The decentralization narrative for cryptocurrency has never been more significant then after the collapse of several fintechs in the DeFi (Decentralized Finance) space. The sudden collapse of venture backed projects showcases the importance for regulation in centralized DeFi (CeDeFi) or CeFi (Centralized Finance) protocols.
There would be less discussion about this if everything was working fine. What exposed CeDeFi was the extreme volatility in the cryptocurrency market. While they offered high yields and the freedom to be your own bank, they could not deliver on that promise.
What Are CeDeFi?
Fintechs involved in DeFi are for the most part centralized. They have an organized structure with a CEO, marketing, finance and legal team. They cannot hide the fact that they operate as a business, but offer DeFi services to customers. These services are protocols (software) that allow customers to earn high yields from their cryptocurrency deposits. These deposits are taken as collateral, often unsecured (no security interest in the collateral), which is then used to reinvest into other financial protocols to earn yield. Lending protocols use the deposits to lend to other customers. Those who deposited in return will earn interest from debt payments.
When a user deposits to a CeDeFi protocol, they are turning over custody of their digital asset. That means their deposit will now be under the full control of the fintech company. The deposit wallet's private key is under their control, so the deposited cryptocurrency is technically no longer under the full ownership of the customer. The fintechs can then take your asset to earn insanely high interest, sometimes 20% or higher. The more control they have over user accounts and deposits to their protocol, the more centralized they are. This is the issue with CeDeFi to the decentralized ideology of crypto in general.
The reason you get higher yields with CeDeFi is because they use DeFi protocols to earn. They are able to pay the high interest (until they cannot) because in DeFi there are less intermediaries to no intermediaries for transactions, meaning more money can be paid back to customers (e.g. middlemen do not get a cut of transaction costs). The only problem is that it appears that this system works well during healthy periods in the crypto market. It falls apart when there is a loss of confidence in the market, which affects liquidity and sustainable payments to customers. While it appears good in theory, in reality it is a very fragile system that is full of risk and uncertainty.
The Problems With Centralization
The most obvious problem that users had with CeDeFi became apparent during the Terra LUNA meltdown in 2022. A crash in the cryptocurrency market affected market prices leading to the downside. This caused a ripple effect, leading to bank runs which depleted Terra's reserves in trying to keep their UST stablecoin peg to the US dollar (USD). They failed, leading to a further decline in the value of their native token LUNA. This affected institutional investors who had exposure to Terra.
It also affected CeDeFi fintechs who had put investments into Terra UST or LUNA. The fall of Terra meant that money invested by fintechs would no longer be able to generate yields. They would also have to owe money to their customers, if they had used their assets as collateral for earning higher yields using Terra UST (e.g. Anchor Protocol). Three Arrows Capital (3AC) was a hedge fund severely affected by the UST selloffs and falling prices of LUNA. 3AC filed for bankruptcy after becoming insolvent. Some CeDeFi fintechs (e.g. Voyager) were exposed to 3AC, and due to insolvency they would have to default. This led to massive liquidations across the market, leading to a downward death spiral in asset prices.
It turns out that some of the fintechs put money into more risk to earn more gains, not only for customers but for their company. This includes DeFi protocols like Compound and AAVE, using the DAI stablecoin. Another asset that fintechs invested in were staked assets like stETH (Staked Ether) which is pegged to Ethereum's ETH (Ether). Unfortunately the prices of crypto's top two assets Bitcon and Ethereum have crashed due to economic uncertainty in the first half of 2022. This depegged stETH from ETH, meaning fintechs who hold it that time will have heavy losses. Until the market recovers, there would be no way to maintain payments from yields on these assets due to lower liquidity.
Other CeDeFi fintechs were also experiencing problems with making payments to customers who deposited their crypto. As a result, some of these companies (e.g. Celsius, Voyager, Vauld) would halt all withdrawals or trading until further notice. Other fintechs like BlockFi are facing buyouts after suffering heavy losses during the crypto market crash (this news is still developing as of posting). Due to the uncertainty that now comes with what will happen to deposits made to these companies, the customers are the ones suffering the most.
CeDeFi Is Like TradFi
It is obvious now that CeDeFi is very much how TradFi (Traditional Finance) works. They are fintech companies that also have a hierarchical structure like banks and other TradFi institutions. Decentralized means that there is no company or entity behind the protocol, though it can be a voluntary group of people. Decentralized protocols are just software that people use. There is no authority controlling it, and all upgrades or updates are community driven. In CeDeFi there is a small group of people making decisions, which is also the same in TradFi.
CeDeFi work just like banks. When a user deposits their digital assets (i.e. cryptocurrency like Bitcoin) to earn on interest, they are surrendering it to the fintechs. Under the agreement, which is often vague and not clearly explained sometimes, the fintech can use the asset as collateral for other financial ventures or lend it out to other institutions. Banks operate in a similar way. The fintechs try to get the highest yields for their customers by doing this, but it is often times risky. If the fintech had lent to 3AC (for example), they will not likely get those assets back since 3AC filed bankruptcy. 3AC won't be able to pay back loans to the fintechs if they are insolvent.
Since CeDeFi are like TradFi, they are very centralized. This is what allowed them to halt customer withdrawals at the height of the crypto crash. Bitcoin fell from $30K (in early June 2022) to just above $17K in a span of less than a month. Since the prices kept crashing, many CeDeFi customers began withdrawing their assets, which is akin to a bank run in TradFi. As a result, the fintechs lost value locked and would not be able to sustain payments to their existing customers. To prevent further collapse, the fintechs began limiting withdrawals. When the market continued to fall, they finally halted all withdrawals which left customers hanging.
If you look at true decentralized protocols in DeFi like Maker DAO, they have not collapsed during the market crisis. They are not infallible, but the DeFi protocols were able to hold out better than CeDeFi protocols. While both offer lending and earning for users, the DeFi protocols had better methods of mitigating disaster compared to CeDeFi.
Should CeDeFi Be Regulated?
Unlike financial institutions in TradFi, the majority of CeDeFi offer no insurance or guarantees to customer's assets. While some fintechs (e.g. Voyager) claim to be FDIC insured, it is actually the banks who they are in business with and not the entity. That means if the bank had problems, they can cover for it. However, the company itself is not fully covered by FDIC or any other disaster plan. Since CeDeFi work mostly like TradFi, should they now be regulated by financial agencies around the world?
Regulation should come for CeDeFi mainly, and not blanket the entire crypto industry. It is fair to allow truly decentralized protocols to remain as they are, but the heavy handed regulation should be against the fintechs who operate just like centralized traditional financial companies which are regulated. They have customers who put their trust and confidence in their service. It is much like a client and broker relationship, which is very centralized and controlled.
They should be regulated on being more transparent to customers regarding what is being done to their cryptocurrency assets as well as being more realistic about the yields they offer on interest. If money lenders and payment processors are regulated in TradFi to comply with consumer protection, CeDeFi can also be regulated in the same manner since they are centralized.
Synopsis
Regulating CeDeFi can help customers much better and improve how fintechs provide financial service. Cenralized exchanges like Coinbase and Binance are already regulated, so this extends to CeDeFi fintech companies. For the most part, CeDeFi fintechs do follow compliance practices by gathering customer information (e.g. KYC/AML Verification). That is not enough for protecting customers, since the fintechs have to agree to certain rules about how they handle assets and mitigate risk.
The risk mitigation part is important, because if there are no rules then fintechs can enter high risk situations at any time. Just take for example how some of the CeDeFi fintechs misjudged risk when handling customer assets. According to Voltz CEO Simon Jones:
"Systemic risk was particularly misjudged by the lenders who provided 3AC with capital. This lending was often made against some form of collateral. However, like 2008, that collateral was overvalued, suggesting the positions were collateralized when actually they were undercollateralized."
When a CeDeFi company prevents customers from withdrawing their assets and collecting interest payments, it leads to a loss of confidence with crypto among the masses. Even though the problem is more to do with CeDeFi's lack of decentralization, the average user will have a negative view of crypto overall because of these experiences.
It is time to restore confidence in CeDeFi and the crypto market. More education leads to less FUD (Fear, Uncertainty, Doubt) and panic among crypto users. The more users learn about "Your Keys, Your Coins", the more they will understand the true value of how decentralization is about full control of your money. Trusting your money to CeDeFi is centralized because you do not have control of it any longer.
Users should still have that option to grant custody if they want, but now they need some form of regulation for consumer protection. Even some form of regulation should be welcomed to assure customers that CeDeFi fintechs do not get away with any dubious activities. There has to be some limits that fintechs have to abide to. This can help bring more clarity and lessen the anxiety among customers.
Disclaimer: The information provided is for educational and reference purposes only, and not financial advice. The views expressed are the opinion of the author. Please DYOR always to verify information.
Photo Cover Credit: Laura Tancredi