DeFi vs CeFi Lending: Pros & Cons

Before the availability of crypto lending to investors, individuals typically had two options for capitalizing on their investments: one, the long-term holding of coins and tokens; and two, the short-term trading in and out of volatile markets. Before the availability of crypto lending, however, investors now have a third option: crypto lending.

As the cryptocurrency industry matured, other services were developed and provided investors with further options. As the use of decentralized finance (DeFi) became more widespread, more conventional businesses, such as banking, entered the cryptocurrency market.

Businesses were able to provide these financial services to cryptocurrency consumers all around the world by using cryptocurrencies such as Ethereum that support smart contracts. One of the most common applications of distributed finance, or DeFi, is the provision of lending and borrowing services to owners of cryptocurrency.

DeFi banking services provide a yield to holders of cryptocurrency, comparable to the rate that a traditional bank provides to customers who deposit cash. Users have the ability to earn interest on their money by depositing crypto tokens into a smart contract and receiving the interest in the form of cryptocurrency, which is often the case.

The fact that these smart contract lending methods give a return that is often greater than that offered by regular banks has piqued the interest of a great number of crypto investors. The elimination of the need for a central party to support the lending and borrowing functions brought about by the provision of banking services by DeFi enables an effective reduction in costs and an increase in returns for the participants.

Using smart contracts' capabilities, DeFi lending can make these services available through blockchain technology.

DeFi Advantages and Disadvantages

The following are some of the advantages that may be gained by utilizing a DeFi lending protocol rather than going to a conventional bank:

• Anonymity

• Decentralization

• An excessive amount of borrowing secured by collateral

• Global accessibility

As the use of the service became more widespread, an increasing number of companies entered the market providing loan and borrowing services that DeFi drove. The number of users on platforms like as Aave, MakerDAO, Compound, and Solend has increased. Currently, a total of $65 billion is secured inside the DeFi lending systems.

If a user wants to use the DeFi banking system, they will be required to interact directly with the protocol. This involves transferring their cryptocurrency to the smart contract as well as managing the investment themselves.

The creators of cryptocurrencies have been concentrating on ways to improve the user experience while engaging with this technology, but despite these efforts, the technology still poses a special difficulty for investors. Because they are unable to utilize a third-party service while communicating with a DeFi protocol, many users who have crypto assets and wish to earn yield on their positions are turned off by the protocol.

CeFi as Bridge Between DeFi and TradFi

Because of these technical limitations, businesspeople saw an opportunity to build a "middleman." Well-known platforms such as BlockFi, Celsius, and Voyager, amongst others, started providing "DeFi as a service," which refers to platforms that merely need users to deposit their coins with a central organization in order to produce yield.

These businesses, which are often referred to as "CeFi" (centralized finance) by the market, expanded extremely quickly due to the fact that they were relatively easy to use and provided beginner consumers with a considerably less complicated experience. They immediately started advertising their services and saw a rapid increase in the amount of assets they managed.

The user experience provided by CeFi is far more straightforward, and consumers only need a single account to get started earning an income on their cryptocurrency holdings. After that, these cryptocurrency organizations would lend the money out directly to borrowers, managing cryptocurrency transfers, underwriting, and other related tasks. The users of the CeFi platforms would need to do nothing more than deposit their money before receiving a monthly distribution of their earnings.

When users interact with DeFi, they simply have to believe that the smart contract is constructed safely. This is a significant distinction between DeFi and CeFi, and it's one that's vital to keep in mind. Peer-to-peer lending, which is what DeFi is, doesn't need the same level of confidence that doing business with a commercial finance organization requires.

There are many of the same hazards associated with conventional banking present whenever a customer makes a deposit of money to a CeFi platform. These risks include the following:

• Continuity of operation of the CeFi platform

• Standards for underwriting that are adequate

• Achieving the required level of collateralization

• Putting your faith in the loan decisions made by the CeFi platform

When a user opts to use a DeFi platform directly, they are expected to have a deeper technical understanding than when using a traditional Wi-Fi network. It is expected of the investor that they would take a far more active role in managing their own assets. The trustless and decentralized nature of DeFi, along with the ability to audit the underlying smart contract code, helps instill a greater sense of confidence in the financial services provided.

CeFi platforms, on the other hand, transfer the responsibility of overcoming technical difficulties from the depositor to the institution, but they still need the depositor to have faith in the lending policies of the central party.

CeFi Warning Signs Erupt

In 2020 and 2021, there was a significant increase in the number of CeFi platforms. The concept of "decentralized finance as a service" gained momentum, and numerous cloud-based financial services platforms successfully managed billions of dollars on their clients' behalf.

The cash of customers on the popular CeFi platforms Celsius Network and Voyager Digital were frozen in the summer of 2022. These online marketplaces did not adhere to appropriate lending norms, resulting in the businesses losing the money of many of its users.

This was caused in part by extraordinary market circumstances (the market valuation of cryptocurrencies has dropped by over 60 percent from its all-time high) and a lack of appropriate risk prevention measures. Since then, both Celsius and Voyager have announced that they would be filing for bankruptcy, which will result in depositors having their accounts locked and a reduced capacity to withdraw their money from the platforms.

Issues around regulatory compliance are also impacting these centralized lending systems. The United States has filed a lawsuit against the popular site BlockFi. The Securities and Exchange Commission (SEC) levied a punishment against the company because it failed to register with the SEC in the required manner. BlockFi has agreed to pay fines totaling $100 million, so the company may no longer sell yield to new customers. It is in the process of applying for the necessary permits and is hoping that it will be able to provide the yield to consumers in the future after receiving SEC permission.

However, there have been no reported problems with the operation of the DeFi systems. The cryptocurrency platforms Aave and MakerDAO, amongst others, did not have the same challenges as the CeFi platforms, and they are now accessible to consumers.

DeFi or CeFi: Which should advisors and clients choose?

Investors are put in a tough position since they must either acquire the technical skills necessary to deal with decentralized finance platforms on their own or trust a centralized finance platform with their money.

It's possible that a DeFi platform, which uses open-source smart contracts, has a steeper learning curve than a CeFi platform, which is much simpler. However, despite the challenging market circumstances, the permissionless and trustless technologies that DeFi employs have shown their viability as a means for investors to produce revenue from their cryptocurrency assets.

In order to be a good counselor, you need to have a solid understanding of the dangers presented by both DeFi and CeFi, as well as the myriad of services that revolve around both technologies.

It is crucial for financial advisers to understand the risks and issues connected with both ends of the spectrum – dealing directly with a DeFi platform and trusting a CeFi platform – in the event that clients show an interest in earning a return on their crypto investments.

It's possible that peer-to-peer lending services could soon be recognized as legitimate enterprises, complete with investor safeguards and effective risk management procedures. However, unless appropriate safeguards are implemented, knowing how to interface with DeFi systems directly provides a novel and more open approach to gaining access to these financial services.

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DISCLAIMER: None of this is financial advice. This newsletter is strictly educational and is not investment advice or a solicitation to buy or sell any assets or to make any financial decisions. Please be careful and do your own research.