Hello Crypto Universe,
In this report, we explore the market of centralized and decentralized lending and borrowing platforms. We look at their growth in the crypto community, discuss foreseeable roadblocks, and the need to create a sustainable ecosystem. For a quick recap of the previous post on Decentralized Finance, go through last week’s Newsletter.
Two ideas that have given rise to the crypto lending and borrowing markets are that no one wants to sell off their crypto unless they have to because they believe the asset will most likely appreciate in value over time. The other being that crypto still has a long way to go before it becomes the preferred medium of exchange for everyday transactions.
Both of these ideas inevitably led to a couple of things:
For lenders, a service that allows them to gain returns on their crypto without selling them and at a rate that dwarfs anything offered by a traditional bank.
For borrowers, a service that allows them to borrow fiat against their crypto assets at rates significantly lower than traditional banks.
While centralized lending and borrowing platforms have a diverse range of products and also have their framework backed by regulatory bodies, decentralized platforms, on the other hand, allows users to set their terms of the services and the platforms are interoperable, transparent, and most importantly, not owned by a centralized authority or institution.
Centralized lending and borrowing have become a vast market. Big platforms such as Nexo and Celsius have originated over a billion dollars in loans and are the major players in this market, and when it comes to Defi, platforms such as Maker Dao, Compound Finance, Dharma Protocol, and DyDx are ahead.
Crypto HODLers can now earn interest on their crypto and get a loan in fiat against their crypto-asset without selling it off. They are also better than traditional banks for generating a passive source of income, that is why these services are of great importance to crypto users.
These platforms offer higher interest on deposits and lower interest on loans than traditional banks. In the United States, banks like Citigroup, have an interest rate on deposits at 0.04% and in the case of Goldman’s Marcus, at 2%.
Whereas, a 10-year bond yield in the United States is around 2.5% and is facing downward pressure as bond prices go up. Comparatively, deposits on centralized or decentralized platforms offer higher rates of up to 12%.
In the chart below, interest earned on deposits of Dai has been used to compare interest rates offered by banks in the USA on deposits of USD. Dai is a stable coin that is synthetically pegged to USD at a 1:1 ratio due to which the value of Dai is supposed to be around $1.
On decentralized and centralized platforms, deposits are also called lending as the users lend their crypto to these platforms.
Currently, only centralized crypto-lending platforms give loans in fiat against crypto-assets as collateral. Decentralized platforms offer loans in stablecoins against your crypto. Nonetheless, they offer loans at lower rates than banks in the USA, where the interest rate on personal loans starts from 10.57%. However, both Centralized and Decentralized platforms have maximum interest rates of around 12 %. As shown below:
Some platforms have also come up with more micro level services in loans. For example, BlockFi offers unamortized car loans against crypto as collateral that is if someone wants to buy a car, but they don’t want to sell their crypto assets for it, they can get a loan from BlockFi for which they will only have to pay monthly interest and can pay back the principal when they want to.
Decentralized platforms also have come up with services to facilitate and build an ecosystem of P2P decentralized crypto banks. Platforms such as Maker Dao which allows you to lock up your Ether to create Dai on which you earn an interest rate of around 10%, DyDx offers margin trading which allows users to borrow crypto from someone for trading for example short selling with leverage up to 4x, which allows traders to enter into positions whose worth is 4 times the amount they have. The amount borrowed has to be paid back with interest. But the person gets to keep the remaining profit or otherwise makes a loss. Compound Finance which algorithmically sets rates based on demand and supply. Instadapp, another decentralized platform that allows users to exploit the best rates in decentralized markets by working as a bridge between different decentralized lending and borrowing protocols.
But due to their complicated UX and lack of regulations, they so far have failed to attract a lot of consumers in the market. The bounce rates of Decentralized platforms for their user base are quite problematic considering their user base is small which implies that users have difficulty in understanding how their platform works or how they will get relatively more benefits out of it.
Overall, centralized crypto lending and borrowing platforms have dominated this market, and it is mainly because:
Regulation and Legality: From 2017, centralized entities have been able to get licenses to operate in several countries such as Singapore, Estonia, and similar crypto-friendly countries by entering in partnership with commercial banks. By this, they fall under the legal framework to which they are answerable. They also use custodian and compliance and KYC service providers such as BitGo and Onfido. This builds trust among the crypto users that their assets are safe, and even if the website is hacked, there is a good chance that they will get their crypto back. This, however, can't happen on most Decentralized platforms because if someone can hack the smart contract, then there is no hope for the recovery of your funds. Argent wallet, a decentralized finance product has partnered with Nexus mutual that insures funds deposited on their platform. We may see more trust in Defi if more platforms enter into such partnerships.
Better user experience and interest rates: Centralized platforms are more comfortable to use as compared to decentralized platforms. And they offer better interest rates. Some Centralized platforms also provide their ERC-20 tokens. These are utility tokens that can be used on their respective platforms to get discounts on transactions or earn more interest on deposits or pay less interest while repaying loans. CEL tokens by Celsius network will earn you 12.03%, which is 2.95% more than what you will make otherwise.
Security Reasons: The level of security on centralized and decentralized platforms have been a cause of concern. On centralized platforms, there have been hacks that resulted in the theft of funds. Also, as these platforms are centralized, there have been cases where members of the team of such platforms were involved in stealing funds because they had direct access to funds that users deposited on their platforms. Nowadays, centralized platforms have multi-signature wallets, and third-party custodian wallets and insurance of funds to protect their customer’s crypto. In Decentralized Finance, users don’t have to trust a third party to store their funds. Funds are stored in smart contracts. But a fault in the code of smart contracts can allow hackers to manipulate the process of intelligent contracts to harm the whole ecosystem.
The hard fork in the Ethereum in 2016 was because hackers exploited bugs in the DAO project code, which had accumulated $150 Mn from the Ethereum community for a proof-of-concept investor fund. Hackers stole $50 Mn by getting multiple refunds for the same investment due to the bug. The community witnessed this theft in real-time. A lot of developers wanted to roll back the transactions to forfeit the amount stolen. Others wanted to stick to the existing blockchain and trust the code. This led to the creation of two versions of Ethereum, which are Ethereum and Ethereum Classic.
Crypto lending and borrowing in both centralized and decentralized ecosystem has yet to overcome a lot of things to maintain a healthy ecosystem which can sustain the growing demand of users. For instance, decentralized platforms have to come up with a more comfortable user experience design and figure out a way to gain more and more users. But as they accumulate more and more capital, regulators will eventually have to interfere. Hence, these platforms have to be ready for regulatory obstacles while maintaining their decentralized approach to banking.
It will be interesting to see how this market grows, while many believe that the future is in decentralized finance, their opponents say that by introducing regulations, crypto markets will be much more stable.
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