DEFI vs CEFI LENDING

Introduction

Traditional finance, also known as centralized finance (CeFi), often sounds strange to most people, as they are mostly unaware of the binding agreements governing goods and services. An average trader in an open market in Hong Kong or California lacks proper knowledge of laws or agreements governing the sale of his product. To him, he engages in daily business and has no idea he is part of an active global financial ecosystem. If that trader needs a loan to fund his business, he will have to apply at the bank or state’s financial institution for the loan with hectic documentation and a lengthy loan-application process.

Decentralized finance (DeFi), on the other hand, operates in a slightly different and better fashion. Imagine a financial system where you (based in Singapore) can give an uncollateralized loan of $100,000 using blockchain technology to a trusted company based in Canada with an interest rate of 7% per loan term, and this company pays back the loan with interest as agreed, in a seamless fashion and without any form of unnecessary documentation or loan processing. It is incredible. That is what decentralized finance is.

Here’s a concise understanding of CeFi and DeFi lending.

What is CeFi lending and how does it work?

Centralized finance, which is the world’s oldest method of conducting business or transacting, is linked to more traditional financial services. Although it can be confusing, the term “centralized finance” can also be used to describe digital asset platforms and exchanges with a traditional financial structure and mode of operation. With centralized finance, investors and corporations can earn yield or profits on their investments. As an investor with $100,000 saved cash, you can earn an agreed yield or make profits on your money via a centralized financial institution without having to own a revenue-generating business.

With $100,000 in cash, you can walk into a bank or financial institution and agree on terms to lend out your cash in return for an agreed yield or profit within a fixed timeline. This makes you a lender who will earn a yield on $100,000 after an agreed time. This $100,000 is given out by the bank or financial institution to a verified borrower who’ll pay back the loan within the agreed time.

On second thought, you have a real estate property worth $300,000 but you are in need of $100,000 in cash to scale your business. You apply for the loan, using your real estate property as collateral against the loan via a financial institution. The process seems smooth, right? Yes, it’s smooth, but some of this lending processing requires customer verification with lots of requirements, numerous signatures, long processing and can take weeks or even months.

Now let’s analyze this.

If you live in China, you can’t process a loan from a bank or financial institution in Hungary because you do not operate your business there and/or you’re not a citizen of Hungary. There are multiple requirements and agreements to be completed before getting involved in centralized finance lending. Ask yourself this, what happens if that bank or financial institution collapses? Your money is gone. With the increasing global inflation crisis, centralized financial institutions are under severe pressure, with many already declaring bankruptcy and collapsing. I’m sure you don’t want your money gone in the wind.

Don’t forget that, as earlier stated, digital asset platforms and exchanges with a traditional financial structure and mode of operation also fall into this category of centralized finance lending. This means that you can use your digital assets like Bitcoin, Ethereum, and Polygon to get a loan. Remember that the CeFi lending process is similar to that of traditional financial institutions and that during the lending period, the centralized digital asset platform or financial institution will have complete custody of your digital assets. Despite the fact that funds are kept on the exchange, they are kept out of users’ control and are vulnerable to threats if the exchange’s security measures are breached. Centralized exchanges have thus been the target of numerous security attacks. Binance, Coinbase, Celsius, Fidelity, CME, and Kraken are a few examples of CeFi companies that carry out CeFi lending.

What is DeFi lending and how does it work?

Computers have disrupted nearly every industry since their inception, and every new tech-driven and/or computer-based innovation builds on the previous one, producing sophisticated digital products and services. The blockchain and digital assets industry aims to disrupt the traditional systems of the world, changing archaic methods and systems to trustless, technology-driven, intelligent systems. The advancement of blockchain technology is currently disrupting many industries; from the finance industry to gaming, infrastructure, prediction markets, voting, insurance, oracles, analytics, development, marketplace, and most recently art via NFTs. The finance industry is the most recent industry to face massive disruption following the advent of DeFi (Decentralized Finance).

Since its introduction in 2017, Decentralized finance has not just gained global traction but has also arguably disrupted the financial industry with its unique features of programmability, immutability, interoperability, and transparency. Decentralized finance simply refers to digital assets, smart financial contracts, financial protocols, financial software, and decentralized applications based on blockchain technology, built to leverage the immutable, programmable, interoperable, transparent, and trustless features of blockchain to reshape finance into a system open to everyone without the need for central authorities like banks, financial intermediaries, and remittance/ cross border settlement institutions. DeFi aims to provide an open-source, transparent, and permissionless financial service environment. Smart contracts are the foundation layer for decentralized finance as they are self-executing and do not require intermediary oversight.

In the last paragraph, notice how I emphasized immutability, transparency, and trust. If there’s anything you should understand today, it should be that: although DeFi and CeFi seem similar, DeFi provides more features with lots of efficiency in financial transactions than CeFi.

As highlighted in the first paragraph of this article, decentralized finance allows two or more individuals or businesses to engage in financial transactions in an immutable, transparent and trustless fashion from any location in the world. All transactions happen on a blockchain, with every record immutable. I’ll explain it with this illustration below:

DeFi Lender A: Cash available to loan out: $100,000, He resides in New York and seeks to earn a 5% annualized yield on his cash, goes to a DeFi platform like Compound and deposits his cash in form of a digital asset like USDT or DAI to a borrower.

DeFi Borrower A: Digital asset worth $100,000 in Ethereum, resides in Taiwan and seeks to take a loan of $100,000 with a repayment plan of 5% annualized yield after 7 months, goes to Compound and also requests for this loan.

What happens is this, Compound serves as a user interface where the DeFi lender A and borrower A meet to execute this transaction on the blockchain, in a transparent way and without the rigors of traditional lending. Approximately 66% of the 1.7 billion people without bank accounts, according to the World Bank, also have a mobile phone. Decentralized finance aims to connect with these individuals in order to advance financial inclusion. The idea is to come up with a fairer version of traditional financial services, available online.

DeFi vs CeFi lending

While DeFi provides financial lending services without intermediaries via smart contracts, centralized financial institutions operate as transaction guarantors in the current financial world. DeFi lending simply replaces the financial institution with a smart contract hence reducing the risk of loss of financial assets by a hack, centralized malware, human error, centralized point of failure and more.

Also, decentralized finance lending provides speed of transactions, transparency, self-custody of assets, non-stop business transactions, low transaction fees, and no mandatory user verification. Decentralized finance lending continues to rely significantly on the long-standing traditional/ centralized financial system.

In summary, DeFi and CeFi lending have the same objective which is to provide high-quality financial goods and services to customers while also powering the global economy. Both CeFi and DeFi lending have their own drawback but integrating and adopting both features in finance is key to enhancing and reinventing global finance.

Thanks for reading.