DeFi vs CeFi Lending: Before Choosing, Understand the Challenges and Risks

Crypto lending has become a very popular way for crypto investors to generate additional income on their crypto portfolios.

Before crypto lending was offered to investors, individuals typically had two methods to capitalize on their investments: one, long-term holding of coins and tokens; and two, short-term trading in and out of volatile markets.

As the crypto market matured, additional services were built and offered additional opportunities to investors. As decentralized finance (DeFi) grew, more traditional services like banking were brought to the crypto market.

Smart-contract enabled cryptocurrencies, such as Ethereum, allowed businesses to offer these banking services to crypto users globally. One of the most popular use cases of DeFi is to offer lending and borrowing services to crypto holders.

You're reading Crypto for Advisors, a weekly look at digital assets and the future of finance for financial advisors. Subscribe here to receive the mailing every Thursday.

Much like a bank that offers a yield to cash depositors, DeFi banking services offer yield to crypto holders. Users are able to deposit crypto tokens into a smart-contract and earn interest on their money, usually paid to them in the form of cryptocurrency.

These smart contract lending protocols typically offer a yield higher than traditional banks, which has attracted the attention of many crypto investors. DeFi banking services eliminate the need for a central party to facilitate the lending and borrowing functions, efficiently reducing fees and increasing yields to the participants.

DeFi lending uses the power of smart contracts to offer these services through blockchain technology.

Some of the benefits to using a DeFi lending protocol over a traditional bank include:

As the service grew in popularity, more businesses began offering DeFi-powered lending and borrowing services to the market. Platforms such as Aave, MakerDAO, Compound and Solend grew in popularity. There is currently $65 billion locked in DeFi lending platforms.

When a user wishes to participate in the DeFi banking system, they must interact with the protocol directly. This includes sending their crypto to the smart contract and managing the investment directly.

Crypto developers have been focusing on improving the user experience when interacting with this technology, but it still presents a unique challenge for investors. Many people who want to earn yield on their crypto positions are repelled because they cannot use a third-party service when interacting with a DeFi protocol.

Read more: Understanding DeFi and Its Importance in the Crypto Economy

Because of these technological barriers, entrepreneurs saw the opportunity to create a “middleman.” Popular platforms such as BlockFi, Celsius, Voyager, among others, began offering “DeFi as a service,” or platforms that would only require users to deposit their coins with a central entity in order to generate yield.

These companies, often called “CeFi” (centralized finance) by the market, grew very rapidly because of their ease of use and a much simpler experience for novice users. They began marketing their services and quickly grew their assets under management.

The user experience in CeFi is much simpler, requiring one account for users, in order to start earning a yield on their crypto positions. These crypto companies would then lend out the money directly to borrowers, handling the crypto transfers, underwriting, etc. The users of the CeFi platforms would simply deposit their funds and then receive their income on a monthly basis.

An important difference between DeFi and CeFi is that when a user interacts with DeFi, they simply have to trust that the smart contract is written in a secure way. DeFi is peer-to-peer lending and does not require the same amount of trust as interacting with a CeFi company.

When a user deposits funds to a CeFi platform, many of the traditional banking risks exist, such as:

When a user decides to use a DeFi platform directly, there is a higher level of technological knowledge that is required. The investor is required to be much more hands-on managing their own investments. DeFi is trustless and decentralized, which creates more confidence in the banking services because of the ability to audit the underlying smart contract code.

CeFi platforms essentially outsource the technological obstacles from the depositor to the institution, yet require the depositor to trust a central party and their lending practices.

CeFi platforms saw tremendous growth in 2020 and 2021. “DeFi as a service” grew in popularity and many of the CeFi platforms were managing billions of dollars on their customers' behalf.

In the summer of 2022, popular CeFi platforms Celsius Network and Voyager Digital froze customer funds. The lending standards of these platforms were not up to par and the companies lost many of their customers' funds.

This was due, in part, to extreme market conditions (the market cap of crypto has fallen nearly 60% from the high) and lack of proper risk prevention measures. Celsius and Voyager have since declared bankruptcy, causing depositors to have their accounts frozen and their ability to withdraw their money from the platforms restricted.

Read more: Behind Voyager’s Fall: Crypto Broker Acted Like a Bank, Went Bankrupt

Regulatory concerns are also impacting these centralized lending platforms. The popular platform BlockFi was sued by the U.S. Securities and Exchange Commission (SEC) and fined because it failed to register appropriately with the SEC. BlockFi agreed to pay $100 million in penalties and are no longer able to offer yield to new customers. It is currently applying for the correct licenses and hopeful to offer the yield to customers with SEC approval in the future.

DeFi platforms, however, have been operating without issue. Aave and MakerDAO, among others, did not have the same struggles as the CeFi platforms, and are currently available to users.

Investors are faced with a difficult situation: learn the technological knowledge required to interact with DeFi platforms individually or trust a CeFi platform with their funds.

The open-source smart contracts that DeFi platforms use may have a learning curve larger than simply using a CeFi platform. However, during difficult market conditions, the permissionless and trustless systems DeFi utilizes have proven to be a sustainable method for investors to generate income on their crypto positions.

Read more: Why DeFi Might Be Safer Than Traditional Finance

As an advisor, you must understand the risks associated with both DeFi and CeFi and the various services offered around the technologies.

Clients may express interest in generating a yield on their crypto positions, and it is important that advisors understand the risks and concerns associated with both ends of the spectrum – interacting individually with a DeFi platform and trusting a CeFi platform.

Perhaps CeFi platforms will soon be regulated businesses with investor protections and satisfactory risk management practices. But until proper protections are in place, learning to interact with DeFi platforms directly presents a unique and more transparent way to access these banking services.

Read more: DeFi vs CeFi in Crypto