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There are two crypto ecosystems. What?!?

The first one is the original ecosystem. Everyone holds their private keys and everything is done on-chain. We'll call this one DeFi (Decentralized Finance).

The second one, which is growing fast, and is the subject of most of the regulation is where for-profit companies assist in making things easier, and help with on-boarding and off-boarding crypto into the traditional financial system (TradFi). We will call this one CeFi (Centralized Finance).

To summarize:

  • DeFi - You hold your own keys. All on-chain transactions. DeFi is just software running everywhere.
  • CeFi - A company (or a designated custodian) holds your crypto by holding your keys. Highly regulated to prevent theft. Has associated counter-party risk.
  • TradFi - The traditional non-crypto related finance consisting of banks, credit unions, etc.

If you want to experience the difference between CeFi and DeFi, download and Defi apps. They come from the same company, and look similar, but work very differently under the hood. The user experience is similar, but the fees are higher in DeFi, and the responsibility of the user is much higher in DeFi.

So, does that mean that CeFi will win?

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The relative performance of these two ecosystems (DeFi and CeFi) to each other will depend on the regulatory overhead that is applied to CeFi. As it stands today, the requirements of KYC, AML, transaction reporting, IRS reporting, geo-fencing to block NY residents, or block US citizens are very burdensome. The burden falls on the centralized service provider, but also on their customers. Other risky regulations have been proposed requiring all CeFi transfers to require transmission of customer information. These requirements will inevitably lead to more data leaks and risks to the financial system because it is never a good idea to replicate Personally Identifiable Information (PII).

The DeFi ecosystem is harder to understand, and harder to use. But, it preserves more financial privacy, and by-design eliminates honey-pots of user information that can be targeted by hackers. Also, by-design, the DeFi private keys are distributed which eliminates the potential for catastrophic hacking attacks.

We sit at a crossroads, where the existing legacy system has completely obliterated financial privacy. The new competing system has the advantage of storing value that isn't someone else's liability (like gold), and includes near-instant settlement as a bonus. This system is operating in two modes -- centralized and decentralized. One is highly subject to regulation, and the other is blissfully unaware of jurisdiction or regulation.

Those attempting to protect the incumbent system run the risk of over-regulating CeFi. This has already happened in places like New York, Iran, and China. The centralized version of the new system will simply draw a circle around those locations, delete them, and carry on. The decentralized version of the new system isn't even aware of these jurisdictional borders as it only cares that the transactions and their corresponding digital signatures are valid.

Imagine a lightly inflated balloon that doesn't pop when you squeeze it, but inflates between your fingers into another area. Bad regulations are those squeezing fingers. CeFi is the part that can be squeezed. DeFi is the new inflated sub-balloon.

I'm unable to predict the future precisely because of the unknowns in future policy making. But, I am convinced that the more that regulations suppress CeFi instead of embracing, supporting, and integrating this new technology, the more that DeFi will thrive.

The respective futures of the bifurcated crypto ecosystem is up to the policy makers.