Lending: TradFi vs DeFi
The difference between lending in a bank and in a DeFi platform
What are TradFi and DeFi?
TradFi stands for Traditional Finance. It is the mainstream financial system as most of us in the early 21st century know it. It is characterized by a high degree of centralization, intermediation, and opacity, with gigantic institutions such as banks, brokerages, and hedge funds.
As a general rule, the degree of centralization is defined by a handful of ubiquitous decision makers that virtually everyone must trust or rely on, in order to reliably ensure a transaction happened.
DeFi, or Decentralized Finance, on the other hand, has a polar opposite approach. It is characterized by a high degree of decentralization, disintermediation, and transparency. Smart contract dominates the DeFi world after its explosive growth in the past few years, and run automatically, removing the need for a large central authority or trusted third party to facilitate transactions on the blockchain.
When it comes to TradFi transactions, both you and the receiver must trust a third party (normally the banks, or the central bank in the case of a cash transaction), to make a transaction. Nothing can be done strictly peer to peer.
For instance, let’s say you are in a clothing shop and want to buy a shirt. You have selected your pick, and now you’re headed to the cashier.
The shirt costs $20, so you take out your debit card to pay it outright. The store has confirmed that they received the $20, and started to bag your newly-bought shirt.
It sounds simple, but what just happened “behind the scenes” wasn’t. The store electronically confirmed with your bank that you have the money to credit $20. Once it’s validated on both ends, the bank now facilitates the transaction.
In this case, both you and the store needed to trust the bank, which acted as the intermediary, on its ability and competence to run the transaction fairly.
DeFi removes the need for that central entity to trust. Smart contracts verify the transaction outright, and this transaction is validated by the thousands of validators in the blockchain.
Think of a smart contract as an auto-executing robot that processes your order once triggered. To ensure that this “robot” properly executes your transaction, thousands of people on their computer verify this “robot”, and then proclaim that it is true, and therefore, can be immutably added to the blockchain ledger.
Should I use TradFi or DeFi for my personal finances?
One of the reasons people go to the bank is either to earn from their deposits or to borrow money.
Does it make a difference if you do it in TradFi or DeFi? Here are some of the aspects you might consider before deciding where to do your transactions:
Registration requirements: To get a bank account, one must provide an official proof of identity, proof of address, source of income, and other relevant documents.
In DeFi, the only thing you need is a crypto wallet address and an internet connection, from anywhere… and that’s it.
However, most DeFi deposit rates are variable and not fixed. Good thing then that nowadays, there are DeFi platforms that offer fixed terms, such as iGain IRS.
A higher lending rate usually is the sign of higher risk, especially in DeFi, instances where a stablecoin may fall off its peg. Users get compensated for taking that extra risk. However, with more popular stablecoins that are audited and fully backed by assets, like USDC, the risk of people losing their money is negligible.
Borrow Interest Rate. Most rates in the bank can be variable and stable, similar to DeFi. Bank’s borrow rates are heavily influenced by the central bank’s interest rates, particularly on variable ones.
DeFi borrowing rates, on the other hand, are determined by the supply and demand of coins in a “liquidity pool.” It simply means that the fewer people borrow, the lower the rates will be because there is a lot of liquidity made available.
Loan Collaterals. When taking a loan with a bank, you normally would need to provide collateral that is at least equal to the amount of your borrowed amount.
For example, a $100,000 loan would require $100,000 collateral in order for the bank to approve you. This could be in the form of cash alone, or also could be in other assets like your house.
In DeFi, most platforms only allow at least 70%-95% utilization of your collateral amount. Let’s say you have $100,000 in USDT as collateral, you will only be able to take a loan for $70,000–$95,000, depending on the platform. And that only pertains to stablecoins.
It gets complicated when you collateralize a volatile cryptocurrency coin like ETH. If ETH’s price drops below the collateral amount, your funds risk getting liquidated by the smart contract, unless you provide more ETH so you won’t be “under-collateralized.”
TradFi has been around for ages, and will probably be around for the next years. But despite the strength of our financial system today, it’s undeniable to say that there’s a lot of growth potential for DeFi, especially for the 1.7B unbanked people in the world.
DeFi will allow everyone, including the most vulnerable, to take custody of their own money, and have access to the financial products that used to be only accessible to the few.