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The Future of Finance: Synthesizing CeFi and DeFi for the Benefit of All

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Luyao Zhang

Submitted: 11 September 2023 Reviewed: 16 September 2023 Published: 17 November 2023

DOI: 10.5772/intechopen.1003042

Financial Literacy in Today´s Global Market IntechOpen
Financial Literacy in Today´s Global Market Edited by Ireneusz Miciuła

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Financial Literacy in Today´s Global Market [Working Title]

Ireneusz Miciuła

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Abstract

Decentralized Finance (DeFi) is changing the world of finance with innovative solutions and groundbreaking innovations such as the Automatic Market Maker, Flash Loans, and Initial Coin Offering, fundamentally reshaping financial ecosystems and promoting decentralization and financial inclusion beyond Centralized Finance (CeFi). Nonetheless, this innovation brings forth critical concerns including potential centralization, ethical issues, and questions about inclusivity. In this chapter, we explore the finance literature at the frontier, delving into the definitions, metrics, and quantification used to gauge CeFi and DeFi performance. We emphasize the importance of a human-centric perspective in addressing the shortcomings of financial technology, with the aim of enhancing global financial literacy and bridging the digital divide. Additionally, we address the blockchain trilemma that curtails DeFi’s potential positing that an integration of CeFi and DeFi approaches could be the key to overcoming this challenge. Drawing upon insights from ancient Greek philosophy, this chapter concludes by underscoring governance models, be decentralized or centralized, that serve the common good or social welfare, emphasizing that technological progress should distinguish means from ends and be rooted in human values to ensure financial prosperity for all.

Keywords

  • decentralized finance
  • centralized finance
  • financial technology
  • blockchain
  • financial inclusion

1. Introduction

Decentralized Finance, or DeFi, is an emerging financial market built on the infrastructure of blockchain technology [1]. Is DeFi the future of finance? By September 8, 2023, DeFi exceeded the market value of 40 billion, supporting various financial services, including payment, exchange, lending, derivatives, and asset management [2]. Furthermore, DeFi introduces brand new financial solutions, such as the Automatic Market Maker [3, 4], Flash Loans [5], and Initial Coin Offering [6]. These innovations have revolutionized the way investors and consumers approach financial systems.

In contrast to Centralized Finance (CeFi), DeFi presents the advantage of liberating financial processes from dependence on centralized intermediaries [7]. Yet, DeFi grapples with the blockchain trilemma: balancing efficiency, security, and decentralization [8]. Recent research indicates potential centralization tendencies in DeFi, attributed to elements such as incentive structures [9, 10, 11]. Additionally, challenges in achieving widespread inclusivity in DeFi have been highlighted, possibly due to technical hurdles, despite its foundational aim of fostering inclusiveness [12]. DeFi’s complete autonomy serves as a double-edged sword, potentially paving the way for ethical issues such as discrimination [13] and criminal activities [14].

However, it is essential to remember that CeFi has created financial prosperity for hundreds of years, emphasizing the importance of human trust [15]. The question then arises, why “throw the baby with the bathwater?” The debate between decentralization and centralization is not about choosing one over the other but about determining the appropriate balance. As Qin et al. [7] and Wieandt and Heppding [16] suggest, the real value may lie in the interdependence between traditional finance and its decentralized counterpart.

In this chapter, we explore the cutting-edge finance literature, delving into the definitions, metrics, and quantification used to evaluate the performance of CeFi and DeFi. We emphasize the importance of a human-centric perspective in addressing the shortcomings of current financial applications, with the aim of enhancing global financial literacy and bridging the digital divide. Additionally, we consider the promise of a hybrid solution that combines the strengths of both spheres, drawing on insights from economics, law, and technology to envision a progressive future for finance. As illustrated in Figure 1, we envision the future of finance for all.

Figure 1.

The future of finance. Note: This figure illustrates a human-centric approach to the future of finance.

2. The frontier of finance literature

Tables 1 and 2 present a curated selection of literature at the forefront of financial technologies (Fintech), detailing the year and venue of publications, as well as their focus on CeFi, DeFi, or both. Additionally, the methods employed—whether theoretical, empirical, or review-based—are highlighted. Notably, the majority of the literature emphasizes DeFi, while nearly a quarter focuses on CeFi and only a handful on both. The research methodologies are well-distributed among theoretical, empirical, and review-based approaches. However, we observe a conspicuous absence of behavioral and experimental methods, which are central to financial and economic research.

Citation (year)VenueCeFiDeFiMethod
TheoreticalEmpiricalReview-based
[16] (2023)Journal of Financial Economics□■✓
[17] (2023)Production and Operations Management■■✓✓
[18] (2023)Management Science□■✓
[19] (2023)Journal of Political Economy■□✓✓
[20] (2023)Management Science□■✓
[21] (2023)Management Science□■✓
[22] (2023)Journal of Accounting and Economics□■✓
[23] (2023)Management Science□■✓
[24] (2023)Management Science□■✓
[25] (2023)Management Science■■✓
[26] (2023)Journal of Finance□■✓
[27] (2023)Review of Economic Studies■□✓
[8] (2022)Proceedings of the 4th ACM Conference on Advances in Financial Technologies□■✓
[28] (2022)Journal of Financial Economics□■✓
[29] (2022)Journal of Political Economy■□✓
[30] (2022)Journal of Financial Economics□■✓
[31] (2022)Management Science□■✓

Table 1.

Literature at the frontier of financial technologies.

Note: The symbols in the table have specific meanings.

■: The topic is the primary focus of the paper.

□: The topic is mentioned or discussed but not the main focus.

✓: The paper covers the theoretical, empirical, and/or review-based method.

Citation (year)VenueCeFiDeFiMethod
TheoreticalEmpiricalReview-based
[32] (2022)Journal of Accounting Research□■✓
[6] (2021)Management Science□■✓
[1] (2021)John Wiley & Sons□■✓
[33] (2021)Review of Financial Studies□■✓
[34] (2021)Financial and Economic Review■■✓
[15] (2021)Information Systems Research■■✓
[35] (2021)Management Science□■✓
[36] (2021)Crypto Valley Conference on Blockchain Technology (CVCBT)■■✓
[7] (2021)Financial Cryptography and Data Security□■✓
[37] (2020)Management Science□■✓✓
[38] (2020)Review of Financial Studies□■✓
[38] (2020)Journal of Financial Economics□■✓
[39] (2020)Journal of Finance□■✓
[2] (2020)Journal of Financial Regulation□■✓
[40] (2019)Review of Financial Studies■■✓
[41] (2019)The Review of Financial Studies■■✓

Table 2.

Literature at the frontier of financial technologies.

Note: The symbols in the table have specific meanings.

■: The topic is the primary focus of the paper.

□: The topic is mentioned or discussed but not the main focus.

✓: The paper covers the theoretical, empirical, and/or review-based method.

We conducted a preliminary natural language processing analysis on the titles and abstracts of the chosen literature. Those intrigued can find the replicable code on GitHub at: https://github.com/sunshineluyao/finance. The word clouds in Figures 2 and 3 visually illustrate the most recurrent words in the titles and abstracts from Tables 1 and 2, with the size of each word indicating its frequency. Furthermore, Figures 4 and 5 display the bigrams derived from the literature’s titles and abstracts. These bigrams spotlight prevalent word pairs, with their position, color, or size denoting their significance. Tables 3 and 4 detail the top 25 bigrams found in the titles and abstracts. The visuals emphasize the dominance of the decentralized finance market. Beyond traditional financial paradigms, there’s a marked rise in attention toward DeFi assets such as Bitcoin, cryptocurrency, and tokens, the crypto crowdsourcing phenomenon of initial coin offerings (ICO), and the pivotal role of blockchain infrastructure. While the literature’s focus on groundbreaking financial technologies heralds potential advancements, there remains a discernible absence of a human-centric lens that highlights how these technologies can elevate financial literacy, decision-making, and strategy.

Figure 2.

The word cloud of literature titles. Note: This word cloud provides a visual representation of the most frequently occurring words in the titles of the literature in Tables 1 and 2. The size of each word corresponds to its frequency.

Figure 3.

The word cloud of literature abstract. Note: This word cloud provides a visual representation of the most frequently occurring words in the titles of the literature in Tables 1 and 2. The size of each word corresponds to its frequency.

Figure 4.

The bigram of literature title. Note: This figure illustrates the most frequently occurring bigrams (pairs of adjacent words) from the titles of the literature in Tables 1 and 2. The position, color, or size of each bigram may represent its significance or frequency.

Figure 5.

The bigram of literature abstract. Note: This figure illustrates the most frequently occurring bigrams (pairs of adjacent words) from the abstract of the literature in Tables 1 and 2. The position, color, or size of each bigram may represent its significance or frequency.

BigramCounts
(decentralized, finance)5
(coin, offering)5
(initial, coin)5
(central, bank)3
(digital, currency)3
(cryptocurrency, market)2
(bank, digital)2
(finance, defi)2
(security, equilibrium)1
(covid-stimulus, check)1
(asset-backed, security)1
(evidence, asset-backed)1
(early, evidence)1
(application, early)1
(blockchain, application)1
(value, blockchain)1
(economic, value)1
(check, economic)1
(retail, trading)1
(impact, covid-stimulus)1
(bitcoin, impact)1
(trading, bitcoin)1
(bitcoin, pricing)1
(uncovering, retail)1
(problem, uncovering)1

Table 3.

Bigrams for titles in literature.

Note: The table presents frequently occurring bigrams (two adjacent words) extracted from titles of the literature in Tables 1 and 2. The “counts” column indicates how often each bigram appears across the surveyed literature.

BigramCounts
(cryptocurrency, market)11
(decentralized, finance)9
(p2p, lending)8
(lending, pool)8
(digital, currency)7
(blockchain, technology)6
(financial, service)6
(traditional, financial)5
(coin, offering)5
(initial, coin)4
(offering, icos)4
(tax, scrutiny)4
(data, set)4
(cefi, defi)4
(net, transactional)3
(special, issue)3
(value, chain)3
(cryptocurrency, return)3
(agency, problem)3
(business, school)3
(operating, performance)3
(post-ico, operating)3
(bank, deposit)3
(mean, payment)3
(cryptocurrency, price)3

Table 4.

Bigrams for abstracts in literature.

Note: The table presents frequently occurring bigrams (two adjacent words) extracted from abstracts of the literature in Tables 1 and 2. The “counts” column indicates how often each bigram appears across the surveyed literature.

3. DeFi or CeFi: Definition, measurement, and quantification

The first step to philosophizing is to define. Qin et al. [7] first point out the lack of clear definitions to distinguish DeFi from CeFi and provide a CeFi–DeFi Decision Tree with three guiding questions on facets of ownership settlement, transaction execution, and protocol governance:

  1. Ownership settlement: Are the financial assets controlled by the user (non-custodial)?

  2. Transaction execution: Can someone single-handedly censor a transaction execution?

  3. Protocol governance: Can someone single-handedly censor the protocol execution?

As illustrated in Figure 6, when adopting a human-centric lens to scrutinize the definition of DeFi, the conclusions drawn can be contentious, especially when viewed without the foundational assumption of a universally high financial literacy level. To delve deeper:

  1. Ownership settlement: Many DeFi platforms indeed eliminate the need for a trusted third-party custodian for asset management. Yet, this does not unequivocally ensure that financial assets are directly controlled by their users. Implicit in this setup is the expectation that all users possess a uniform level of financial literacy, particularly the expertise to use a cryptocurrency wallet [42]. However, the proficient and safe use of a self-custodial wallet demands a combination of technical acumen and a sustained commitment to security practices. This includes the safeguarding of the wallet’s private key, ensuring that the wallet software, associated devices, and networks are secure, and vigilance against potential phishing or fraudulent threats [7].

  2. Transaction execution: While many DeFi platforms are erected upon public blockchains, offering open access for transaction recording, they do not necessarily ensure immunity from individualized transaction censorship. Implicit here is the notion that all participants possess equivalent financial literacy to engage in transaction execution, a presumption that often falls short of reality. The phenomenon of miner extractable value (MEV) exemplifies this, highlighting how dominant entities can disadvantage average users by manipulating transaction inclusions, exclusions, or sequencing. This raises significant ethical quandaries within the DeFi realm [43, 44]. Studies by Wahrstätter et al. [45] and Heimbach et al. [46] further spotlight the centralized tendencies within transaction executions, especially emphasizing the block-creation process of the Proof-of-Stake (PoS) Ethereum blockchain. Additionally, Wahrstätter et al. [47] elaborate on PoS Ethereum’s censorship tendencies, noting that nearly 46% of its blocks are produced by censoring entities.

  3. Protocol governance: Current DeFi systems still grapple with the threat of unilateral censorship during protocol execution. Investigations by Sai et al. [48] highlight the disproportionate influence of core developers and founders of major public blockchains over the protocol’s developmental trajectory. Compounding this concern, research by Feichtinger et al. [49] underscores the challenges within decentralized governance structures, such as DAOs in DeFi platforms, pointing to steep participation costs, minimal engagement rates, and a trend leaning toward voting power centralization.

Figure 6.

The definition of CeFi-CeFi. Note: This table expands upon the CeFi-DeFi decision tree as presented in ref. [7]. It delves deeper into the nuanced responses to guiding questions, particularly when factoring in the underlying assumptions about financial literacy levels.

Zhang et al. [9] offer a comprehensive systematization of knowledge pertaining to blockchain decentralization, emphasizing measurement techniques, quantification, and rigorous scientific methodologies. The suite of metrics they introduce—including Shannon entropy, the Gini Coefficient, the Nakamoto Coefficient, and the Herfindahl-Hirschman Index (HHI)—not only gauge blockchain decentralization but can also be applied to assess the decentralization of financial markets. Expanding on this, Ao et al. [10] and Zhang et al. [11] integrate insights from social network analyses, employing network characteristics like the number of components, the giant component size ratio, modularity, standard deviations of degree centrality, the number of cores, and the p-values from the core-peripheral test to quantify transaction decentralization within decentralized banks. Surprisingly, these measures collectively reveal an inclination toward centralization, seemingly at odds with the foundational tenets of decentralized finance. Even more concerning, research by Ao et al. [10] and Zhang et al. [11] pinpoints centralized exchanges as the dominant forces, or “cores,” within the network landscape of decentralized banks. This leads to a pressing conundrum: Given the decentralized ethos of DeFi, why is there an observable deviation from its peer-to-peer transaction ideal? The resolution to this may rest in a holistic viewpoint that emphasizes human-centric factors. While the infrastructure for decentralization exists, it requires a well-thought-out incentive design to encourage genuinely decentralized user interactions. Analogously, a distributed transportation system also needs incentives that encourage widespread travel rather than mere clustering around metropolitan hubs.

4. The blockchain trilemma and a synthetic solution

The blockchain trilemma1, a term initially coined by Vitalik Buterin, the founder of the largest smart contract blockchain Ethereum by market value, posits that when designing a blockchain, developers face a challenging balancing act between three critical pillars: decentralization, security, and scalability. Conventional wisdom asserts that a blockchain can effectively optimize only two of these three factors at any given time. Abadi and Brunnermeier’s study [50] offers a robust mathematical substantiation and advancement of the trilemma, demonstrating that any consensus approach, whether centralized or decentralized, inevitably sacrifices one of the key objectives—be it fault-tolerance, resource efficiency, or full transferability. Building on the foundation of blockchain consensus [51, 52, 53, 54], DeFi is not exempt from this trilemma. Yet, DeFi indeed contributes beyond CeFi in numerous ways: from the innovative introduction of crypto assets with unique utilities [55, 56, 57] and the advent of automated transaction fee models [58, 59], to the development of groundbreaking rule-bound financial management strategies encompassing crypto assets [33, 60, 61, 62, 63]. Moreover, DeFi’s role in facilitating rule-based monetary policies [64, 65] has bolstered trust in financial systems. The pressing question remains: How can DeFi transcend the trilemma to unlock its full potential?

Current research illustrates the strategies to foster synergies between DeFi and CeFi, enabling them to mutually reinforce each other, especially in scenarios where one might falter [7, 66, 67]. This collaboration aims to enhance the efficiency of financial services by establishing trust for financial data interoperability across diverse systems and entities. It endeavors to offer a dual trust safeguard for digital assets and to protect users from financial crimes and crises. Moreover, it facilitates broader financial user onboarding, effectively expanding the inclusivity of financial ecosystems.

In Figure 7, we provide an illustrative comparison between CeFi and DeFi. Let us consider two scenarios: In CeFi, four individuals—B, C, D, and E—hold assets valued at 5, 7, 8, and 10 units, respectively. In DeFi, four different individuals—A, B, C, and D—own assets amounting to 10, 5, 3, and 2 units, respectively. If we arrange individuals in CeFi by ascending financial literacy and those in DeFi by descending financial literacy, Person A could be someone proficient in economics and finance but lacks the technical skills for DeFi. Conversely, Person E might be adept in coding and the blockchain domain but lacks the traditional credentials required to open a bank account in CeFi. In choosing between DeFi and CeFi, one would have to forgo the advantages of the other. However, in an integrated world where both coexist, all five individuals can equally possess assets of 10 units, leading to a more inclusive economic landscape.

Figure 7.

Financial equality and inclusion: Comparing DeFi, CeFi, and their integration. Note: This illustration provides a concrete example of how an integrated approach, combining both DeFi and CeFi, might enhance financial equality and inclusion, as opposed to opting exclusively for one or the other. Inclusion than choosing one over the other.

We then calculate the Gini coefficient, a widely used statistical measure of income and wealth distribution in a population, used by economists and policymakers to gauge economic inequality [68]2. In the realm of DeFi, CeFi, and their combined scenarios, the respective Gini coefficients ranging from most to least unequal are as follows3:

  • For DeFi: 0.325, or 0.460 when accounting for individuals with 0 units of assets.

  • For CeFi: 0.1333, or 0.307 when considering individuals with no assets.

  • For the combined scenario: 0.

It’s worth noting a unique challenge in DeFi: Due to its inherent decentralized anonymity, perceived equality may surpass actual levels. For instance, individuals A, B, C, and D might distribute their assets across 10, 5, 3, and 2 crypto wallets, respectively. This distribution would yield an observed Gini coefficient of 0, masking the actual coefficient of 0.325. Consequently, DeFi’s drift toward centralization might be more pronounced than it appears.

Our example reinforces the imperative of adopting a human-centric approach, emphasizing that the optimal financial system hinges on individuals’ specific financial literacy levels.

  • Ideally, if everyone possesses equal and high literacy in both CeFi and DeFi, either system would achieve maximum inclusion and equality.

  • In an extreme scenario where the populace has profound literacy in CeFi but minimal familiarity with DeFi, CeFi emerges as the preferred choice to serve the collective interest.

  • Conversely, in a situation where individuals are well-versed in DeFi but lack proficiency in CeFi, DeFi stands out as the best system for universal benefit.

In practice, given the varying expertise levels among people, a hybrid solution promises to cater to a larger demographic, fostering both equality and inclusion. Furthermore, bolstering the overall financial literacy of the public emerges as the ultimate pathway to shared prosperity, irrespective of the chosen governance model.

5. Conclusions

DeFi marks a significant shift in the financial landscape, introducing groundbreaking solutions that have redefined our relationship with financial systems. With its rapid growth and innovation, it’s undeniable that DeFi has carved a prominent space in today’s financial ecosystem. However, as with any new technology, it comes with its set of challenges, from concerns of centralization drift to questions about broader inclusivity. CeFi has anchored global economies for centuries, emphasizing the inalienable value of human trust. After a deep dive into the definition, measurement, and quantification of DeFi, we find that improving global financial literacy is crucial to fulfilling the underlying assumption for DeFi to achieve its core goal of decentralization. Otherwise, the name of DeFi might be merely a pretentious marketing that “justifies and veil decisions of a ruling dictatorship behind the facade of a community [49].”

We contend further that neither decentralization nor centralization is the ultimate goal in themselves, but rather tools to achieve the common good or social welfare [41]. This perspective echoes ancient Greek philosophy, as depicted in Figure 8. Ancient Greek philosophers evaluated the merit of a government based on whether it acted for the collective benefit of the community or favored select groups or individuals at the cost of justice. By this standard, we can discern both commendable and flawed governance models across varying degrees of centralization. For a decentralized system to promote the common good, it demands a higher level of civic maturity from its citizens, where autonomy becomes preferable to paternalism in such settings, as discussed in Ref. [69].4 At its best, the most decentralized governance can epitomize true democracy when complemented by a highly civilized citizenry; at its worst, it risks degenerating into ochlocracy. Conversely, centralized governance can lead to an ideal monarchy or aristocracy when led by benevolent rulers, but it might also devolve into tyranny or oligarchy, subscribing to the adage that absolute power can corrupt absolutely. This same principle extends to financial governance. To harness the potential of decentralized governance for the common good, it’s imperative to adopt a human-centric approach that enhances global financial literacy, empowering individuals to actively participate in digital-age financial governance. Such decentralization can be realized through the collaborative efforts of DeFi, leveraging advanced technology, disintermediation, and cross-border engagements, and CeFi, utilizing judicious oversight, networking hubs, and a gold standard of efficiency [2].

Figure 8.

The future of financial governance: Ends or means? Note: This figure illustrates the distinction between centralized and decentralized approaches in governance design. It highlights the ultimate goal of achieving common goods, drawing upon insights from ancient Greek philosophy.

To wrap up, instead of framing the ascent of DeFi as a threat rendering traditional finance redundant, it’s more insightful to envision it as a collaborative frontier. Marrying the trust and solidity of CeFi with the dynamism and inclusivity of DeFi can herald a composite financial paradigm. Such a system would not only elevate global financial literacy but also pave the way for an inclusive financial future for all. As we move forward, it’s imperative to ensure that our pursuit of technological innovation remains anchored in human-centric values, embracing the best of both worlds to achieve financial prosperity for everyone.

Acknowledgments

Luyao Zhang is supported by the National Science Foundation China on the project entitled “Trust Mechanism Design on Blockchain: An Interdisciplinary Approach of Game Theory, Reinforcement Learning, and Human-AI Interactions (Grant No. 12201266).”

Notes/thanks/other declarations

I would like to acknowledge the pioneering scholars in financial technologies, including Profs. Campbell Harvey, Lin William Cong, and Hanna Halaburda, for their invaluable inspiration.

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Notes

  • https://coinmarketcap.com/alexandria/glossary/blockchain-trilemma
  • The Gini coefficient, denoted as G, is a measure of statistical dispersion representing the inequality in a distribution. It ranges between 0 and 1, where 0 represents perfect equality (everyone has the same income) and 1 represents perfect inequality (one person has all the income, and all others have none). Given a population with n individuals and their incomes sorted in non-decreasing order x1,x2,…,xn, the Gini coefficient is defined as: G=∑i=1n2i−n−1xin∑i=1nxi However, it’s important to note that this formula assumes non-negative and nonzero values for xi, and the incomes are sorted in non-decreasing order.
  • The replicable code for calculating Gini coefficient is on GitHub at: https://github.com/sunshineluyao/finance.
  • For example, if all citizens can securely safeguard the private keys to their financial assets, they would not need to depend on custodial institutions for recovery when their keys are lost or stolen due to financial crimes.

Written By

Luyao Zhang

Submitted: 11 September 2023 Reviewed: 16 September 2023 Published: 17 November 2023

© The Author(s). Licensee IntechOpen. This chapter is distributed under the terms of the Creative Commons Attribution 3.0 License, which permits unrestricted use, distribution, and reproduction in any medium, provided the original work is properly cited.