Until recently, there were simply no other alternatives to banking. But, the state of banking is radically changing.
Today, institutional banks are losing their monopolistic position for the first time in history with the so-called crypto banks.
Decentralized finance (DeFi) and centralized finance (CeFi) build their authority and gain mainstream adoption.
CeFi vs. DeFi
But what exactly are these platforms?
There are essentially two types of platforms: centralized finance platforms (CeFi), such as BlockFi, Lend, Celsius, or Nexo, and decentralized finance platforms as Aave or Compound.
The mechanism is quite similar to traditional banking.
A user who has crypto-assets can lend them to the platform and receive some interest in exchange.
The platform will then lend those assets to institutional or retail investors for a higher rate and pocket the difference.
While the offerings on both platforms are highly similar, the average crypto investor generally prefers to use a centralized platform. CeFi is simply more practical, user-friendly, and offers customer support.
However, CeFi platforms are not FDIC insured for such products in the event the platform goes bust. Therefore, using CeFi contains certain risks.
The most apparent risk is counterparty risk. CeFi platforms hedge their risks in two ways.
First, they lend less money than they borrow. Second, centralized platforms always over-collateralize their loans. In general, they require collateral ratios of 200%+ to secure a loan. For example, if a client wants to borrow $5,000, she must put down $10,000 worth of collateral.
However, even with extensive collateral, the risk of a rapid market crash always remains. For instance, when clients do not meet margin calls and the exchange will not liquidate the collateral, it could bankrupt the platform.
Although CeFi platforms could easily sustain even large market swings in recent months and years, the theoretical risk remains.
The second risk to be aware of is hacking or cyber risk.
In a DeFi platform, you as the user hold the private keys and, thus, custody of your assets.
In centralized lending, you transfer your crypto to the platform.
That leaves open the inherent risk of a hack, as a bad actor can swoop into the custodian that holds the funds for that platform.
The third consideration comes down to traditional fraud risk.
For example, a platform may not return your funds due to fraudulent activity or negligent risk management. The bankruptcy of lending platform Cred was a good example.
Crypto Banking Vs. Traditional Banking
All things considered, the reality is that people are generally happy to lend out their crypto to CeFi platforms. As opposed to traditional banking, investors have more control over their finances and can freely trade or even put their assets into cold storage for greater security.
And although yields for crypto lending have come down recently, they remain about ten times higher when compared to traditional financial instruments.
According to the principles of Game Theory, institutional banks will eventually have no choice but to join the revolution to remain relevant.
So, while decentralized finance is yet to achieve mainstream adoption, two things remain certain for the individual.
First, as the adoption rate of DeFi and CeFi increases, the banks’ market share decreases.
Second, for the first time in history, an individual has more power than ever to benefit from personal banking and finance.
People have finally awakened to the fact that giving a small group of unelected individuals the keys to the money printing press is not a solution to the current problem.
In the long run, crypto banking is the inevitable future of banking.