DeFi versus CeFi lending: Which is right for you?

Lincoln Murr

Decentralized Finance, or DeFi, has been the buzzword of the cryptocurrency space recently, and has seen a rapid surge in popularity as an easy way to gain passive income. However, Centralized Finance, CeFi, has also been growing, and offers some benefits over DeFi. 

Many see lending cryptocurrency as an easy way to gain passive income and hedge against short-term price fluctuations of volatile cryptocurrency assets. All of these loans are overcollateralized, meaning that a borrower must put more money down as collateral than they are borrowing. This is useful for investors who want to take out cash, but not have to sell their cryptocurrency position for tax reasons. There are two main ways to borrow and lend money: DeFi and CeFi. The two biggest DeFi options are Compound and Aave, which have $784.9 million and $1.55 billion in funds locked up, respectively. To newcomers in the crypto space, interacting with smart contracts in order to lend cryptocurrencies can be intimidating, but there is an alternative. CeFi options allow users another way to lend out their funds and receive interest from overcollateralized loans. The two biggest CeFi platforms are Nexo and BlockFi, but their holdings are private, as they do not disclose their financial records.

Let’s take a closer look at these four platforms and compare CeFi and DeFi to find out which one is a better place to store money for passive income.

History/Founders:

Compound Labs released their whitepaper detailing the v1 version of their product, Compound, in February 2019. Written by Robert Leshner and Geoffrey Haynes, the whitepaper detailed how the project aimed to create a protocol that allowed users to “exchange the time value of Ethereum assets” and earn interest rates on their tokens. On May 23, 2019, v2 of Compound was released, which allowed for integrations with other dApps and general improvements. Leshner, CEO of Compound Labs, received a Bachelor’s Degree from the University of Pennsylvania in Economics, and was a product lead at Postmates before creating Compound Labs. Haynes, CTO, received a Bachelor’s from the University of Pennsylvania in Computer Science and also worked at Postmates as an Engineering Manager. On June 16, 2020, the Compound protocol took a huge step towards decentralization, as they distributed the governance token, COMP, to platform users. Holders of this token have a vote in what the Compound protocol does, such as adding a new token or changing overcollaterization rates. This effectively moved governance decisions of the protocol from Compound Labs to users of the platform, making it truly decentralized. Since then, Compound has been growing in funds and users.

Aave originally launched under the name ETHLend on November 29, 2017. The team held an ico and raised $18 million for 75% of the 1.3 billion tokens. Since then, the tokens have increased in value by 43 times their initial value. In the original ETHLend whitepaper, the token served four utilities: As a discount for fees on the platform, as a reward incentive for lenders and borrowers, special functions for LEND holders only, and for affiliates. In January 2020, the protocol rebranded, mainly to change from a peer-to-peer lending strategy to a pooled strategy, like Compound, where funds are pooled together then loaned out instead of being loaned from person-to-person. With this new protocol came new technical features, such as flash loans, which allow for users to arbitrage on decentralized exchanges . In Aave v2, which launched August 14th, lots of new features were added, like a stable borrow rate instead of the typical variable rate, private markets, and governance features for the AAVE (formerly EthLend) token. Aave has recently overtaken Compound as the largest DeFi lending platform, and that lead does not seem to be disappearing anytime soon.

Aave’s Founder and CEO is Stani Kulechov, who has a Master’s Degree in Law from the University of Helsinki, but no notable prior work experience. They do not have a CTO.

BlockFi was founded in 2017 by Zac Prince and Flori Marquez. The company states they were created “with the goal of providing credit services to markets with limited access to simple products like a savings account”. Since their inception, they have continued to roll out new options for lending, such as GUSD and ETH, and create advertising campaigns aimed at bringing in more users. They have Venture Capital backing from notable firms such as Coinbase Ventures, Winklevoss Capital, and SoFi. A notable moment in the company’s history occurred when Zac Prince, CEO of BlockFi, was on CNBC to talk about managing wealth for cryptocurrency investors.

Prince has a Bachelor’s from Texas State University in International Business and graduated Cum Laude. Mahesh Paolini-Surbramanya, CTO, received a Master’s Degree from Notre Dame in Electrical and Computer Engineering, and has worked in the blockchain sector since 2016. With their impressive team and company goal, BlockFi has taken the world of CeFi by storm since its founding.

The CeFi platform Nexo was created in 2018 by European FinTech company Credissimo, who have specialized in loans and financing since 2007. Nexo and Credissimo are technically separate entities, but they work closely together to create a powerful cryptocurrency lending platform. They held an ICO for their NEXO token, which offers higher interest rates and dividend payouts, on March 31, 2018. They raised a staggering $52 million for their ERC20 token, and sold 70% of the total supply. Since their inception, they have facilitated over one billion dollars in cryptocurrency loans and have over seventy thousand users. They release support for new cryptocurrencies frequently, and currently support fourteen coins. In April 2019, the company gained a lot of attention by backing a mortgage for former EOS spokesperson Brock Pierce’s million-dollar home using cryptocurrency.

Nexo’s Co-Founder and main company figurehead is Antoni Trenchev. He has a Master’s Degree in Law from Humboldt University of Berlin. The company’s CTO is Vasil Petrov, who has an Information Technology degree from New Bulagrian University.

One controversial member of Nexo’s team is Simeon Rusanov, head of digital assets research. In 2017, Rusanov, who was working under the name Dimitrov, was sued for releasing a report on a publicly-traded company in order to create panic and short the price. To those in the cryptocurrency space, this sounds eerily similar to the Chainlink report that was released a few months ago, which came from a fake company and tried to short the price. Some have blamed Nexo for this report, as there are a lot of coincidences and hints that would make Nexo appear like the culprit. A couple examples include: The report was sent to emails of Nexo users, a link inside the document points to a user named “Simeon,” a reference to Nexo in the FUD website’s source code, and the announcement of collaboration between Nexo and Chainlink a few days before the attack. Perhaps the most damning evidence of all comes from the fact that Nexo borrowed 350,000 LINK at almost the same exact time that the report was released. 

The company denies these allegations, but their reputation has been damaged ever since this accusation.

Returns:

Both Compound and Aave calculate the lending percentages using a system of supply and demand. The more supply a certain token has, the less the lenders will receive, and the less the borrowers have to pay. Both platforms offer around 2-3% on stablecoins, such as USDT, and closer to 0.5-1% on assets such as Etheruem and Basic Attention Token. Though these percentages are incredibly volatile, and may be 10% one day and 1% the next day.

The only fees a user has to pay on both Compound and Aave are the gas prices associated with sending tokens to a smart contract. Recently, these fees have been as high as $5, but are typically around $0.50. 

Compound’s Supply and Borrow APY interface

Nexo and BlockFi offer much higher and more stable interest rates. Nexo offers 8% compounding interest paid out daily for stablecoins, and 4% on most other cryptocurrency assets. These numbers get boosted to 10% and 5% respectively if a user holds 10% of their balance in NEXO tokens (Ex. An account with $500 total and $50 in NEXO tokens would be eligible). On the other hand, BlockFi offers 6% APY on Bitcoin, 4.5% APY on Ethereum, and 8.6% APY on stablecoins. However, both companies explicitly state in their terms and conditions that these returns are not guaranteed and are liable to change without warning at any time.

On top of their high returns, BlockFi also runs promotions in order to incentivize users to join the platform. Some of their previous promotions include a free $10 in BTC after depositing $100, double interest rates for the first month, and rewards for reaching specific trading volumes on the service.

BlockFi offers users one free withdrawal per month, then charges a fixed rate from $0.25 to $2.50 depending on the asset. Nexo offers free withdrawals on all assets. Both require blockchain transaction fees when depositing into the platforms, as these cannot be avoided.

Clearly CeFi offers better interest rates, but this interest rate does not come risk-free.

Risks:

DeFi protocols have a unique risk set that is not seen in any other sector of finance. The main area of concern in DeFi protocols is the possibility of bugs, glitches and exploits in the smart contract. Bugs in smart contracts are fairly common, and have resulted in the loss of funds previously. An example of this was the DAO hack of 2016, where a hacker was able to steal $70 million in Ethereum due to a vulnerability in a smart contract. Granted, in this case the Ethereum blockchain was forked and all users received their funds, but this was a very contentious issue and resulted in the creation of Ethereum Classic, a fork that maintains the original state of the Ethereum blockchain without the returned funds. Furthermore, this type of rollback is unlikely to happen again, as Ethereum is much larger now and has billions of dollars at stake, and making changes to a blockchain that is supposed to be immutable and decentralized is not a great look. Both Compound and Aave have undergone multiple rigorous third-party smart contract audits, which look for bugs and any critical errors in the code. Compound alone has undergone over ten audits and has an active bug bounty program. However, these audits do not guarantee security by any means, and it is very likely that potential hackers are looking at Compound’s smart contract right now for vulnerabilities.

In order to hedge against the risk that a smart contract has a vulnerability, the DeFi app Nexus Mutual offers decentralized insurance plans. These plans cover “unintended uses of code” and would have covered users in the case of the DAO hack. For about $5 DAI per one Ether, a user can purchase insurance on Aave or Compound for a year. For anyone with lots of money in these platforms, this is a great way to cheaply secure their investments, and makes the DeFi protocols exponentially safer.

Another area of concern in DeFi is its usability. In order to send money to these platforms, users have to interact with smart contracts through a wallet like MetaMask. Even though this process may seem simple to a cryptocurrency expert, newcomers may have trouble and accidentally lose their funds as a result of sending them with an incredibly low gas fee or gas limit, or send cryptocurrency to the wrong place.

One of the greatest problems that cryptocurrency enthusiasts have with CeFi platforms is the blatant centralization of these solutions in a space that is supposed to be decentralized and trustless. By placing money into BlockFi or Nexo’s accounts, one must trust that these companies will act as trustworthy custodians and not run away with the money, get hacked, or otherwise lose their users’ funds. Furthermore, users of both platforms have to complete Know Your Consumer, or KYC, compliance measures to use each platform. These measures include verifying identity using a license or other government-issued ID. This data is not stored with BlockFi or Nexo, but with a third-party company Onfido, which specializes in document recognition and online identity verification. This company is the same behind verification for many other centralized cryptocurrency ventures, such as Coinbase and Bitstamp. Even though this company is well-trusted and takes security precautions such as being SOC 2 Type II compliant, which is one of the highest levels of security attainable for storing user data, there is still the risk that the company gets hacked and highly sensitive and personal data becomes available. For those looking to keep their privacy completely protected, CeFi is not a viable option.

BlockFi secures their funds into a custodial account with Gemini, a licensed depository trust and familiar name in the cryptocurrency space. Gemini is a trust company based in New York and holds the majority of their assets in cold storage. Furthermore, they have commercial crime insurance for Digital Assets in their hot wallet, which protects against hacks, fraudulent transfers, and embezzlement. Unfortunately, BlockFi states in their terms and conditions that they are not liable for lost profits, negligence, fraud, or intentional misconduct with users’ funds. This requires users to take on massive risk and trust that BlockFi will not steal funds, and scares many users away from trusting this company with their money.

The custodian for Nexo’s funds is BitGo, another well-known name in the cryptocurrency sector. They have insurance underwritten by Lloyd’s of London protecting against one hundred million dollars in hacks, theft, or loss of keys. BitGo also boasts 100% cold storage in Class III vaults, which withstand up to six man hours of attempted breaching.

Nexo has wording similar to BlockFi in their terms and conditions that imply they are not responsible for mismanagement of funds.

DeFi and CeFi both have unique risk sets. On one hand, DeFi contracts can be breached and funds can be irreparably stolen, but decentralized insurance plans exist to hedge against this possibility. On the other hand, CeFi has insurance for their asset, but not protection against their company’s mismanagement of user funds. Even though this type of negligence has not happened yet in the CeFi space, there is no guarantee that something won’t happen in the future. A good way to prevent total loss of funds in the case that one of these platforms shut down is to diversify funds between multiple CeFi platforms. Both DeFi and CeFi have their risks, but an established and audited DeFi smart contract with proper insurance appears to be the safer place to store money.

Profitability:

A unique feature of DeFi services is that they are not companies looking to please shareholders. Thus, their main goal is to provide competitive interest and borrow rates to their users. Both platforms do have a governance token, though, and these governance rights are valuable. Though the value of these governance tokens long-term remains to be seen, COMP currently has a market capitalization of $560 million, and these tokens are solely used for voting purposes. Aave’s LEND token has a market capitalization of $860 million, but also has other use cases mentioned above. The creators of both of these platforms hold a significant amount of these tokens, which is how they made money on their creations.

As established companies, Nexo and BlockFi’s goals are to make a profit. Thus, they charge much higher interest rates than what they pay to lenders in order to make a profit on the difference in borrowing versus lending. Nexo has a unique system in place to distribute some of their profits to holders of their NEXO token. Each year, holders of the NEXO token receive 30% of the company’s net profit. On August 15th, NEXO paid out their third dividend, totaling $6 million, to users who had completed KYC and held NEXO tokens in their Nexo wallet (29). After this last payment, Nexo has successfully paid out $9 million through three dividends. Unfortunately for token holders, the price of the token corrected to account for this dividend after the ex-dividend date, so holders basically exchanged some of their gains in NEXO’s price for payment in BTC. The NEXO token is a unique way to bet on the success of the CeFi platform, but also carries the risk of complete uselessness should Nexo shut down. 

Conclusion

When it comes to choosing between Decentralized and Centralized finance platforms for earning passive income, there is not one clear answer for everyone. DeFi’s main benefits are the anonymity given by not requiring any KYC, a smart contract-based solution, and the ability to hedge against hacks using insurance platforms. On the other hand, the interest rates on DeFi are subpar, but still greater than traditional banking interest rates, and are highly variable. CeFi offers users stable and incredibly high interest rates, but at the cost of identity and with the risk that a users’ funds are lost. Even with insurance on these platforms, one cannot be sure that the clause in the contracts of both companies about their lack of liability in the case that money is lost will allow for insurance money to be paid out to users.

The best solution for those wanting to use CeFi would be to split their funds between multiple CeFi platforms. The identity verification companies are the same for both BlockFi and Nexo, so there is no risk in having sensitive identification documents spread out between verification companies. Moreover, if one company shuts down or exit scams, at least half of the user’s funds are safely stored away in a completely separate platform. This solution still poses risks, but offers the best way for users to use CeFi safely.

Enthusiasts of cryptocurrencies who believe in a bankless and trustless future will have the best experience using DeFi solutions like Compound and Aave. These platforms may be hailed as the future of finance, where no sole entity has control over a user’s funds.

Regardless of whether you choose DeFi or CeFi, the potential to make passive income on cryptocurrency assets is exciting and a great way to make a little extra crypto.