As experienced investors in the FinTech space, we’ve been closely following the evolution of financial services in Web 3.0 and the possibilities that blockchain technology offers this vertical.
In the world of cryptocurrencies, a lot has been written about the merits of CeFi (Centralized Finance) and DeFi (Decentralized Finance) services, from the user’s perspective. In this blog, we want to lay down the pros and cons of CeFi and DeFi from the entrepreneur’s perspective. And the question isn’t nearly as simple as one versus the other. Instead, it’s a matter of knowing the strengths and weaknesses of each and applying them wisely.
Here’s our short analysis of both CeFi and DeFi solutions and our investment thesis in this space. As always – we welcome your feedback.
The Advantages of CeFi
With the growth of cryptocurrencies, CeFi solutions were the first to emerge. In the beginning, CeFi offered the option to buy or sell Bitcoin and other cryptocurrencies through a centralized entity. A couple of years later, CeFi services have expanded to other fields such as loans, leveraged trading, and custody services.
Here’s what makes CeFi a popular option for entrepreneurs:
● Governance and flexibility – in CeFi solutions, the founders control the product and can easily make changes, whether because they found a bug, thought of a better business model, or just realized that a new feature would drastically improve the user experience. In addition, CeFi solutions can more easily offer different types of cryptocurrencies without the need for risky bridges and wrapped coins.
● Security – CeFi solutions can more easily tackle security breaches or block fraudulent activity and are less exposed to market manipulation. Moreover, they rely less on other protocol layers or on third parties, compared to DeFi solutions. That doesn’t always mean better security, but it does mean more control.
● Customer management – centralization means that you usually have some sort of communication channel with your customers. That is to say, you can send them promotions, provide customer service, and offer new features.
● Talent acquisition – CeFi solutions usually require much more common skill sets for both development and business positions. That’s not the case in DeFi. For example, if you want to develop a DeFi protocol, you may have to recruit numerous solidity developers, who are still very hard to find.
● Market education – there is no doubt that we have a long way to go in terms of market education about crypto as a whole. However, with a DeFi product, you’ll probably have to spend more resources educating the market since the differences between DeFi and traditional finance are more significant.
● Regulatory compliance – regulators are far behind the market in both CeFi and DeFi, but in DeFi it can be hard to even know where to start. As a DeFi founder, you might find yourself legally responsible for a protocol that you created, without any insurance to cover you. The regulatory and jurisdictional uncertainty around DeFi doesn’t stop at the founders’ door and can be a barrier to user acquisition. For example, a recent lawsuit filed against bZx DAO has raised big questions about DAO members’ liability.
Although these are important reasons for choosing CeFi, many people see CeFi as missing one of the most important advantages offered by cryptocurrencies.
The Advantages of DeFi
One of the major advantages of blockchain technology and cryptocurrency is the opportunity for decentralization. For some, DeFi systems are the whole point. The ability to conduct financial services, including exchanges and loans, without any intermediary, is the most appealing aspect for many entrepreneurs because it translates into some key abilities:
● Growth accelerator – the decentralization of DeFi allows the creation of new economic models, where the interests of users and founders are much more aligned. The use of tokens can lead to exponential growth by incentivizing users to use the DeFi product and help it grow.
● Pulling the community together – as DeFi is decentralized and transparent by nature, it allows users and third parties to chip in and contribute to the development efforts.
● No single point of failure – DeFi solutions mitigate single points of failure by not having one central server or one central control system. When choosing a DeFi solution, you probably won’t have any “the server is down!” crises.
● Regulation neutrality – DeFi has the potential to be “regulation neutral”, meaning that the protocol may not be subject to specific jurisdictional regulations or specific national tax authorities, based on its place of foundation. Of course, this can be a double-edged sword, as having no established location may end up with multiple regulators claiming authority.
● Market reach – putting the regulatory issues aside, being permissionless lets DeFi solutions expand their market reach. Theoretically, anyone can access the service without approval from a centralized entity.
A Third Option: CeFi-DeFi Hybrids
We will probably not see many pure decentralized solutions in the near future. However, the choice between DeFi and CeFi isn’t binary. Some companies have tried to offer the best of both worlds. Aave Arv is a good example, offering a “permissioned DeFi” product designed for compliance with AML regulations. Another type of hybrid solution involves allocating special capabilities to privileged accounts, including the ability to change the protocol or veto specific actions. Privileged accounts make it easier to implement upgrades or block malicious attacks, but they also carry a higher risk of account compromise.
So Which is the Right Choice?
The way we see it, thinking in terms of decentralized vs. centralized is missing a big chunk of the picture. When developing new products, entrepreneurs need to think in terms of pain points and solutions, rather than technological and financial trends. In our experience, people don’t adopt new technologies because the solutions are cutting-edge – they choose the solutions that make their lives better in terms of affordability, efficiency, ease of use, etc. The same applies to cryptocurrencies.
We will only see mass adoption when using cryptocurrencies is easy and efficient, whether it’s through DeFi or CeFi. In either system, on-ramping and off-ramping must be frictionless, with a user-friendly, intuitive UI. Regulatory compliance should be guaranteed. Crypto should be easy to acquire, but also easy to use for practical purposes.
Founders must remember that while incentivizing users with tokens can fuel growth and create exciting new business models, user experience must not be ignored. We believe that blockchain technology offers many advantages and opens up countless new possibilities in both payments and investing. But currently, only a small group of people use crypto. This is partly because it takes time to educate the market. But it also takes time to reach the right product-market fit. A frictionless user experience is the crucial first step.
Blockchain technology is still in its infancy and most companies don’t yet know how to manage its financial possibilities. Therefore, FinOps solutions, such as cost management, tax, accounting, and fund management, are all important factors in driving the adoption of crypto.
Eventually, the solutions may be decentralized, centralized, or hybrid, but they must focus on clients’ needs rather than technological features.
A special thank you to our community feedback which enabled us to update our Israeli web 3.0 / blockchain map. We are always happy to learn about new and existing companies that should be included. For the updated map, click here.
As always, if you are working on something interesting in the web 3.0/ blockchain space, we would love to hear from you at email@example.com.