Breaking the Illusion of Financial Custody
September 15, 2008. The GFC (Global Financial Crisis) broke out with the collapse of the US housing market. The crisis caused a severe contraction in liquidity and precipitated the Great Recession (which lasted two years, 2007–09). Most economists agree that reduction in the federal funds rate and hence lending rate of banks is the causality.
In the 2000s, investors looking for a low-risk, high return investment invested in the US housing market. The returns would be higher than Treasury bonds, which offered minimal interest. Global investors bought mortgage-backed securities from financial institutions. Mortgage-based securities are mortgages bundled up and sold together. These felt like a safe bet as real estate prices rose. Lenders could sell defaulters’ houses for more money. Credit rating agencies gave these securities the AAA rating (the best rating) and advertised these as safe investments to investors.
When the demand for these securities increased, lenders loosened their standards to make loans to people with low income and poor credit. These are called sub-prime mortgages. Credit rating agencies continued pointing to historical data to substantiate their safety and investors continued to pour money in.
The prices of houses shot up rapidly and steeply. The real estate prices increased beyond their intrinsic value, creating a housing bubble. Borrowers were defaulting, which put more houses on sale. Global investors stopped investing in it and lenders got stuck with bad loans. Bankruptcy hit the big players too.
Eventually, the bubble burst and brought down the economy. Unemployment was at an all-time high. The impact is still prevalent — increased levels of student debt and diminished job prospects among young adults. The main culprit — a centralized financial industry, which controlled the market.
Traditional finance (TradFi) runs on a central authority regulating money. While it provides services like savings, loans, and other transactions, it is subject to the bias of policymakers, bankers, and the big players. If the centralized authority goes down, it takes everything down with it.
Enter Web3, Blockchain, and the world of cryptocurrency — creating a:
- Decentralized (without a central authority regulating it — not organization or government-regulated)
- Permissionless (does not require authorization)
- Trustless system (a third party does not have to be trusted).
Participants of the system are the sole decision-makers and custodians of their assets. Transactions are public, with lower interests and higher returns. They can be made round the clock, unlike transactions with fiat currencies that depend on the bank’s whims and policies.
The Inception of CeFi
The subprime mortgage crisis paved way for a transparent trading system — Decentralized Finance (DeFi). To begin with, managing finances using DeFi can seem challenging and complicated, particularly for folks without much technical knowledge. CeFi platforms like BlockFi and Nexo step into the picture by bridging TradFi with DeFi. CeFi, or Centralized Finance, is an organized financial system. One can apply for loans or earn interest on cryptocurrency through a centralized establishment. It uses ‘traditional’ financial tools to help crypto reach everyone!
‘Harvesting’ yields using CeFi
Centralized means that all crypto trading must happen through a central exchange. Users create accounts to send and receive tokens. The centralized companies store deposited funds in wallets and use them for lending, borrowing, and margin trading, worldwide! They offer more accessible means to take a cash loan.
The exchange is entrusted with the private keys of your assets to make the desired transactions. Some or all crypto holdings are loaned to earn interest. A portion of this interest is passed to the crypto user, much like a traditional bank.
I do, CeFi.
But why choose CeFi over TradFi, if both have a central authority? CeFi’s seamless conversion of fiat currency to cryptocurrency and vice-versa sets it apart. Moreover, it’s easy to exchange multiple cryptocurrencies using CeFi — it is interoperable. Bitcoin can easily be converted to Ether and vice-versa, or fiat currency to Bitcoin and vice-versa. The higher returns and customer service don’t hurt either!
Why not CeFi?
CeFi has had a stronghold over much of the trading industry since its inception. But, a central authority regulates it, which means users do not have access to their wallets. The authority possesses the keys to the user-owned assets and facilitates the transactions.
Moreover, the exchange decides which cryptocurrencies can be traded on the platform. It also levies a charge for providing the service, that is, it can be costly to the end-user. There is a lack of transparency.
A substantial risk of a centralized system is the potential for hacking. CeFi users provide sensitive data in addition to money. A hack could jeopardize their privacy and money.
The Trump Card: DeFi
DeFi, over the past few years, has given CeFi tough competition in the market. With smart contracts, DeFi makes transactions fast, secure, transparent, and offers full custody of one’s money.
At the heart of DeFi is to remove intermediaries and become community-owned. Everyone has a say in how the application should be run. Users remain the sole owners of their assets and can examine the rules that govern the operation of financial assets. Moreover, the hassles of KYC, unlike those in CeFi, are absent! It protects user anonymity, unlike CeFi, where the central exchange requires personal data for security.
With CeFi, one has to place complete faith in the centralized authority. DeFi, however, is a trustless system! One does not have to trust anyone to make a transaction or exchange — it is a publicly verifiable system.
The best part about DeFi, you ask? Anyone with a decent internet connection and computer can dive into DeFi to build, exchange or invest in DeFi goods!
We are building a decentralized finance app built on the Ethereum layer and Aave protocol. It generates up to 10% of yield on fiat currency with secure, fast, and free payments.
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References:
- coinbase.com/learn/crypto-basics/what-is-cefi
- https://www.analyticsinsight.net/defi-vs-cefi-exploring-the-differences/
- cybavo.com/glossary/cefi/
- https://blog.liquid.com/defi-vs-cefi
- https://www.analyticssteps.com/blogs/introduction-centralized-finance-cefi
- https://www.hodlnaut.com/academy/what-is-centralized-finance-cefi
- https://cointelegraph.com/defi-101/defi-vs-cefi-comparing-decentralized-to-centralized-finance
