Does crypto have the same problems as TradFi?

The recent market decline will go down as one of the defining events in crypto history. By exposing the systemic risks that had been bubbling inside the crypto lending system, the downturn has called into question crypto’s longevity and legitimacy. The surrendered positions of centralized lenders such as Celsius Network and Voyager were exposed as market conditions changed, culminating in their eventual collapse. The ongoing credit and liquidity crisis highlighted the vulnerability of centralized finance and the promise of decentralized finance (DeFi) to fill this gap. This questions whether these two conflicting paradigms can co-exist in crypto.

DeFi has proven itself as a viable financial alternative that remains largely unscathed from contagion risk and still represents a market capitalization of US$47 billion, according to current data. It has the potential to grow further and earn its place in global finance, but for that to happen effectively, it needs to develop working relationships with CeFi and TradFi.

How did we get here?

The rise of Bitcoin, Ethereum and other alternative decentralized monetary solutions aimed to disrupt the traditional financial system responsible for the 2008 financial crisis and create a new one. But more than 13 years later, we see the birth of similar problems of systemic risk and excessive credit in crypto (specifically in centralized finance, or CeFi). CeFi crypto-lending platforms have adopted similar behavior to their traditional counterparts – lending and borrowing to investors without implementing proper credit risk management, aided by the absence of regulation in digital assets.

Until the recent collapse, Celsius’ business model was founded on two premises – the promise of depositor returns as high as 18% and borrowing crypto from customers and DeFi protocols to sustain its lending habits. This raised concerns that the returns were the result of speculative gains, which undermines the sustainability of such returns.

Concealed under the guise of the recent crypto bull market and highly expansionary monetary policy, this business model downplayed the danger of unregulated positions with survival. Conversely, when market conditions and subsequent returns began to reverse, these concentrated outsized positions of CeFi platforms were quickly exposed.

The current crypto crisis has called into question the legitimacy and longevity of crypto lending in its current state. Regulators are taking a tough stance on those who triggered the contagion and have accelerated legislative discussions on industry-wide bills. Whether this is pure optics or a genuine effort that will result in stricter compliance is up for debate, but it underscores the complexity of merging the essence of decentralization in crypto within existing paradigms. However, the upside here is that regulators chose the path of increased regulation rather than an outright ban, suggesting that crypto lending – and DeFi lending in particular – has proven its significant market scale and resilience to market shocks.

CeFi-DeFi is disconnected

There are also broader implications from the downturn, particularly the distorting perceptions between CeFi and DeFi, which have strained the industry and could affect the evolution of crypto and its lending structures going forward. Many in the community do not seem to agree on what constitutes CeFi and what constitutes DeFi.

CeFi is the centralized coordination of economic activity for traditional institutions and individuals. This involves gathering resources and redirecting them according to the institution’s discretion and internal guidelines. In commercial terms, the purpose of this is to facilitate lending/loans by assessing both subjective and objective characteristics while ensuring full privacy.

DeFi is the decentralization of lending and borrowing, where credit parameters are based on a set of rules defined in smart contracts. The purpose is to provide full transparency of the flow of funds for existing and potential users to consider. A characteristic of DeFi lending protocols is that they rely on over-security due to the anonymous and trustless nature of the borrowers.

Both financial systems each have their own function and play an important role in the design of crypto. CeFi enables investment opportunities from traditional markets while DeFi offers ground-breaking innovative solutions that offer an alternative paradigm for deposits, loans and new distribution channels to traditional finance (TradFi). The development of both will be crucial to how we navigate through this bear market and beyond.

How might crypto lending evolve?

Following the shock waves that have been felt across the industry, retail sentiment towards crypto is currently low, with current lending and borrowing models at the heart of this issue. Given that crypto already has an unprecedented trust problem, how can we begin to rebuild trust in crypto and strengthen our lending products that were created on the promise of providing a better and safer experience for users?

DeFi protocols provide forward-looking solutions for self-regulated lending by combining the use of smart contracts and the immutability of blockchains with the use of proven TradFi models. These solutions include risk management, asset allocation and credit assessment, and work to protect private and institutional investors while maintaining the integrity of lending and borrowing.

One such case study of this shift is the introduction of know-your-customer, know-your-business and anti-money laundering standards, which require institutions to undergo administrative onboarding procedures before being placed on a participating whitelist. These standards ensure that institutions undergo compliance checks, record relevant transactions and use of proceeds, and provide a regulatory structure that allows DeFi projects to cooperate with financial and legal authorities.

Although these measures originate from TradFi, they should not be dismissed as irrelevant to DeFi and crypto. Just as current CeFi crypto lending models have been imported from TradFi, these measures have implications for the wider ecosystem and the growth of the financial market as a whole.

Basic incompatibilities

Although DeFi has shown remarkable progress given its short history with much room for improvement, it faces some fundamental challenges, some of which are characteristic of its commitment to decentralization.

An obvious fundamental challenge is that DeFi suffers from a lack of a unified approach to finance. Risk management concepts and self-regulatory standards are few and far between among DeFi projects, underscoring the urgent need to unlock capital efficiency. This has partially prevented mass institutional adoption due to a lack of standardized models for compliance. One approach is through unsecured lending while maintaining anonymity on the blockchain.

In addition to traditional market risk, DeFi also suffers from an additional layer of smart contracts and resulting infrastructure risk that may be too technical for retail users to appreciate. This is important as poorly designed DeFi protocols are more vulnerable to risks of malicious attacks, hacks and exploits.

There is no doubt that DeFi is a disruptive force – by nature this is part of the mandate and this is evident on the regulatory and compliance front and the challenges that exist there. But to convert the promise and value of crypto into action plans, we need to take advantage of the opportunities that lie ahead and find existing synergies to align with. The disruption creates extraordinary operational improvements and financial incentives for builders, and it also opens up new arenas and channels for discussion and negotiations with regulators because technological developments are superior to the existing financial system. This is something the regulators are and should be keen to learn and understand.

Looking for a hybrid model

A future where a hybrid model can coexist is much more likely and sustainable, rather than one paradigm replacing another. Basic differences aside, there are several layers of complexity that come with DeFi. It is a system that requires users to take full responsibility for their finances and financial decisions, and acquire a certain level of financial and technical expertise to engage with. The effort and time required to achieve this and learn about new DeFi protocols and features is not for everyone, which is why there will always be a market for CeFi.

While crypto-natives promote the idea of ​​trust in technology and mathematics behind the construction, the policy-by-design type of concept, many still choose to trust real-life authoritative figures and relationships. Retail finance has always first been a service industry before a financial industry, and this will always be true when it comes to serving the tailored needs of certain institutions and individuals. All these problems make the full adoption of DeFi instead of CeFi incompatible and even unnecessary.

Conclusion

CeFi’s advantages lie in its intuitiveness and ability to act as a seamless entry point for users. The established position and anchoring in TradFi has been crucial in attracting institutional investment and stimulating the growth of crypto. DeFi’s benefits lie in understanding blockchain and smart contract technologies, using them to design unique solutions that have changed the way we do finance.

The last bear market has given the industry an opportunity to reflect and reset, and we are at a critical juncture where new solutions are necessary. Now is the time to develop a crypto-economy where DeFi and CeFi can co-exist as a hybrid model, each operating in functionalities with core advantages to strengthen each other’s weaknesses. In order to usher in a new era of lending that ensures not only longevity and sustainability, it must avoid repeating past mistakes of existing systems, close loopholes and find a better middle ground between DeFi and TradFi.