Would you rather the decisions about your money be made by an institution, composed of individuals susceptible to fear and greed, or a set of pre-established rules and protocols?
There is not necessarily a right or wrong answer to that question, but the question itself is a fundamental reflection any investor should make. It is also a reflection at the centre of the debate on whether DeFi (decentralised finance) is superior to CeFi (centralised finance) or TradFi (traditional finance).
Let's go back a few steps: the fact that you can even make that reflection and get any kind of choice in the matter is because DeFi exists.
Spoiler (but not really, since we're not exactly being subtle): investing in crypto through DeFi has many advantages compared to CeFi or TradFi. But don't just take our word for it – there are a number of factors and data that support this argument.
In order to understand them, let's first have a quick pass at what exactly DeFi is, and how it differs from CeFi and TradFi.
What is DeFi?
DeFi is an acronym for decentralised finance. It is a blockchain-based system through which institutions are removed as the middleman during financial transactions – in other words, the system is not controlled by a player nor does it use a middleman, like a bank.
Rather, it is built upon distributed ledgers and protocols that ensure anyone can use it, without the need for interference from institutions.
By eliminating those intermediaries, DeFi allows users – people, but also businesses – to conduct transactions (such as sending, receiving, investing and more) transparently without all those third parties making the rules.
That is not to say, of course, there aren't rules in place. In fact, DeFi makes those rules even more transparent and enforceable. Because of the way the blockchain is built, you can trust that rules and protocols will be followed.
And what is CeFi and TradFi?
If decentralised finance is the one without an intermediate at the helm, then naturally centralised finance is exactly the opposite, right? Well, yes – but there are some particularities that differ CeFi from TradFi.
TradFi is a no brainer: it is the financial system as you know it, with legislative regulators providing governance, and banks and other financial institutions serving as the guardians through which transactions need to be made.
CeFi, on the other hand, does share technology similarities with DeFi. CeFi rotates around the blockchain and crypto universe without actually putting its toe in the water. The core idea behind it is to allow people the possibility to invest in crypto through centralised systems.
For instance: on DeFi, your assets stay in a non-custodial wallet – that means you, the user, are the only one with any kind of control over them, since you hold your own private keys to a specific blockchain network.
In CeFi, on the other hand, you might go on a platform that operates in the crypto universe but has its own set of rules. If bad practices are put in place, for instance, and the business goes under, so do your assets.
That doesn't mean you can't lose money in DeFi, far from it – crypto, like many other investments, can be risky. The whole point is that the ecosystem won't be liable to people or companies going rogue, because the decentralised system does not allow for that to happen. In DeFi, these rules are hard-coded.
DeFi x CeFi: which one is better?
That brings us back to the original question: who do you want making the calls? An institution (or group of institutions) that is moved by their own interests (and can decide to bend or even break the rules if it suits them), or a system that is code-wired to follow those rules?
Let's look back to a recent example to understand what changing the rules means in concrete terms. In 2022, the whole crypto universe suffered many drops in market value, in what has commonly been referred to as a "crypto winter". Those moments can make or break projects, and showed just how vulnerable CeFi can be when compared to DeFi.
Centralised lending platforms: how CeFi failed users
Crypto winters are typically marked by extreme volatility, drops in liquidity and sell contagion. They also have the tendency to show vulnerabilities that are often hidden from plain sight – and that is exactly what has happened in CeFi.
In 2022, many centralised lending firms went into insolvency due to classic over-leveraging and lowering of borrower’s prerequisites – like lower collateral requirements and different deals for different players.
At this time, players in this market – such as BlockFi and Voyager – were found to be degrading lending standards. In other words, they were bending their lending rules in order to attract more capital, disregarding important quality checks to whom they were lending and not fulfilling responsible collateral requirements.
BlockFi, for instance, had approximately US$600 Million in loans not covered by collateral, according to their own Q2 transparency report. They loaned out US$1.8 billion, but only had about two thirds of that in collateral.
As Warren Buffet once famously said, "It’s only when the tide goes out that you learn who has been swimming naked." As the crypto market started going down in value, the very predictable next step was a sort of bank run: people saw prices dropping and rushed to get their money back before they went even lower.
But because of all of that rule bending, centralised lending firms were simply not solvent enough. Their solution? They froze their accounts – a.k.a., people couldn't get their money out.
Where DeFi comes in
In DeFi, a deal is code-wired so it cannot be broken - no matter who the counter party is, the amount being invested or any prior reputation.
Case in point: both Voyager and BlockFi lent to all sorts of projects, companies and people. That also included lending on DeFi protocols – and as things started to take a downturn, those platforms were the first ones to get paid back.
The "a deal is code-wired" logic of DeFi is exactly what protected these protocols and the people who invested in them.
You can't simply freeze accounts in DeFi, because the system is code-wired to enforce the deal. So, while centralised lending firms started preventing people from accessing their money by freezing user accounts, they were unable to do so with DeFi protocols.
The result is that DeFi protocols, such as Aave and Compound, were the very first to get paid when things started going down. In fact, decentralised lending protocols have continued to work without a glitch through the volatility.
Impartiality has actually protected these projects from over-leveraging, and everything worked as initially set, even in extreme market conditions.
Both crypto winters and market frenzies have come and gone over the last decade, and decentralised exchanges remain trading non-stop through them. Those moments offer lots of challenges, but the system and rules remain intact, and users are never prevented from taking part in transactions if they wish to do so.
What are the advantages of DeFi?
We've covered some of the issues posed by CeFi and TradFi (specially in extreme market conditions), but what are the actual advantages of DeFi as opposed to them – in other words, what does in fact make DeFi superior?
Some of the key factors that play a part in this are trust, capacity to operate and composability.
1. Trust in DeFi
There is a lot to be said about how DeFi works towards the democratisation of the financial system, allowing people to have full ownership over their own assets, without intermediates that could potentially not have their best interests at heart. But none of that would work if people couldn't trust the DeFi system.
The whole point of DeFi is that you don't have to choose to trust it: it is built in such a way that trust is intrinsic, supported by some key pillars:
- Impartiality: decentralisation means there is not a single powerful player (or a small group of powerful players) at the helm. Centralisation makes room for those players to put their interest in front of users – when the going gets tough, they will protect the institution rather than the users, the exact opposite of what happens in DeFi.
- Protection: DeFi is protected by code. That essentially means DeFi abides by a set of ground rules and protocols that cannot be changed just because an institution decided it was the best path. The way DeFi is constructed, the rules are clear, and no one has the ability to change it mid-game. Centralised finance is protected by intentions of the people running the institutions, and more often than we’d like, that comes into conflict with the users.
- Transparency: DeFi is transparent at its core. The blockchain ensures users can track the entire history of transactions if they choose to do it, and defrauding the system is a much harder job than it is in CeFi and TradFi.
2. Operational resilience
As we've covered in length, DeFi is much more capable to operate in extreme conditions than centralised and traditional finance.
You don't need to dig too deep into TradFi to see the gaps – throughout history there have been no shortage of famous near-collapses in which the entire system needed to break the rules in order to survive. Does the "Great Depression" or "Subprime Mortgage Crisis" ring a bell?
Data also shows CeFi has a much lower capacity to operate in times of high volatility, often losing customers’ funds due to poor risk management.
Some of the consequences were the implementation of fees for customers to make withdrawals, freezing trades, bail-outs and bankruptcy.
At the same time, blue-chip DeFi protocols managed to pull through a major sell-off, keeping their operations running regularly, never freezing transactions and without losing customer funds. That was accomplished due to not compromising on their risk management standards and core business practices
3. DeFi composability
Composability is a major upside of DeFi. It basically means decentralised applications (dApps, as they are called) can be stacked together as if they were Lego blocks to create other assets, execute more complex orders and facilitate innovation.
Consider how DeFi was created: at the beginning, there was the Ethereum blockchain and ETH. From that, the first exchanges were created, and soon the lending and borrowing protocols.
All of those technologies were made possible because of the decentralised nature of the system. If it were centralised, it would be up to the companies at the helm to decide whether to open source a codebase and allow others to build on top of it. Centralised institutions are a ripe place for conflicts of interest and not a great birthbed for innovation.
DeFi's composability capacity is essentially a driving force to innovative financial technology, creating new and more creative possibilities for people to interact in the system.
So, is DeFi superior after all?
DeFi is a more trustworthy, transparent and secure system than centralised and traditional finance. Not only that, it is built in a way that facilitates innovation in the financial system.
DeFi is still a nascent sector, a fraction of the size of traditional finance. One of the best ways to earn dependable returns on your stablecoin is to deposit it in a yield-generating DeFi product. That’s why we’re building Savings Vaults for investors like you.
