Lending and Borrowing: CeFi Problems and DeFi Solutions

By offering transparency, real yield, self custody, and algorithmic execution mechanisms ensured by smart contracts, well-designed DeFi protocols can stay true to crypto’s original mission and solve the problems that CeFi recreated. A hefty promise, however, DeFi is already delivering vast improvements to the future of finance, namely:

• Solvency Assurance
• Counterparty Risk Mitigation
• Effective Liquidation Mechanisms
• Favorable Rates Structures
• Convenience and Privacy
• Key Management

So without further ado, let’s have an in-depth look at how two of the most reliable lending DeFi blue-chips, Aave and Liquity, put CeFi’s flaws to shame.

As with any investment, there are risks involved with DeFi products on both the lending and borrowing sides. There is liquidation risk on borrowed assets, as well as impermanent loss on LP positions. In DeFi, however, these risks are transparent and quantifiable. When users engage with CeFi institutions, they add an additional level of unquantifiable risk: counterparty risk. This means that users are putting their trust in the institution to handle deposited funds properly and maintain solvency.

Take the now extinct CeFi lending platform Celsius for example. Celsius offered low interest loans and high yield on crypto deposits, taking depositor’s funds to MakerDAO in order to obtain the leverage necessary to provide these artificial rates. They also built up a large staked ether (stETH) position to inflate yield earning. However, stETH can’t be redeemed for ETH directly, so its price isn’t pegged. stETH price dropped significantly below ETH price, and it became known that Celsius was insolvent on ETH. Once the following onslaught of withdrawals couldn’t be met, Celsius was forced to declare bankruptcy, leaving users to pay the price for the utter lack of risk management.

DeFi's Sound Design

Now let’s look at one of the top DeFi lending platforms, Aave, and how its construction eliminates counterparty risk. The premise of Aave is simple: lenders lock assets in pools, where borrowers are able to access them. Key principles utilized to maintain solvency are:

1. Loans are overcollateralized - borrowers must post collateral with value higher than the amount to be borrowed. Exact ratios depend on the assets involved, but it is always over 100% of the loan.
2. Borrowers are assigned a “health factor” equal to (collateral * liquidation threshold) / amount borrowed. If this number falls below 1, the collateral becomes eligible for liquidation.
3. Assets are stored in smart contracts. All transactions such as liquidations are executed automatically by code.

With its sound economic design and rules enforced by code rather than human decision making, Aave has been able to maintain operations and solvency throughout all sorts of market conditions and volatility. Borrowers can’t default on a loan, their collateral is simply liquidated to compensate lenders if necessary, eliminating counterparty risk.

Liquity offers a different flavor of borrowing. Known as a collateralized debt position, or CDP, it involves users collateralizing ETH to borrow its stablecoin, LUSD. Similar to Aave, loans on Liquity are overcollateralized, and the ETH deposits are all handled exclusively by immutable smart contract vaults. Solvency across the protocol is also maintained by the redemption value of LUSD, which is always equal to $1 worth of ETH. The redemption mechanism works by essentially paying off the LUSD debt of the troves closest to the 110% minimum collateral ratio in exchange for an equivalent amount of the trove’s ETH collateral, further ensuring the health of the system.

This process, along with the sturdily designed incentives for maintaining LUSD’s $1 peg, are the major components that have enabled Liquity to operate uninterrupted even throughout extreme market conditions, which there has been no shortage of since the protocol launched back in April of 2021. The point to be made here is that when deposits are handled by open-source code that establishes hard rules on how those assets are stored and moved, users don’t have to worry about whether or not those assets will be there when they want to withdraw.

When it comes to protocol health for lenders, handling liquidations and setting leverage controls are highly important. This is another area where DeFi protocols differentiate themselves from CeFi counterparts, as the automated liquidation mechanisms written into smart contracts ensure that leveraged borrowing cannot imperil the protocol’s solvency. We witnessed these mechanisms in action in November, as the loans that Alameda had taken out on Aave were the first to be paid back when they began to unwind. The automatic nature of Aave’s liquidation process essentially forced Alameda to repay their debt or lose the collateral, which would have been more costly due to overcollateralization requirements. In contrast, Alameda was given no-liquidation accounts by FTX, which allowed them to use irresponsible amounts of leverage on risky trades. FTX’s treatment of customer deposits as an uncontrolled slush fund for Alameda’s prop trading wass one of the main factors in its demise.

The Beauty of Algorithmic Governance

To give another example of DeFi robustness, Liquity encountered a similarly significant stress test during June 2022, when massive drawdowns sent ETH price as low as $800. This caused a high volume of troves to fall below the 110% minimum collateral ratio, triggering the largest week of liquidations in the protocol’s history.

Over 100,000 ETH was liquidated in a single week, which Liquity was able to fully absorb through the stability pool. This pool consists of deposited LUSD, which is burned to offset the amount lost when liquidations occur. In exchange, stability pool depositors receive an equivalent amount of the liquidated ETH collateral, allowing them to acquire ETH at a discount when liquidations are high. As can be seen in the chart below, the stability pool APR during June spiked up to 700%.

Anyone who was borrowing from BlockFi must have been completely in the dark about the DeFi alternatives, as the loan parameters were not at all borrower friendly.

If someone wanted to borrow $1,000 worth of stablecoins on BlockFi, they would need to provide at least $2,000 worth of collateral. Add in the 9.75% interest rate for this structure, plus a 2% borrow fee, and a one year stablecoin loan for $1,000 would end up costing over $2,117.50.

Rates on Aave do fluctuate to some degree based on supply and demand of assets, but currently the maximum LTV for ETH collateral is 82%, meaning a $1,000 loan would require at least $1,220 in collateral. Aave users have a choice between a stable and variable interest rate on loans, but for this example we’ll use the stable rate, which is currently 10%. There are no borrow fees to consider, so in total this $1,000 loan would cost ~$1,320.

The same loan on Liquity would require a minimum of $1,100 worth of ETH, no interest fees, and a floating borrow fee that ranges between .5 - 5%, for a total cost of between $1,105 and $1,150. Significantly, while the borrow fee may potentially reach 5%, it has historically never risen about ~1.2% – a dramatic improvement over BlockFi’s 9.75%. In summary, BlockFi gets absolutely blown out by both Aave and Liquity when it comes to borrowing terms.

One of the main marketing points for CeFi platforms like BlockFi or Celsius was simplicity and accessibility, which played into the public perception that DeFi protocols come with a steep learning curve. However, the private data leaks that occurred with Celsius go to show that these conveniences can have unintended consequences.

The reality is that DeFi UI/UX on high quality protocols is relatively intuitive already and will continue to improve as the industry attracts more design talent. DeFi also has none of the problematic KYC requirements that infringe upon user privacy and censorship resistance. Overall, DeFi transactions are faster, cheaper, and more private than CeFi products. On top of all that, it is also completely permissionless, meaning that anyone around the world can access it with an internet connection.

No DeFi benefits analysis would be complete without addressing the custody issue. Poor risk management and fraudulent use of customer deposits played a big role in the aforementioned CeFi scams. However, users are not fully exempt from blame, as they accepted the custodial nature of depositing with these firms. “Not your keys, not your coins” is a phrase commonly used to outline the custody issue, and former CeFi depositors have now realized exactly what that entails. When holding assets on a platform like BlockFi, Celsius, or FTX, that corporate entity is the one who actually has ownership of the assets, while user balances are little more than an IOU to be paid out on withdrawal. If the corporation is forced into bankruptcy, users are subjected to a long and messy court proceeding to hopefully get back a portion of their deposits. Not ideal.

Conversely, DeFi users are able to access all the same financial products as CeFi offered, plus many more, without relinquishing custody of their tokens. In the event of a DeFi protocol unwinding, user’s tokens would remain safely in their own custody. While some may argue that self custody isn’t a viable option for mass adoption due to the perceived difficulty of setting up and securing a wallet, the reality is this is no more complex than obtaining a TradFi bank or brokerage account. Overall, the risks of not using self custody far outweigh the added responsibility, and self custody methods will only get more streamlined as crypto continues to develop.

No counterparty risk, no shady corporate governance, hard coded mechanisms for maintaining solvency, better rates, real yield, and users retain ownership of their assets. Lending protocols are one area of the financial markets where DeFi has already established extremely strong roots, and there’s really no argument for the use of any CeFi lending platform after what took place in 2022. In 2023 and beyond we’re self custodying our tokens and enjoying the sweet benefits that the future of finance has to offer.