CeFi vs. DeFi — Comparing Centralized to Decentralized Finance Kaihua Qin∗ Liyi Zhou∗ Yaroslav Afonin [email protected] [email protected] [email protected] Imperial College London Imperial College London Imperial College London Ludovico Lazzaretti Arthur Gervais [email protected] [email protected] Independent Imperial College London Abstract trading, decentralized governance voting, stablecoins. The range To non-experts, the traditional Centralized Finance (CeFi) ecosys- of products is rapidly expanding, and some of the more complex tem may seem obscure, because users are typically not aware of products, such as options, and derivatives, are rapidly developing the underlying rules or agreements of financial assets and products. as well. 1 Decentralized Finance (DeFi), however, is making its debut as an Contrary to the traditional centralized finance , DeFi offers three ecosystem claiming to offer transparency and control, which are par- distinctive features: 1. Transparency. In DeFi, a user can inspect tially attributable to the underlying integrity-protected blockchain, the precise rules by which financial assets and products operate. as well as currently higher financial asset yields than CeFi. Yet, the DeFi attempts to avoid private agreements, back-deals and central- boundaries between CeFi and DeFi may not be always so clear cut. ization, which are significant limiting factors of CeFi transparency. In this work, we systematically analyze the differences between 2. Control. DeFi offers control to its users by enabling the userto CeFi and DeFi, covering legal, economic, security, privacy and mar- remain the custodian of its assets, i.e., no-one should be able to ket manipulation. We provide a structured methodology to differ- censor, move or destroy the users’ assets, without the users’ con- entiate between a CeFi and a DeFi service. Our findings show that sent. 3. Accessibility. Anyone with a moderate computer, internet certain DeFi assets (such as USDC or USDT stablecoins) do not connection and know-how can create and deploy DeFi products, necessarily classify as DeFi assets, and may endanger the economic while the blockchain and its distributed network of miners then security of intertwined DeFi protocols. We conclude this work with proceed to effectively operate the DeFi application. Moreover, the the exploration of possible synergies between CeFi and DeFi. financial gain in DeFi also presents a significant contrast toCeFi. In the years 2020 and 2021, DeFi offered higher annual percentage 1 Introduction yields (APY) than CeFi: the typical yield of USD in a CeFi bank is about 0.01%[53], while at the time of writing, DeFi offers consis- Centralized finance was originally invented in ancient Mesopotamia, tent rates beyond 8%[12]. On the one hand, DeFi enables mirroring several thousand years ago. Since then, humans have used a wide traditional financial products, on the other hand, it enables novelfi- range of goods and assets as currency (such as cattle, land, or cowrie nancial primitives, such as flash loans and highly-leveraged trading shells), precious metals (such as gold, which have enjoyed near- products, that yield exciting new security properties. universal global cultural acceptance as a store of value), and, more In this paper, we aim to compare and contrast systematically the recently, fiat currencies. As such, it has been shown that a currency traditional Centralized Finance and Decentralized Finance ecosys- can either carry intrinsic value (e.g., land) or be given an imputed tems. Firstly, we compare both domains in their technological differ- value (fiat currency). All these known attempts to create an everlast- ences, such as transaction execution order, throughput, privacy, etc. ing, stable currency and finance system were based on the premise Secondly, we dive into their economic disparities, such as the differ- of a centralized entity, where e.g., a government is backing the ences from an interest rate perspective, transaction costs, inflation financial value of a currency, with a military force at its command. and possible monetary policies. Finally, we contrast the legal pecu- History, however, has shown that currencies can also be valued liarities, such as regulations around consumer protections, know arXiv:2106.08157v2 [q-fin.GN] 16 Jun 2021 using an imputed value, that is an assumed value assigned to a your customer (KYC) and anti-money laundering (AML) techniques. currency, which can be unrelated to its intrinsic value, and, e.g., may even be zero. In summary, our contributions are the following: With the advent of blockchains, and their decentralized, permis- sionless nature, novel imputed currencies have emerged. One of CeFi — DeFi Decision Tree We devise a decision tree which en- the blockchain’s strongest innovations is the transfer and trade of ables the classification of a financial service as CeFi, DeFi,or financial assets without trusted intermediaries [185]. In addition a hybrid model. We highlight that commonly perceived DeFi to this, Decentralized Finance (DeFi), a new sub-field of blockchain, specializes in advancing financial technologies and services on top of smart contract enabled ledgers [168]. DeFi supports most of the products available in CeFi: asset exchanges, loans, leveraged 1We prefer to refer to the (currently) traditional finance as CeFi, as centralization isone of the most distinguishing properties, and the term “traditional” might not withstand ∗Both authors contributed equally to the paper. the test of time. 1 The paper is organized as follows. Section2 provides a system- atization of DeFi as well as a background on CeFi and applicable properties for the remainder of the paper. Diving into specific case- by-case comparisons, Section3 focusses on the legal similarities, Section4 exposes the differences in the financial CeFi and DeFi ser- vices, while Section5 exposes economic and market manipulation analogies. We positively derive possible synergies between DeFi and CeFi in Section6 and conclude the paper in Section7. 2 Background In this section we provide a primer on finance, blockchains, DeFi and its distinguishing properties when considering CeFi. 2.1 What is Finance? Finance is the process that involves the creation, management, and Figure 1: Decision tree to differentiate among DeFi and CeFi. investment of money [100]. A financial system links those in need of finance for investment (borrowers) with those who have idle funds (depositors). Financial systems play an essential role in the assets (such as USDC or USDT stablecoins), are in fact cen- economy since it boosts the economy’s productivity by regulating trally governed, allowing a single entity to censor or even de- the supply of money, by ensuring high utilization of existing money stroy cryptocurrency assets. We find that nearly 44M black- supply. Without a financial system, each entity would have tofi- listed USDT were destroyed by Tether Operations Limited. nance themselves, rather than rely on a capital market, and goods We show how this power may lead to significant financial would be bartered on spot markets. Such a system would only be danger for DeFi protocols incorporating these assets. able to service a very primitive economy. An effective financial sys- DeFi Systematization We provide a comprehensive systematiza- tem provides legally compliant, safe, sound, and efficient services tion of DeFi, its underlying blockchain architecture and fi- to market participants. Financial systems typically consist of the nancial services, while highlighting DeFi’s ability to perform following three components, namely the institution, instrument atomic composability. We also exposit the various market and market [182]. On a high level, financial institutions issue, buy, mechanisms that can be targeted from traditional CeFi as and sell financial instruments on financial markets according tothe well as novel DeFi market manipulations. practices and procedures established by laws. Case Studies We separately provide a case-by-case comparison Financial Institutions refer to financial intermediaries, which between CeFi and DeFi focussing on legal, financial services, provide financial services. Traditional financial services in- economics and market manipulations. We conclude the case clude banking, securities, insurance, trusts, funds, etc. Corre- studies by distilling possible synergies among CeFi and DeFi. spondingly, traditional financial institutions include banks, securities companies, insurance companies, trust investment CeFi — DeFi Decision Tree Due to a lack of definition when companies, fund management companies, etc. A comprehen- it comes to DeFi, we have prepared in Figure1 a possible decision sive definition of financial institutions is contained intitle tree that may help classify a financial product or service as CeFi or 31 of the United States Code, including financial auxiliary DeFi. In this tree, the first decisive question is whether the financial service providers such as travel agencies, postal services, etc. assets are held by the user, i.e., whether the user retains control Financial Instruments refer to monetary assets. A financial in- over its own assets. If the user is not in control, does not retain strument can be a paper document or virtual contract that custody nor the ability to transact the assets without a financial represents legal agreements involving monetary value. All intermediary, the service is an instance of CeFi. Otherwise,