What is Centralized Finance (Drawbacks of Decentralized Finance)

What is Centralized Finance? Centralized Finance (Decentralized Finance, DeFi) is a major participant and investor in the cryptocurrency market. With the continuous rise of Bitcoin prices and the increasing transaction volume on the Ethereum blockchain, centralized finance has gained more and more users worldwide. However, this situation is not as simple as many people think because it lacks any intermediaries or security measures to protect user funds, and it may also lead to systemic risks and failures.

Centralized finance allows traditional banks, insurance companies, and other financial service providers to directly offer digital assets to users without the need for third-party custody. The use of trustless technology to address this issue is a major advantage of centralized finance. Centralized finance typically approaches this issue from a single perspective: centralized finance allows users to lend their tokens to other platforms or protocols of their choosing. For example, in DeFi, the smart contracts of these platforms can send equivalent tokens to users, such as dollars, and execute transactions without compromising privacy.

However, for most ordinary consumers, this solution is almost impossible to achieve due to the lack of liquidity and low-cost accessibility. Therefore, if a business wants to become a reliable portfolio management tool and leverage these products to improve its profitability, it must rely on significant capital support from hedge funds, family offices, and brokers.

But due to the highly centralized control of centralized finance, it makes it difficult for them to handle all complex issues. To address the aforementioned shortcomings, some companies have adopted different approaches to build their systems and meet certain requirements.

For example, in MakerDAO, there are two types of tokens: stablecoins collateralized by Bitcoin and synthetic tokens based on credit score (CVTs).

Although there are various methods available for people to obtain loans, strict regulations still need to be followed in practice, which may result in greater economic losses.

One of the key factors of centralized finance is to ensure that funds are always locked in an “irrelevant” environment.

When it comes to collateral assets, there are generally two key aspects: one is the debt position, including the interest generated by borrowers during the liquidation process. The second reason is that collateral is often held by customers. Finally, if a particular investment fails due to the high volatility of its value, the lender cannot fully recover their principal or burden. Such a result will not occur if there is default or vulnerability.

In centralized finance, we often see a view that if a person wants to get a loan, they can deposit all their money into a margin account and there is not enough time for liquidation; otherwise, they will lose all their funds.

Therefore, although traditional financial technologies provide very effective alternatives, another example has emerged, namely the cryptocurrency derivatives exchange Gemini, which attempted to short its tokens using leverage.

Drawbacks of Decentralized Finance

Editor’s note: This article is from Blue Fox Notes (ID: lanhubiji), the original author is Alex, translated by the “DeFi Way” of the “Blue Fox Notes” community; authorized reprint by Odaily Star Planet Daily

Decentralized finance is an emerging technology or application that values depend on the new features it brings and the demands of new users. Compared to traditional finance, it offers more possibilities, flexibility, and new points of innovation. However, despite the significant benefits of these new tools in many aspects, they also come with a common problem.

1. The decentralized financial market carries significant risks and uncertainties.

The core of decentralized finance is a protocol that facilitates transactions and provides funding. In this way, cryptocurrencies can be used as a trusted and volatile market mechanism to incentivize participants. This means that anyone can access this platform and earn profits.

For example, Uniswap is a decentralized exchange based on the Ethereum blockchain, designed to allow token holders to stake and earn rewards.

2. Trustless systems make it a more flexible solution.

With the increasing liquidity and use cases of various asset classes entering the field, decentralization has become a mainstream trend. However, there are still many challenges to be addressed due to the lack of transparency and regulatory frameworks.

3. Trustless systems allow people to withdraw their digital assets or borrow funds from wallets without third-party control—even including their own wallets. These smart contracts cannot hide data from each account, which undermines the integrity of the entire market.

4. Centralized infrastructure can lead to catastrophic consequences.

One of the main drawbacks of decentralized finance is that it relies on third parties rather than real banks. This, in turn, increases the monopoly position of centralized institutions in customer service and product demands, further causing centralized entities to lose competitiveness and eventually have to shut down their business and transfer it to individual investors. If we return all ownership to the central government, then we will no longer have a banking industry. Trustless networks may bring some bad things, such as network effects. When it comes to decentralized systems, another major issue arises. Firstly, whether decentralized finance can really make Bitcoin more vibrant and whether it can be widely accepted, just like Bitcoin?

In reality, a trustless environment is not always a good result, and it changes once you want to use it. On the contrary, when people want to buy Bitcoin, it is impossible and must go through rigorous security auditing for approval. So, to prevent hacking attacks, you need to ensure the security of your private keys. This is why trustless systems typically require users to maintain complete anonymity because they know your password.

In addition, trustless technology can also be used to help users who want to leverage their own data avoid losses and create a fair competitive environment for users.