Is Decentralized Finance Safer Than Centralized Finance? The Crypto Debate Rages On
The recent crypto crash has drawn attention to the inherent flaws of Centralized Finance (CeFi). A lot of crypto platforms, such as Vauld, Three Arrow Capital, Voyager, Hodlnaut and Celsius are either going bankrupt or halting customer withdrawals altogether. Initially, cryptocurrency was created with the purpose of tackling all the flaws present in the traditional centralised financial system, where a third party is responsible for keeping your funds secure, providing loans, or holding stocks. Its purpose was to remove the third-party in any transaction and act in the same manner as digital cash.
Key Features of Decentralized Finance
Decentralized Finance (DeFi) provides peer-to-peer service for all the products that are similar to traditional banks offerings, such as borrowing, lending, insurance, or trading of assets, but in the absence of any third-party involvement. Everything is built on ‘open source’ smart contracts. These contracts define the basic rules of the particular DeFi protocol.
DeFi protocols are governed democratically by Decentralized Autonomous Organizations (DAOs), such as Ethereum Foundation, where the governance token holders decide the rules and tokenomics. So, all the rules are made by the people who own the tokens. The decision-making is done through a Blockchain explorer, and the information is available in the public domain. The new decision and transactions are stored on the Blockchain, and anyone who knows your wallet address can track your transactions through Blockchain explorer websites, such as blockchain.com.
As it doesn’t require any permission, so there is no central authority which can block a particular transactions on the Blockchain. It is faster than the traditional banking system; loans gets approved quickly. The most essential feature it is, that it is almost free in comparison to traditional banking.
“The objective of DeFi is for you to have complete custody of your own assets, complete control of your own assets, and to get more return on your money. By taking out the middleman, you get cheaper loans, and better deposit and insurance rates,” says Rajagopal Menon, vice president at WazirX, a crypto exchange.
“DeFi is indeed a safer option than CeFi, thanks to the inherent features of the latter, including systemic transparency, over-collateralised lending, and automated liquidation of borrowers. We need to understand the point that DeFi is still an evolving concept, and with greater adoption, it will become safer and accessible to the masses,” says Sumit Ghosh, CEO and co-founder, Chingari, a Blockchain social media platform.
CeFi’s Flaws
Bitcoin was launched with purpose of tackling the inherent flaws in the traditional banking system. CeFi is governed by a central authority, which can always block a particular person’s account or transaction.
CeFi platforms, such as Celsius, Hodlnaut, and Vauld are going bankrupt and halting withdrawals, amid the crypto market meltdown. If a traditional government bank goes bankrupt, the investor gets a certain amount back, as the investors’ funds are insured by the government. This is not the case with crypto CeFi.
Also, as a lot of these exchanges are located in tax heavens like Cayman Islands and Singapore, it is highly unlike that the investors’ funds are insured.
The fall of Terra Luna created a domino effect which led to the fall of Three Arrow Capital, a crypto hedge fund which was heavily invested in Terra Luna and Bitcoin Grayscale Trust. Then, Three Arrow Capital defaulted on a $670 million loan by Voyager Digital Holdings, which led Voyager to go into bankruptcy. The promise of returns in short period of time is one of the marketing tactics often used by these crypto companies, and it is, therefore, advisable that investors do their own research before investing into any financial product promising high returns, including crypto.
Adds Menon: “CeFi exchanges are the first step for new users to dip their toes into the world of crypto. They usually buy their first Bitcoin, Ether or USDT at a centralised crypto exchange like WazirX. Once they become familiar with crypto, they deploy their crypto assets into NFTs, DEX (Decentralised Exchanges).”
“The problem usually occurs when people get greedy. Customers chasing every higher returns nudge companies to riskier strategies to generate those returns. The solution is for users to be more vigilant – only sign-up for exchanges that allow full withdrawal of your assets – both fiat and crypto. Be wary of companies promising high returns, and lastly, take full custody of your crypto assets. Rule 1 in crypto is ‘not your key, not your crypto’,” he says.
Menon further said that in CeFi, crypto trades and related activities are managed through a central exchange, whereas DeFi uses smart contracts and cryptocurrency to deliver services directly to customers. In today’s financial environment, financial institutions function as transaction guarantors.
“Your money goes through these institutions, thus they have a lot of power. However, in DeFi, a smart contract takes the position of the financial institution in the transaction, which means these systems are un-censorable, transparent, and safe,” Ghosh adds.
