The fundamental difference between these two ecosystems is that CeFi platforms, such as Coinbase and Nexo, rely on a central trusted entity, to manage & run the entire platform, whereas DeFi platforms, such as Uniswap, are based on smart contracts that can operate without any centralized control. For example, on Uniswap, a decentralized exchange, you don’t need Uniswap’s permission to make trades or list tokens, whereas to trade or list tokens on Coinbase you must go through a centralized approval process, and any assets used for trading on Coinbase are centrally held by the exchange.
Traders may use different types of platforms depending upon their trading strategy or risk tolerance. Let’s investigate some of the key differences between DeFi and CeFi.
DeFi, or “Decentralized Finance”, is a term that has come to represent the sector of permissionless financial services that can be accessed by any user on Ethereum or other blockchains.
DeFi platforms are financial services that are used directly on a blockchain like Ethereum using smart contracts. Smart contracts are programs that automatically execute blockchain transactions in accordance with the program code. DeFi products and services are often referred to as “protocols”. These protocols can be involved in trading, lending, payments, and other financial functions. Some of the the most popular DeFi Protocols on Ethereum are:
At its core, a DeFi Protocol is a set of hard-coded rules governing how its services can and cannot be used. For example, Uniswap’s DEX allows you to exchange tokens at a rate based on a programmatic pool structure. If you wish to buy ETH on Uniswap, you can swap USDC for ETH in the ETH-USDC trading pool. If you wish to sell ETH, you can do the reverse, and swap ETH for USDC in the same pool. Uniswap’s Protocol is the set of rules that define how this system works.
These rules are written in code and uploaded as “smart contracts”. When you use a DeFi protocol, you need to interact with these contracts by opening your crypto wallet and submitting transactions. These transactions tell the protocol’s smart contracts what actions you would like to take. Like everything else on a blockchain, these transactions are non-reversible.
CeFi products in crypto are similar to traditional financial services, except they deal in crypto-assets. Because they operate in a similar way as traditional finance (TradFi), they are typically easier for new crypto traders to access and understand than equivalent DeFi products. For example, the first platform any crypto user will likely use is a centralized exchange, to ‘onramp’ fiat currency into the crypto ecosystem.
Centralized exchanges such as Binance, Coinbase or Robinhood are the most well-known entities in CeFi and provide traders with a convenient way to buy, sell, and trade crypto. They also provide onramping services - by allowing users to send real-world cash from their personal bank accounts to the exchange to swap into tokens. This is something that only CeFi has been able to achieve (so far), as the DeFi world is mostly unable to directly engage with traditional money transfer to and from banks.
CeFi trading platforms allow you to do more than just buy and sell crypto. Many CeFi products provide services such as custody, lending, and leverage trading in addition to the ability to simply purchase cryptocurrency. Custodial services allow their users to hold crypto without needing to maintain their own crypto wallet. Some of these platforms even allowed their users to earn a small percentage of interest from holding crypto on their platform.
When choosing a CeFi platform to use, traders have multiple options. Often, there will be a sub-sector of crypto platforms to serve their needs specifically. For instance, a futures trader may want to use a centralized exchange offering perpetual futures - or, an options trader may wish to use platforms that specialize in offering options trading, like Deribit.
One of the most powerful features of blockchains is the ability to make & verify transactions without 3rd parties like banks or payment processors involved. One step further is the sector of financial applications that are built on top of these blockchains, i.e. DeFi. DeFi is trustless, permissionless and publicly verifiable - if not perfectly so, then at least relative to CeFi.
Trustless - DeFi exists because smart contract platforms like Ethereum allow anyone to write software applications on top of them and define rules for how certain contracts can be used. Thanks to these properties, users can make advanced trades with each other, or a pre-existing pool of assets, without needing to rely on a 3rd party to settle these transactions for them. Often this allows traders to take a higher cut of any profits from a transaction. In contrast, all CeFi products by their nature involve trusted intermediaries - all users trust the exchange operators not to steal funds, halt withdrawals, or engage in reckless lending practices. However, it must be noted that, unless you directly audit the code of a smart contract, using a DeFi protocol requires trusting the creator (or the auditing firm they hired) that the protocol code has no major vulnerabilities.
Permissionless - DeFi platforms cannot restrict access to their product, whereas a CeFi platforms can and nearly always do. CeFi platforms often need to collect ID documents from users opening an account on their platform, because they are required to comply with KYC (Know Your Customer) and other legal requirements. DeFi protocols do not typically have any way to distinguish between different users on-chain, and they have no way to prevent users from interacting with their contracts.
Publicly Verifiable - DeFi products are coded to run entirely on-chain, meaning that much of their operations occur in a public domain. For example, all trades made with Uniswap on Ethereum are recorded in Ethereum’s history, meaning that anyone can use a block explorer to follow specific transactions and trace the flow of funds.
There are many different characteristics of DeFi and CeFi products that may make them suitable for different users. CeFi and DeFi products come with different benefits - but also different risks. Let’s take a look at these:
Liquidity: Depending on how large your trades are, you may only be able to trade on platforms that have enough liquidity to match the other side of your order. Alternatively, you may wish to trade on more liquid places as a principle - for peace of mind that your exchange won’t run out of funds. Either way, the order-book model of centralized exchanges, combined with market-makers having optimized their systems for CeFi products, may ensure more liquidity on CeFi trading platforms as opposed to DeFi platforms. This is because DeFi platforms typically use a more inefficient system to match trades, but which is cheaper for users to interact with on-chain.
Number of Tradable Assets: Since DeFi protocols are fundamentally permissionless, many decentralized trading platforms (such as Uniswap) allow anyone to use any two assets to create a trading pool allowing swaps between those two assets. Due to this, tokens are often listed on decentralized exchanges before they are listed on centralized exchanges. However, this also means that it may be easier for scam tokens to be listed on decentralized ones. On the other hand, many centralized exchanges require project teams to pay some kind of listing fee & undergo due diligence before they can be accessed by their platform’s user base - which restricts the number of tradable assets.
Execution Cost & Speed: Blockchains are more expensive to run than a CeFi platform’s servers. These extra costs are paid by the users, in the form of ‘gas fees’ paid when doing a transaction. Gas fees are often high when there is market volatility - and users may end up not realizing how much they are paying simply to execute a transaction that they could have made for more cheaply through a centralized platform. Centralized platforms usually charge a percentage fee on trades, but so do most DeFi platforms. Blockchains are also much slower than centralized servers - Ethereum, for example, only produces a block once every 12 seconds. Users on Ethereum can only make transactions as part of blocks - which may mean that they are unable to act on information that requires a faster response time, such as news headlines and announcements. Centralized exchanges don’t execute trades on the blockchain directly but through their own internal, non-blockchain based ledgers.
Users: CeFi trading platforms may be suitable for newer traders - they generally provide custodial services, a high level of liquidity, and the ability to make quick, easy and simple transactions - often with a less steep learning curve. However, more technically experienced traders with a higher risk tolerance may find DeFi trading platforms more appealing, with their generally higher amount of tradable assets, and their propensity to list earlier-stage and smaller market cap tokens.
Arbitrage Trading involves traders taking advantage of price differences across different exchanges or platforms. However, depending on the type of trading platform you use, you may employ different strategies when trying to perform arbitrage trades. So - what is the difference between DeFi and CeFi arbitrage?
Arbitrage in DeFi involves using DEXes like Uniswap or Balancer. On the other hand, CeFi arbitrage involves traders trading price differences on CEXes.
Advanced Note: CeFi arbitrage strategies will often involve trading a spot pair against a futures pair - for instance, selling spot and buying perpetual futures if there has been a large futures liquidation spiking price downwards (thus taking advantage of the price drop to sell as the futures price reclaims the spot price).
On the other hand, DeFi arbitrage usually involves taking advantage of price discrepancies across different DEXes. Due to the vastly different levels of liquidity and pricing mechanisms, large buys or sells on DEXes can often spike prices out of correlation with other platforms. This can be taken advantage of by traders who buy on one exchange and sell on another - and can even occur across multiple different blockchains. Of course, traders who are performing DeFi arbitrage need to incorporate gas fees in their pricing calculations, unlike their peers using CeFi trading platforms. This may impact their profit potential, or the viability of a specific strategy.
The volume of trading taking place on DeFi trading platforms increased rapidly throughout 2020 and 2021, leading many traders to question whether it is possible that this new sector of financial applications could overtake or even replace its centralized counterpart.
On November 10th 2021, the Total Value Locked (TVL) across all DeFi products hit highs of $177.76B - with the DeFi ecosystem processing almost $10 billion in volume on that day alone. This followed a trend in 2020 and 2021 of DeFi platforms’ market share increasing rapidly against CeFi trading services after the initial boom of “DeFi Summer”.
What about now? In early September 2023, then-Binance CEO Changpeng Zhao estimated that current DeFi trading volume is still “somewhere between 5 to 10% of CeFi volumes” - and that Uniswap DEX processed more volume than Coinbase Spot products for the past 2 quarters. This may have partly been due to the failure of FTX in late 2022 and USDC’s depegging in March 2023 - both events striking a significant blow against widely-trusted CeFi exchanges and stablecoins.
Today, there is around $40B of Total Value Locked in the DeFi ecosystem - while this is lower than the highs of the bull market, it is far higher than even the highs of the previous bear market. This value is split amongst many different types of DeFi products, but most notably represents value deposited in lending products, as well as liquidity provisioned on DEXes.
In general, DeFi trading platforms seize market-share from CeFi trading platforms when interest in crypto increases - as interest in crypto wanes, fewer asset managers are as keen to allocate liquidity to crypto-native products. However, DeFi has certainly maintained a significant market-share up until this point in the crypto ecosystem.
Many teams in DeFi incorporate certain elements of CeFi. For instance, many DeFi trading platforms maintain a core team for ease of development, and have legal structures in place in order to raise funds or comply with regulation. Referring to this phenomenon, Changpeng “CZ” Zhao, Binance’s former CEO, coined the phrase “CeDeFi” in September 2020, referring to a fusion of decentralized and centralized elements in new crypto trading platforms.
There is a spectrum of decentralization that reflects the tradeoffs different DeFi projects make in different parts of their organization. For example, Uniswap has multiple layers to its structure, which stand at various positions along the spectrum of decentralization:
The Uniswap Protocol is a set of smart contracts that run on Ethereum. These contracts allow any user to deploy a liquidity pool, deposit relevant assets, and perform asset to asset swaps. Existing deployed contracts can be used by any on-chain user with an internet connection, and cannot be modified by any entity (not even the founder of Uniswap Labs, Hayden Adams).
The Uniswap DAO refers to holders of the UNI token, who have a say in the future direction of Uniswap’s development. Although any user can purchase UNI tokens to vote on proposals, the initial distribution of UNI tokens was concentrated in the investors and core team of Uniswap Labs - a real-world company that still maintains significant influence in Uniswap’s ongoing development.
The Uniswap Frontend is the website that can be found at uniswap.org. This website is hosted by Uniswap Labs, a real-world company in the United States. It essentially lets users use Uniswap through a user-friendly site.
Uniswap Labs is a company that manages Uniswap’s development and upkeep. It is a centralized entity based in the United States, associated with real-world individuals such as its founder, Hayden Adams.
Neither Uniswap Labs nor its founder Hayden Adams should be able to alter existing code deployed as part of Uniswap’s existing on-chain contracts. They would be unable to control assets deposited in Uniswap liquidity pools.
DeFi and CeFi trading platforms are susceptible to different security challenges that involve different risks and tradeoffs. Traders often want to know that their assets are stored safely, and will need to take different precautions to secure their assets depending upon the type of platform that they decide to use.
Both types of platforms may be susceptible to hacks that may cause partial or complete loss of assets - typically for DeFi trading platforms, a hacker may take advantage of bugs in contract code to drain a DeFi platform’s assets. For CeFi trading platforms, a hacker could make unauthorized withdrawals of assets they do not own.
If CeFi platforms lose custody of user assets, withdrawals may seem indistinguishable to legitimate user activity. Unless the platform team discloses a hack themselves, it can often be months or years until a platform is discovered to be insolvent. On the other hand, DeFi platform exploits occur publicly on-chain, and are often recognised within minutes.
Many DeFi products allow traders to custody their assets themselves - but this can often be a technical challenge for inexperienced traders who are not familiar with the security conventions of crypto wallets. This can introduce further risks such as losing a seed phrase, having a wallet drained, or losing assets by making an incorrect on-chain transaction.
As a general rule, those who are either less technical or newer to crypto may find themselves more at home using CeFi products - whereas those who are more experienced, more technical, and comfortable taking higher risk may be more likely to prefer DeFi platforms. There are many factors that traders typically consider when deciding whether to use DeFi or CeFi trading platforms. Individual requirements, risk tolerances and preferred trading strategies will vary wildly amongst different traders, leading them to make different choices.