Defi vs Cefi – How to Earn Income with Cryptocurrencies

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As you know, I started investing in cryptocurrencies earlier this year. What I haven’t told you was that one of the big reasons why I warmed up to the assets is because of the developments in decentralized finance (Defi). For those who don’t know, the traditional way of finance is called centralized finance (Cefi) because there’s always an institution you interact with when you borrow or deposit money. For instance, you can bank at Wells Fargo or get a mortgage through Bank of America. Either way, there’s a centralized place that holds your money and ownership information.

Decentralized finance is completely different. Through technology, you interact with a protocol, and that in turn connects you with multiple people anonymously for any financial transaction. If you need to borrow, you simply send your request through the protocol and it’ll pair you up with other people who want to lend their assets.

The crypto crowd will tell you that Defi is going to take over the world or how centralized institutions like banks and the government can’t be trusted. My views aren’t that extreme. The future is unpredictable, but governments around the world won’t just give up control of the monetary system. It’s also dangerous for society if there is an absence of centralized control because a powerful entity like the Federal Reserve and Treasury can provide the needed safety and control to reign in greed that’s embedded in civilization whenever things get too far out of wack.

Still, Defi is rapidly becoming the next big thing in the world of finance. The technology is such a disruptor that big banks are looking at it as a huge threat to their business.

Defi is Exciting and Potentially Lucrative for Investors

What really excites me is that Defi enables investors to earn income by lending their assets to others through digital smart contracts. Because borrowers have to put up collateral and collateral is automatically deducted to pay off the loan instantly when asset values decline, there’s virtually no default risk. The yield is also completely transparent and calculated automatically based purely on supply and demand.

I started dabbling to learn how everything works via one of the bigger protocols out there called Aave and it’s as they say – extremely efficient and fast. Because everything is rule-based and done through computer algorithms, I can literally lend and take my money back within minutes regardless of how much money I’m lending or borrowing.

The ecosystem isn’t without its faults though.

For instance, Aave is run on the Ethereum network and the transaction fees are pretty costly for small amounts as of writing. Transaction costs are known as gas fees in the Ethereum network and it’s based on how busy the whole network is at the time. Note that cost is based on the transaction itself and not the dollar amount. This means that it’s the same to lend a penny or a billion dollars. When I made my transaction, it basically cost roughly $150 to get the deposit going. If gas fees stay the same, it’ll take another $150 to take money back out of the protocol. This is acceptable for a large loan, say $10,000 or more. It wouldn’t really make sense for the test loan amount I used at $1,000 if it wasn’t made for the purposes of learning because the fees would eat up 30% of the entire loan amount.

You can also only borrow and lend cryptocurrencies. If you don’t want to own a volatile asset, then you’ll want to lend what’s known as stablecoins. These are cryptocurrencies that are pegged to fiat currency. An example is USD Coin (USDC). The value of each USDC is pegged to the US dollar at a 1:1 ratio and it’s also fully backed with an equal amount of reserved assets and audited on a continuous basis.

The third and maybe the biggest hurdle for the masses is how complicated the entire ecosystem is to set up. The interfaces are all pretty easy to work with once you know what you are doing but I’m also technology savvy who can write programming code and runs a web company.

It still took a while to set everything up. To lend my money via Aave, I need a way to buy cryptocurrencies, then I need to transfer the funds to a wallet, then use it to connect to Aave and lend it out. I also had to buy two different cryptocurrencies because I needed Ethereum to pay for gas fees and I wanted to lend out USDC. And you really don’t know how much the gas fees are until you interact with the Aave protocol. So, you have to buy a bit more Ethereum than you think you need to transfer to the wallet.

There are also fees every step of the way. Coinbase, which I used to buy USDC, didn’t charge fees to buy the stablecoins, but it was happy to charge withdrawal fees. I also had to pay it twice to withdrawal both the USDC and Ethereum to a wallet. Then, I had to pay more fees to initiate the lending. And because I wanted to save some fees and tried to pay for the slow option of approving the lending transaction, the contract ended up not getting executed and I had to pay a fee to cancel it before I finally got my second transaction to go through. One day if I ever want to get back US dollars that I can actually use, I will have to go through the whole process in reverse, paying fees all the way through until I see the money in my bank account. At least I likely won’t have to pay a cancellation fee anymore because I’m now more comfortable with how these transactions work.

The fees I can deal with if everything was known upfront. What’s annoying is not knowing exactly how much it’s going to cost before you start the whole process. It also complicates matters when some fees are charged in Ethereum and others are charged with the cryptocurrency being withdrawn. As a result, I now have some Ethereum left over in my wallet doing nothing. It triggers a bit of OCD in me. It’s too small an amount to transfer because transaction fees make it prohibitive, but it annoys me to have assets just sitting there doing nothing even if it’s a small amount.

What About Cefi Lending?

A related development in the space may be the ticket to solve all the issues I mentioned. Companies such as Blockfi or Celsius Network provide a platform that’s more like a bank where you log in with an account to see all your assets. In the case of Blockfi, you can buy stablecoins and other cryptocurrencies right on the platform via a linked bank account and have them earn interest as soon as the assets are purchased.

They charge a higher fee than going through the convoluted steps I mentioned with the Defi option, but you won’t have to deal with different cryptos and possibly messing up the steps. They also allow you to transfer cryptos right into the platform. That means you can always buy the cryptos elsewhere and then transfer the assets to these platforms.

I have done that too. I have bought Ethereum at Coinbase Pro and sent it to Blockfi. It’s much simpler to do and I only had to pay one small withdrawal fee when the transfer was made.

This Cefi option isn’t without its own set of risks though. The cryptocurrency space is booming, but these are relatively new companies and they are almost like startups in some way. While I’ve never once worried that money I have at Fidelity or Charles Schwab would vanish, I’ve wondered whether cryptocurrencies I have parked at Blockfi would just be stolen because either Blockfi gets hacked or the company just goes under.

Additionally, these companies don’t disclose how they are making money to pay you the generous interest rates they offer. If they start losing money on their investments, there’s a chance they won’t have enough assets in a crisis to make every customer whole.

And even if they don’t go under, what if these companies place restrictions on withdraws when the next crisis happens? I don’t see cryptocurrencies going away, but that doesn’t mean that the asset values will just keep going up. During the last bear market, Bitcoin went down 80%+ and that’s relatively tame when you compare it to other coins in the space. Ethereum went down 90%+ and there are other smaller cryptos that went down 98% in value. If this happens again, there’s really no telling what these companies will do.

Finally, there’s the issue of customer service. If you’ve ever tried to talk to a support person at these Cefi companies, you know how ridiculous the response times are. You likely won’t find a live agent, and your emails will take weeks to get a response. You could argue that this is still better than the Defi options with absolutely no customer service, but Defi protocols are much direct in nature. There’s a reason why everything works and when it doesn’t, you can figure out why on your own. Not true with Cefi options. For instance, withdraws always happen when you pay enough gas fees in a Defi transaction, but there’s a chance that withdraws just get stuck with the Cefi options that require a customer service rep to resolve.

Having said that, the vast majority of transactions happen smoothly. Still, I would feel pretty anxious if I had tens of thousands of dollars or (gulp!) hundreds of thousands of dollars stuck at one of these platforms, and customer service takes weeks to respond to each question.

Bottom Line

The way I see it, Defi is going to become a bigger and bigger player in the finance space over time. There are financial institutions figuring out how to work with Aave with their system as we speak and there’s a gigantic amount of money being thrown into development in the space. This changes if governments decide to completely demolish the system through legalization and taxation, but I don’t see that happening because it’ll just push the whole ecosystem more and more underground. Notice that I’m not saying that cryptocurrency values will continue to go up from here. Even if Defi and one of these crypto networks become the system running all finance one day, it doesn’t mean the cryptocurrency is going to explode in value. And even if it does, it doesn’t mean you invested in the right cryptocurrency. I own a bunch of Ethereum and I hope it happens, but getting rich is far from certain. Going back to earning income though, these generous yields being offered will eventually come down as people become more comfortable with the whole process.

If you aren’t comfortable with the Defi route, then the Cefi options represent a simpler way to dabble in the space. Even so, the risk of a complete loss isn’t zero and that’s scary to think about.

Is it worth the risk? For me, I’m only investing with the money I’m okay with losing. The income right now is great but I have to constantly temper my enthusiasm. In some way, I’m mentally treating it as a very expensive hobby akin to people buying classic cars. I can’t drive these assets obviously, but I’m having fun learning the technology and trying out the different platforms. If one day I can cash out big, then that would be awesome. If I lose everything I’ve put in, then I’ll be sad but it won’t financially ruin our family.

What do you think? Will you ever invest in cryptocurrencies?

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  • Lucas MoneyMaker says:

    I’ve tried Aave but I agree with you how it’s really complicated to set up right now.

    And your worry of redemption restrictions came true. Some exchanges like Coinbase were down a couple of days ago and others disabled the ability to withdraw.

    I mine with Nicehash and someone said they weren’t able to withdraw their coins there for a few hours. And we haven’t hit anywhere close to 80% down yet.

  • Samson T says:

    I want to invest too. I see these ads touting 10% and it just sounds too good to be true though.

  • Joe on the Move says:

    Interesting. I’ve been eyeing the runup in crypto but I’m glad I didn’t jump in yet. If it crashes some more I’m going to start buying to earn a yield.

    Income from these assets is too risky for me when you can have 30% moves in one day.

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