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These last few weeks we were all forced into economic and financial reflection, courtesy of the three failed US banks, problems at Credit Suisse, regulators’ reaction, and the Fed’s heating money printing press.
Crypto enthusiasts used this to point a finger at the current financial system and claim that a blockchain can be used to solve its shortcomings.
Crypto skeptics blamed the US banks’ demise on “risky crypto bets” (NY Times), stressing all the recent instances of fraud and malfunctioning in the crypto space.
The interesting thing is that all these claims are valid – but only to some extent 😉
The reason for misunderstandings is that “crypto” has become an umbrella term ☂️ for a wide range of ventures, with different degrees of centralization and very different characteristics. When it comes to crypto finance, we can separate it into three big groups: CeFi, TradFi, and DeFi.
While a new financial crisis may be developing before our eyes, it feels like the right moment to define those groups, clarify the confusions they have generated, and try to understand whether crypto can indeed fix our financial system 💰🔧
CeFi is a term that describes centrally managed financial companies that offer products and services related to crypto: centralized exchanges (Binance, FTX💀), derivative trading platforms (Deribit), asset management (Grayscale, BlockFi💀), centralized stablecoins ($USDC, $USDT), lending-borrowing (Nexo, Celsius💀)…
The most remarkable instances of fraud and malfunctioning in the crypto industry concern the CeFi, mostly because it operates in a traditional way, staying opaque and hiding its dirty laundry until a major problem exposes it all with a bang 💥
This is the way all financial companies function, and the fact that CeFi works with crypto does not change much: all CeFi’s notable failures were very conventional: using clients’ money to fund side operations (FTX), poor risk management (Celsius)…
The tools to prevent these faults are the same for all financial companies: audits, reporting, certification, and in some jurisdictions even special crypto licenses… which all end up being inefficient when push comes to shove.
TradFi is a term describing traditional financial institutions that have diversified their proposal to include crypto-related products or crypto-related clientele.
Crypto-friendly banks (you all know at least three 😅), Asset Management firms (Fidelity, VanEck), stock exchanges (Chicago Mercantile Exchange) can all belong to the TradFi category.
A risky bet on crypto did indeed contribute to the collapse of at least two banks – Silvergate and Signature.
However, the key word here is not “crypto”. The bet could have been on biotech, social media, or AI, the new headlines’ darling.
The key word is “risky” and it refers to poor risk management, as well as the very system that allows a handful of bank execs to take arbitrary decisions, some of them clearly not judicious enough.
DeFi is short for decentralized finance, i.e. protocols built on blockchain, which make it possible for users to engage in financial activity without intermediaries. DeFi offers a decentralized version of exchanges (Uniswap, Curve), derivatives trading platforms (dYdX), asset management firms (Yearn, Enzyme), lending-borrowing (Aave, Compound), decentralized stablecoins (MakerDAO, TerraUSD💀) as well as services proper only to DeFi, like liquid staking (Lido).
We have recently written a separate piece on DeFi and the top 5 protocols that illustrate it the best – read here if you have missed it, or here if you want to know more about DeFi in general.
The key takeaways about DeFi are :
📌 no barriers to entry,
📌 DeFi protocols do not get into the possession of users’ funds,
📌 they cannot be arbitrarily halted (even if the interface is shut, users could interact directly with the smart contract),
📌 governance decisions are usually taken by the community via a DAO.
DeFi is the most natural extension of cryptocurrencies, and they share the qualities of being transparent and accessible to all, which greatly reduces the room for fraud, while community governance rule help take weighted decisions.
DeFi undoubtedly has great potential, but for the moment it has too many issues that make it near impossible for mainstream use:
Technical issues ⚙️
As any software, DeFi protocols can have bugs and other smart contract flaws that will allow hackers to exploit them or can lead to unintended consequences. The protocols can also hide structural inefficiencies, like the defunct decentralized stablecoin TerraUSD.
Smart contracts audit firms and generous bug bounties are a way DeFi is handling this problem, but 100% security likely does not exist, and the space needs more insurance companies that would cover any losses incurred by users.
Poor user experience 🧮
Even if some protocols can make their use simple (like the Uniswap feature allowing to swap coins directly inside the wallets), overall the space is still way too complicated for non-crypto natives.
User responsibility 📑
Who says “decentralization”, says “responsibility”: if a mistaken bank transfer can be reversed, your Bitcoin sent to the wrong address is lost forever.
This kind of responsibility scares away many people, and the abundance of phishing websites 🪝luring users into approving fraudulent transactions makes the problem even more critical.
🧑💻 Nowadays DeFi users must not only know how to use a wallet and navigate diverse protocols. They also must be extremely careful and attentive to phishing, hacks, and other security threats. This is too much for many people, and they choose the easiest solution to just give their money to a person and let them manage it… which sometimes leads to dramatic consequences 💸
The thing that can break this vicious circle is a radical improvement of the DeFi user experience, with integrated solutions, proper insurance, and guardrails making the overall user journey easier ☔ Only then we can speak about crypto saving the financial system.
Until that time, crypto finance will mostly grow in its CeFi and TradFi iterations, trying to reassure the regulators and fight off the growing crypto stigma… which ironically is rooted in traditional finance’s flaws 😏