The recent market downturn will go down as one of the defining events in the history of crypto. By revealing the systemic risks that had been bubbling inside the crypto lending system, the downturn has called into question crypto’s longevity and legitimacy. The overleveraged positions of centralized lenders such as Celsius Network and Voyager were exposed when market conditions shifted, culminating in their ultimate collapse. The ongoing credit and liquidity crisis highlighted the vulnerability of centralized finance and the promise of decentralized finance (DeFi) to fulfil this gap. This calls into question whether these two opposing paradigms could co-exist within crypto.
DeFi has proven itself as a viable financial alternative that remains largely unscathed from any contagion risk and still represents a US$47 billion market cap, according to current data. It has the potential to grow further and carve its place within global finance, but for that to happen effectively, it needs to develop collaborative relationships with CeFi and TradFi.
How did we get here?
The emergence of Bitcoin, Ethereum, and other alternative decentralized monetary solutions aimed to disrupt the traditional financial system that was responsible for the 2008 Financial Crisis and create a new one. But more than 13 years later, we are seeing the birth of similar issues of systemic risk and overleveraged credit in crypto (specifically, in centralized finance, or CeFi). CeFi crypto lending platforms have adopted similar behaviors as their traditional counterparts — lending and borrowing to investors without the implementation of proper credit risk management, aided by the absence of regulation in digital assets.
Until its recent collapse, Celsius’ business model was founded on two premises — the promise of depositors’ yields as high as 18% and the borrowing of crypto from its customers and DeFi protocols to maintain its lending habits. This raised concerns that the yields were a result of speculative gains, undermining the sustainability of such yields.
Hidden under the cover of the last crypto bull market and highly expansionary monetary policy, this business model downplayed the danger of unregulated overleveraged positions. Conversely, when market conditions and subsequent yields began to reverse, these concentrated overleveraged 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 asserting a tough stance on those who sparked the contagion and have accelerated legislative discussions on industry-wide bills. Whether this is mere optics or a genuine effort that will result in more stringent regulatory compliance is up for debate, but it underscores the complexity of merging the essence of decentralization in crypto within existing paradigms. The silver lining here, though, is that regulators chose the path of increasing regulations rather than an outright ban, suggesting that crypto lending — and especially DeFi lending — has proven its substantial market scale and resilience to market shocks.
The CeFi-DeFi disconnect
There are also wider implications from the downturn, notably the distorting perceptions between CeFi and DeFi, which have burdened the industry and could affect the evolution of crypto and its lending structures going forward. Many within the community can’t seem to agree on what constitutes as CeFi and what constitutes as DeFi.
CeFi is the centralized coordination of economic activity for traditional institutions and individuals. This involves the pooling of resources and redirecting them at the discretion and internal policies of the institution. In trading terms, the purpose of this is to facilitate lending/borrowing by assessing both subjective and objective characteristics while preserving full privacy.
DeFi is the decentralization of lending and borrowing, where credit parameters are based on a set of rules defined in smart contracts. Its purpose is to provide full transparency for the flow of funds for existing and prospective users to assess. A distinguishing feature of DeFi lending protocols is that it relies heavily on over-collateralization due to the anonymous and trustless nature of its borrowers.
Both financial systems have their respective functions and play an important role in shaping crypto. CeFi enables investment opportunities from traditional markets while DeFi provides cutting-edge innovative solutions that offer an alternative paradigm for depositing, borrowing and new distribution channels over traditional finance (TradFi). The development of both will be crucial for how we navigate through this bear market and beyond.
How can crypto lending evolve?
Following the shockwaves that have been felt across the industry, retail sentiment toward crypto is currently low, with current lending and borrowing models at the heart of this issue. Given that crypto already has an outstanding trust problem, how can we begin to rebuild trust in crypto and strengthen our lending products that were created on the promise to offer a better and safer experience for users?
DeFi protocols provide forward-thinking solutions for self-regulated lending by combining the use of smart contracts and the immutability of blockchains with the adoption of tried and tested TradFi models. These solutions include risk management, asset tiering and credit ratings, and work to protect retail and institutional investors while upholding the integrity of lending and borrowing.
One such case study of this shift is the adoption of know-your-customer, know-your-business, and anti-money laundering standards, requiring institutions to undergo administrative onboarding procedures before being placed on a participatory whitelist. These standards ensure institutions undergo compliance checks, record relevant transactions and uses of proceeds, and provide a regulatory structure that enables DeFi projects to collaborate with financial and legal authorities.
While these measures originated from TradFi, it should not be dismissed as irrelevant for DeFi and crypto. Just as current CeFi crypto lending models have been imported from TradFi, these measures hold significance for the wider ecosystem and the growth of the financial market as a whole.
Although DeFi has shown remarkable progression given its short history with much room for improvement, it faces some fundamental challenges, some of which are characteristic of its commitment to decentralization.
One 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, underlining the pressing need to unlock capital efficiency. This has in part prevented mass institutional adoption due to a lack of standardized models for compliance. One approach is through uncollateralized lending while maintaining anonymity on the blockchain.
In addition to traditional market risk, DeFi also suffers from an added layer of smart contracts and resulting infrastructure risks which can be too technical for retail users to appreciate. This is significant as poorly designed DeFi protocols are more vulnerable to risks of malicious attacks, hacks and exploits.
There is no question that DeFi is a disrupting force — by nature, this is part of its mandate and this is clear on the regulatory and compliance front and the challenges that exist there. But to convert the promises and values of crypto into plans of action, we need to capitalize on the opportunities in front of us and find existing synergies to align on. The disruption creates extraordinary operational improvement and financial incentives for builders, and it also opens new venues and channels for discussion and negotiations with regulators because the technological advancement is superior to the existing incumbent financial system. This is something that the regulators are and should be eager to learn and understand.
Calling for a hybrid model
A future where a hybrid model can co-exist is much more likely and sustainable, rather than having one paradigm replace another. Aside from fundamental differences, there are additional layers of complexity that come with DeFi. It’s a system that requires users to take full accountability over their finances and financial decisions, and to acquire a certain level of financial literacy and technical proficiency in order 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 maths behind the construct, the sort of policy-by-design concept, many still opt to place trust on authoritative figures and real life relationships. Retail finance has always been first a service industry before a financial industry, and this will always be true when it comes to serving the bespoke needs of certain institutions and individuals. All of these issues make full adoption of DeFi in place of CeFi incompatible and even unnecessary.
CeFi’s merits lie in its intuitiveness and ability to act as a seamless entry point for users. Its established position and grounding in TradFi have been crucial in attracting institutional investment and fueling the growth of crypto. DeFi’s merits lie in its understanding of blockchain and smart contract technologies, using them to design unique solutions that have changed the way we conduct finance.
The latest bear market has offered an opportunity for the industry to reflect and reset, and we are at a critical juncture where new solutions are needed. 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. To usher in a new era of lending that ensures not only longevity and sustainability, it needs to avoid repeating past mistakes of incumbent systems, close loopholes, and find a better middle ground between DeFi and TradFi.