This introductory article will explain the differences between some aspects of Traditional Finance (TradFi) and Decentralized Finance (DeFi).
Custody of Funds
Everyone is familiar with the concept of banks. We all use them for various reasons, but have you ever asked yourself how they work?
Many believe you can simply deposit your funds into a bank and access it at any time. The reality is not so simple.
A bank is a centralized institution and has full control of all funds deposited. They can use your money, block your account, change saving and interest rates and, in extreme cases, should they collapse, you risk losing all of your funds. Every country has different rules on how these situations are handled, but the risk is always present.
Opposed to that are decentralized platforms. Lending Markets are an example of what DeFi can offer. A lending market enables you to keep custody of your funds and retain control over how they are used. With your assets deposited into “smart contracts”, the lending market does not have control of your funds. When you deposit your funds, you receive “receipt tokens”, which are used to keep track of your assets.
When you wish to withdraw funds, you simply exchange the receipt tokens for the assets you deposited.
Opening an Account and Running Costs
Opening a bank account can be a lengthy and complicated process. You will likely need extensive paperwork including proof of identity, proof of income, net worth and other various details.
Additionally, most banks require you to pay fees. Monthly fees are most common, but they can also include transaction fees, fees for international and national transfers, annual card fees and more. Furthermore, many of the bank’s offered services require administrative work, may experience delays and may have certain requirements (e.g. income above a specified amount) before you can access such services.
In DeFi, anyone can create an “account” (digital wallet) for free without the need to provide any type of information. To use a decentralized platform such as a lending market, you simply connect your wallet and you can start using the available services. You can deposit an asset and start earning immediately.
Besides the normal transaction fee to interact with the platform (can vary greatly based on the blockchain and usage) there are no further costs associated with having a DeFi account.
Every blockchain transaction requires what is known as a gas fee. These gas fees are paid to validators who help keep the blockchain secure by processing the transactions and adding them to the public record. Gas fees are paid in the token chosen by the network (e.g. ETH on Ethereum, AVAX on Avalanche, ETH on Arbitrum, etc.).
Getting Returns on Your Money
In TradFi, you place funds in a “savings” account and gain a small return on it. Usually, the rates are well below 1% and only amount to a very small share of the bank’s profits. Banks use your money in various ways (e.g. lending, investing, etc.) and you have no control over what the bank uses your money for or whether they even offer anything in return.
With a lending market, when your funds are deposited, you automatically accumulate a return, also known as Annual Percentage Yield (APY) or Annual Percentage Rate (APR). The return you receive depends on a few factors, but is normally well above normal bank rates as there are no third party institutions taking a cut as a middleman. Many lending platforms give the majority of their revenue back to their users.
Need a Loan?
In TradFi, depending on your financial situation, you can get a loan from your bank with fixed or variable fees and a payment plan. An additional fee for opening the loan contract and a fixed period to pay back are standard. Getting a loan can be difficult and the approval process may be a lengthy period. Many financial records need to be disclosed and the use of funds declared. Having money in your bank account does not guarantee a loan will be granted. Sometimes a credit and/or background check will be performed and you may be declined the loan.
On the other hand, lending markets could not be easier. You can instantly borrow against the assets deposited on the platform as collateral. Loans are generally “over-collateralized”, meaning the loan is backed by more collateral than it is worth and has no fixed window to pay back. You simply borrow against your assets and pay back when you want. Keep in mind that you will pay interest on the loan for as long as it is open.
Many platforms offer incentives as rewards for using their services by depositing and/or borrowing money.
Security, Regulations, and Important Information to Consider
Banks are strictly regulated financial institutions that operate in TradFi. Worst case scenarios aside, banks are commonly very safe and robust institutions. Investors need to concern themselves more with comparing fees and offers than research safety when choosing a bank.
Lending markets in DeFi are commonly built on smart contracts. These contracts are audited by third party protocols to check for vulnerabilities and issues. One of the most important things to consider when doing research on a protocol is their smart contracts and what audits have been completed. Audits detect bugs and vulnerabilities; they check the code for optimization and security flaws. Smart contracts ensure that your money is secure on the blockchain. Even if the protocol’s website or UI was unavailable due to technical reasons, the funds are still secure and can only be accessed by the wallet they belong to.
The protocol’s history is an important aspect to look at. Factors to review include the number of exploits, security procedures to secure funds, the transparency of the documentation, and in case of emergency, the ability of the team building the platform, etc. This information can usually be answered directly by doing a bit of research on the protocol’s official social media and website. Asking questions and making sure you understand the mechanics and tokenomics is crucial. It is your money: be diligent!
Regulations, protection and laws in the crypto space are still developing and there are no universal solutions. It is very important to research regional laws that apply to you, based on your country of residence.
In this context, it is vital you understand the importance of taking custody and responsibility of your assets. Securing your wallet is paramount! Hardware wallets such as Ledger, Trezor or similar help with keeping your assets safe and under your control.
Personal safety and security will be explored in a future part of this series.
The Big Advantages of Blockchain and Lending Platforms
Not only are interactions in DeFi fast, effortless and, after some first learning curves are mastered, easy and secure; it also offers direct peer-to-peer interactions. Profits are made and shared without big institutions taking their share and the potential rewards reflect that clearly. Some protocols go as far as to share 100% of revenue with the users, making it self-sustaining based purely on demand and supply.
Another big advantage is the ability for real time monitoring, 24/7 availability and smart contract security to ensure the safety of the platform and funds. In terms of transparency, unlike a bank’s private books, all activities on the blockchain are transparent. Every transaction can be followed and observed on the blockchain.
Closing Word
We hope this introduction and overview to DeFi lending platforms and their TradFi counterpart helped to clearly explain the main differences and advantages/disadvantages of each.
In our next article we will dive deeper into the topic, introducing UwU Lend as a lending platform and what it can do for you.
