Some of the most significant innovations in p2p lending and fixed income investing are happening in the cryptoeconomy. More different types of cryptocurrency lending are available now than just a couple of years ago. And you might be surprised to learn that there are low-risk options in this market to explore.
Most p2p lending falls into one of 2 categories: CeFi or DeFi. What I mean by these is either centralized finance or decentralized finance. This includes the crypto markets.
So what’s the difference? Let’s take a look.
CeFi: The Familiar
All of you that invest Euros on Mintos or dollars on Prosper understand what CeFi is even if you haven’t heard the term before. CeFi or centralized finance means that there’s a central figure in the lending process. Centralization itself means that there is a single point of failure. Failure can mean the business itself failing or, more likely, it means a central point of decision-making like a business that can approve or decline a loan request. Or approve or decline a transfer of your money from your account with them to your bank. We’ve talked about these issues when we address platform risk or loan originator risk with questions like Is P2P Lending Safe? Both the platform itself and a loan originator can be points of failure that cost you money.
Have you ever had a legitimate transaction with a bank or payment app declined? Despite the fact you wanted to buy or sell a product and someone else wanted to buy or sell that product to you? That’s centralization and points of failure.
Platforms like VIAInvest in Euros or BlockFi in cryptocurrency can step in to assist with a transaction or step in to negate a transaction because they are centralized. Decentralized platforms do not have this issue.
BlockFi, who I like and recommend, is an example of a centralized finance business in the cryptoeconomy. They can decline your account, they choose who your money goes to and who pays you interest. And they have many protections for you as an investor too. They know trust is essential, and they want to show they are trustworthy.
But what if trust in another business wasn’t required? What if you could lend your money in a trustless way? That is DeFi.
DeFi: The New Kid on the Block
If you don’t want to rely on other companies or potential points of failure like these above, then DeFi is for you. DeFi is trustless. Trustless doesn’t mean trust is not there; it means trust is not required to transact.
Just Connect Your Wallet and Go with DeFi.
How Does DeFi work?
While Ethereum was the first and the biggest platform for DeFi lending, they aren’t the only one. But Ethereum’s innovation that all DeFi platforms use is smart contracts.
A smart contract is a self-executing contract for the loan. It’s a programmable transaction that locks in the value of the collateral and the payment terms. If the contract does not complete through a loan default, the collateral is automatically lost, and the platform pays you off with it.
So all DeFi lending is collateralized lending, loans backed by collateral.
Does that mean that DeFi lending has no risk?
No, it doesn’t. Things can still happen. The collateral on these platforms is other cryptocurrencies, so their price can fall. That could mean you have collateral worth less than the balance of what you lent.
Other issues besides price volatility of the collateral are:
- Program hacks. Hacking Ethereum or Bitcoin and their blockchains are just about impossible. But what about hacking an app that’s doing DeFi on Ethereum? Well, that could happen, and you could lose your funds if the hack results in funneling the loan proceeds, payments, or collateral to another crypto wallet.
- Price manipulation through low liquidity. When a DeFi market has low liquidity, it’s easier to arrange the algorithms to manipulate prices against you as the lender. Thankfully, you can avoid this by using liquid markets that already have high volumes.
- Your repayment token loses value. This is the most common reason people lose money in DeFi. This isn’t like Euro lending, where you lend Euros and receive Euros in return. It’s more like if you lend in Euros, but you are repaid in Argentinian Pesos. There’s an exchange rate risk that you have to deal with, and it can affect your returns. With DeFi, you are lending one cryptocurrency and being repaid in another. To get the highest yields, you have to lend a high-value token like ETH (like the Euros above) and receive as payment a lower value token like the Balancer token (like the Pesos above). The reason why you are getting a higher yield is to use and trade in this lower value token in the first place, even if you swap it out later. So if you get paid in the Balancer token (BAL), the native token for the Balancer DeFi platform, you can immediately swap that out for a higher value token like ETH or the Ethereum-compatible version of Bitcoin. But if BAL loses value while you get paid in it, then it buys less of the high-value token.
The mechanics of DeFi are entirely different since there is no central figure to approve accounts or loans or decline them. All you do is:
- create a login for the DeFi platform of your choice
- make sure you have the cryptocurrencies the platform requires for you to invest or lend
- connect your crypto wallet
and 15 minutes later, you can start lending.
Centralized Finance vs Decentralized Finance: The Breakdown
Let’s look at some other significant differences between CeFi and DeFi.
Yields and Loan Types
One of the first differences between CeFi and DeFi is the yields you can earn and the types of loans you can make.
CeFi: The yields are generally MUCH MUCH lower with CeFi loan options. When you lend your Euros on Mintos, your average interest rate is 12.10%, according to their blog from May 2020. At that time, 46% of their loans were at higher rates than this between, 15% and 26%. BlockFi’s average interest rate earned is 8%.
And as a p2p investor, you know that you are not earning the average due to the combination of loan performance and portfolio selection. You have lots of control over which loans you invest in by choosing individually, waiting for those loans to fund, and then earning the interest. Most prefer to manually invest or put strict criteria into automated investing options to ensure you invest in quality loans. So your portfolio might look something like this:
- 70% in A and B loans that earn on average 7%
- 20% in C loans that earn 9% and
- 10% in very high-risk loans that have a 50/50 chance of earning 22% or 3% based on default rates
So with 10,000 Euros and using simple interest, that return will look like 490 Euros from your A & B loans, 180 from your C loans, and either or 220 or 30 from your high-risk loans making a total of either 890 Euros or 700 Euros or either 8.9% or 7%.
And this is a pretty good return for a relatively conservative portfolio. You could earn more or less by investing in more A loans or by investing in more high-risk loans that either pay off, increasing your returns or default, which reduces your returns.
Your own strategy and portfolio selection play a significant role.
DeFi: In DeFi, the entire premise is to put your coins to work to earn interest that would otherwise just be sitting in your wallet doing nothing. Platforms understand that for many cryptocurrencies like Bitcoin and Ethereum, just holding them over time and doing nothing is profitable by itself. This means that to induce someone to lend their coins directly or by converting to another coin from one of ‘big’ coins like Bitcoin takes a good offer.
The result is that DeFi interest rates are much higher. You are often providing liquidity to a market for a much smaller coin and getting paid interest for that. People all over the world can buy big coins like Bitcoin, Ethereum, Litecoin, or Binance Coin relatively easily from many different places. But SWINGBY, a network providing tools to move Bitcoin and other coins from their blockchain to other blockchains, only has a market value of $85 million, which makes it a very small coin. If people want to trade SWINGBY, the market needs some extra liquidity. You can give it some and get paid for it.
On Pancake Swap (forget the silly name, they are the largest automated market maker on the Binance Smart Chain), you can earn 187% APR to supply a pool that is half SWINGBY and half BNB the Binance Coin. An automated market maker or AMM is an algorithmically programmed market where prices adjust every time a new wallet and smart contract adds liquidity by putting coins in or removes it by taking coins out. Again, it’s decentralized, so people aren’t doing this; coded programs are.
Notice this says SWINGBY-BNB LP. We are providing both coins in equal USD amounts, and LP stands for liquidity pool. This is known as yield farming.
And those who are very aggressive and trying to earn the biggest returns possible are constantly shifting their assets between liquidity pools as some may try to earn even more than this 187% that the SWINGBY-BNB pool pays. They can immediately harvest those coins and move them to another pool.
For most of us, yield farming is a higher risk lending option, and you should only do it with money you can afford to lose.
The more common investment technique for p2p investors is basic liquidity pool investing.
With liquidity pool investing, you are providing coins into the liquidity pool just like yield farming. But there are some major differences too.
- We can pool for higher quality coins, not the 337th largest coin like SWINGBY who needs the liquidity
- We can keep our investment there without having to jump around to chase interest rates like yield farmers
- We can protect our money best by staying in the most liquid markets
- We will likely earn less and the stated interest rates, and APRs will be less, BUT our risk goes way down too
We are going to use the popular Ethereum based DeFi platform Compound for this example. Compound currently has $4.7 billion USD worth of cryptocurrencies borrowed on its platform. And it’s not even the biggest one.
Let’s look at the differences in interest rates we can earn. Like the yield farming technique, because this is programmed into a smart contract in advance, we are both protected by the code, and we can quit the contract at any time for maximum flexibility.
Here are the interest rates:
These are the four big markets on Compound. Two of them, DAI and USD Coin (USDC), are stablecoins whose purpose is to maintain price stability against the USD. The other two, Ether and Wrapped Bitcoin (WBTC), are the tokens for the world’s 2nd biggest blockchains Ethereum and the Ethereum version (and fully backed by audited code) of Bitcoin. What exactly Wrapped Bitcoin is may be beyond the scope of this article, but it’s Bitcoin’s representation on the Ethereum blockchain.
So people are lending here and adding liquidity to earn 0.19% in ETH or 0.24% in WBTC. And why would people lend so low when you can earn more in Euros, Pounds, or USD? If you are a believer in these cryptocurrencies and that their price and value will continue to grow, then any interest earned denominated in that is well worth accepting.
This is why interest on Euros is much lower than the interest earned if you got repaid in Venezuelan Bolivars (VES), Argentinian Pesos (ARS), or Nigerian Naira (NGN). The same principle applies. The highest quality currencies from the lowest risk places command the lowest interest rates.
Yet, the two USD-backed stablecoins of DAI and USDC are paying 6.96% and 8.96% annually to get repaid in these cryptocurrencies. This is a pretty good deal and like Euro p2p platform interest rates. The difference is you are earning USD ultimately and can lend to whoever you want wherever they are with no restrictions.
For many of you, stablecoin lending through a liquidity pool like this is an excellent introduction to DeFi lending. DeFi provides other advantages we will discuss in the rest of this article.
CeFi: In all CeFi platforms in the Euro, Pound, or USD world, there is regulation. The regulations are based on factors like who can invest, who can borrow, or what interest rates platforms can charge. These or other vital parts of the investing process are heavily regulated by the SEC in the US, the FCA in England, the BaFin in Germany, just to name a few.
And the regulation is important, primarily due to their citizens borrowing money. The agencies want to be sure the borrowers are not being taken advantage of by the platform or the lenders.
CeFi platforms in the cryptoeconomy are regulated too. The reason why BlockFi in the US or other centralized lenders in crypto is centralized is to properly deal with the regulatory entities that regulate them. After all, just because BlockFi deals with Bitcoin and USD Coin does not mean they can be non-compliant with their regulators.
DeFi: Now here is a different story. There is no regulation at all. None. What guides the decisions of the platforms, rates to lend or borrow are all determined by code. The algorithms that are preprogrammed tell us what the market is. Both the buyer and the borrower have to beware.
Yet, the upside to this is no money wasted in maintaining compliance. This is a free market where the market itself is setting the rates. Some of you will be comfortable with this, and others not. It’s understandable because it’s different from what we are used to.
Most countries treat cryptocurrency-based gains and investments as income, but not all.
CeFi: Every country treats interest earned as income in some type of way.
DeFi: While you still have to pay interest on your interest income, if your cryptocurrency gains in value, like the coin you get paid in from yield farming like our SWINGBY example above, those gains may or may not be taxable. Two notable European countries that don’t tax crypto gains are Portugal and Malta. You may want to make yourself aware of how taxes affect your crypto gains based on where you live.
CeFi: There is no anonymity or privacy. You have to give your name, address, and other documentary information to get approved to lend or borrow on a CeFi platform.
DeFi: There is almost total anonymity. All you do is connect your wallet and start investing. The only thing that can identify you is your wallet address. There are no investment options with this level of anonymity. Even complex corporate investing structures can eventually get to who the real owners are if someone is willing to dig deep enough to find out. In DeFi, there is no need for this. Your investment is only known through your wallet address. You never give your name, and the borrower never gives theirs. But remember, you are still protected by the terms of the smart contract that governs the loan.
Lending Across Borders
CeFi: With some CeFi platforms that use loan originators from different countries, you are lending to people in different countries, although you are getting repaid in Euros.
DeFi: All DeFi platforms allow for transnational lending. You can lend to whoever you want, wherever they are. And you can do that because you are lending in crypto, and they are repaying in crypto. Do you like the idea of lending to someone in an emerging market but still wanting to get paid? If you do, then lending crypto through DeFi is a good option for you.
Using Crypto DeFi Lending in P2P Investing Portfolio Construction
If you are newer to crypto as an asset, then jumping into yield farming seems unlikely without some experience and educating yourself first. You should learn about what cryptocurrencies are, how wallets work, what differentiates Ethereum from Bitcoin, and some other things before working the DeFi market aggressively.
But stablecoin lending, as we saw on Compound and many other platforms offer, is a great way to get started in DeFi lending. All you need is a crypto wallet, a place to buy your crypto, and a DeFi platform where you want to lend it to get started.
Without lots of knowledge of this new asset class, I would not recommend you put a large portion of your portfolio into DeFi. I am very excited about DeFi now and its prospects for the future, but we should also be realistic.
I personally recommend, for those who have not worked with cryptocurrency before, that you keep at least 90% of your portfolio in conventional p2p lending platforms. So 90% should be in CeFi. Five to ten percent of your portfolio in DeFi through stablecoin lending is more than enough to learn how it works.
DeFi through stablecoins can potentially increase your overall returns with less risk. Since both your borrowers and the currency they pay you will be different than your Euro-based platforms, your DeFi returns can lower your total risk. They are not dependent on things like the value of the Euro or what the German economy is doing. This lack of correlation to the rest of your portfolio will lower your risk. You really can reduce risk in your portfolio while increasing your returns through lending non-correlated assets like USD-based stablecoins.
So the answer to the question in our title is that while you can love DeFi for what it offers now and for its future potential, both systems have a place in your portfolio today.
As part of a series of articles on crypto lending, we have also made an article on stablecoins as an asset and an investment tool. I personally love their potential and think you will too as you learn more about them.