CeFi vs DeFi: Assets and Crypto Assets
- Bitcoin is positively linked to risk assets, including stocks, bonds, and commodities, and negatively linked to the U.S. dollar, which is a typical safe-haven asset. Therefore, Bitcoin is closer in nature to a risk asset than a safe-haven asset.
- In 2023, the US SEC asserted that DeFi might fall under rules governing securities.
Let’s start with a simple definition – an asset refers to a specific resource with economic value owned or controlled by an individual, corporate entity, or country with the potential to provide future gains.
Assets have many faces – generally, it can be just something that is useful or holds a certain value. For example, people tend to keep personal assets such as cash, life insurance policies, savings accounts, jewellery, and collectibles.
In business, we need to demonstrate that an asset has economic value. A resource with economic value implies that something is scarce, and encompasses the ability to produce economic advantages.
If we think in a wider sense, most things a company owns or controls refer to assets – from the building the employees work in, to intellectual property rights, to any piece of machinery or inventory used.
As you can see, the basic definition of an asset is wide. However, since we are discussing the intersection between decentralised finance (DeFi) and centralised finance (CeFi), we shall narrow down this definition and focus on financial assets.
Decentralised finance (DeFi) refers to an umbrella term that includes a wide range of financial services and decentralised applications. It presents a novel and decentralised financial system as opposed to traditional finance and its financial institutions. To learn more about DeFi, check out this article: 'Getting started with DeFi'.
What are traditional financial assets?
Most assets can be characterised as tangible, financial, or intangible. While tangible assets refer to physical types of assets that draw their value from properties or important substances such as land, precious metals, real estate, and oil, intangible assets lack physical features and refer to intellectual property.
Financial assets stand between these two categories. At first, financial assets seem intangible since their abstract value is stated on a piece of paper or a listing on a computer screen. However, that physical trait presents a claim of ownership of a corporate entity or a contractual right to payment such as interest.
Therefore, financial assets are types of assets that draw their value from an ownership claim or contractual right. These are, for example, stocks, bank deposits, and stocks. Apart from their value being stated on a piece of paper or a listing on a computer screen, it is driven by the laws of supply and demand in the relevant marketplace.
What does DeFi bring to the table?
All these types of assets belong to centralised financial services under the control of a central authority. With the rise of blockchain technology and the DeFi ecosystem, we are witnessing the creation of a new financial system. Being among crypto's new frontiers, the DeFi ecosystem is still in its early stages, but it has already seen rapid growth.
Within traditional finance, a centralised institution usually defines rules for financial institutions such as banks and brokerages, which consumers rely on to access capital and financial services directly.
When it comes to decentralised finance and cryptocurrency-related financial services, the new ecosystem challenges the centralised financial system by empowering users to access capital, financial applications and execute transactions without an intermediary.
Blockchain technology is based on immutability, transparency, security, and autonomy. Therefore, DeFi platforms don't rely on any intermediaries such as centralised finance does, and are not subject to corruption, bankruptcy, or any other kind of adversity. The decentralised side of DeFi protocols manages to mitigate most of these risks.
DeFi applications and platforms are generally built using smart contracts as pieces of code that determine the rules DeFi protocols operate by. This results in users interacting with DeFi smart contracts and doing similar things or using similar financial services they would do with the help of centralised financial institutions such as trading assets, lending, and borrowing.
DeFi services and the new digital economy present a significant advantage over the traditional system, but long-standing principles of economy and finance didn't change. In a world that is constantly evolving, basic principles are just being moved to a new decentralised path
If you have been keeping track of the crypto and Defi space, you probably know that the US Securities and Exchange Commission (SEC) has been pushing a new narrative: crypto assets are securities. If an asset falls under the definition of a security, the issuer has to fulfil certain requirements and disclose information to the SEC.
Many legal battles are being fought by crypto and DeFi projects to determine whether crypto assets are securities or not with an undetermined outcome. For now, let's explain what a security is. It can be done simply by differentiating them from commodities.
A commodity presents a basic good that can be interchanged with other goods of the same type such as a raw material used in producing other goods. It is a tangible product indeed. Commodities can be hard such as oil, gas, and precious metals, or soft, such as agricultural goods. Commodities are being traded on the market directly or by using derivatives.
A security refers to a financial instrument with monetary value that can be traded on the market. It presents a fungible financial instrument issued by corporations and governments to raise capital. Typically, they present equity, debt, or a fusion of equity and debt.
Commodities and securities both present assets that can be traded. Investors are more than often recommended to diversify their portfolio by having some exposure to commodities because they can be a good tool for investors who want to hedge against inflation.
However, securities are subject to more severe regulatory oversight. Those who issue securities, such as stocks or bonds, must provide detailed, transparent information to investors and the central authority, while commodity issuers are subject to less strict requirements.
What does all this have to do with the DeFi space?
When you read the basic definitions of commodities and securities, you might jump to the conclusion that the difference is evident, yet the commodity vs security debate goes way back to 1946 when the Supreme Court determined in the case of Howey vs SEC that a contract involving the sale of agricultural land and services represents a security.
What does all this have to do with the DeFi space?
This notion resulted in the Howey test that is now being used in determining whether crypto assets are securities. In a few cases that have already been decided in court, judges agreed with the SEC that some types of crypto assets can be classified as securities. Therefore, if crypto assets are determined as securities, they are subject to stringent regulatory oversight.
Definition and classification of crypto assets
According to the explanation provided by the International Monetary Fund, crypto assets refer to digital representations of value based on distributed ledger technology and cryptography. Due to blockchain technology and the use of distributed ledgers, there is no need to have an intermediary such as a central bank.
Crypto assets can be categorised further; first, we have Bitcoin-like crypto assets (BLCAs) such as Bitcoin, Ether, Litecoin, Stellar, and others. Even though the term BLCA is generally used in reference to all crypto assets, these are assets with a main purpose to serve as a medium of exchange for peer-to-peer payments.
While some BLCAs are put into circulation as a result of mining, others are issued at the launch of crypto projects. However, several other crypto assets can be defined as digital tokens that are generally being issued through Initial Coin Offerings (ICOs). Digital tokens belong to a category known as crypto assets other than BLCAs.
Digital tokens can be defined as units generated within a distributed network that tracks ownership of these units through the use of blockchain technology. They are issued through ICOs to raise money to fund projects, usually described in their white papers.
An alternative classification makes a difference between traditional crypto assets and stablecoins. To reduce the volatility of crypto assets and the cryptocurrency market, stablecoins are backed by real or virtual assets as collateral.
How to categorise digital tokens
In line with their main economic function, digital tokens can be divided into four categories.
First, we have payment tokens. These are intended to become BLCAs and to be used universally without being attached to a specific platform. Crypto assets serving primarily as a medium of exchange usually fall outside the contemporary regulatory framework, except when specifically mentioned.
Secondly, utility tokens are designed to provide their holders with future access to services. They assume the role of digital coupons that can be exchanged for future benefits, products, or services through the issuer’s platform. The capital raised from the sale of utility tokens is typically used to fund the development of the project. While these can be subject to regulations regarding consumer protection, online trading, and data protection, they usually fall outside the scope of financial regulations.
The third category is asset tokens; these represent debt or equity claims on the issuer. Asset tokens generate interest to the holder or promise a share in the future earnings of the project. They may be structured to confer rights equivalent to those of traditional financial instruments. In that sense, they can overlap with securities.
Lastly, we have hybrid tokens. These digital tokens are a mixture of utility and asset or payment tokens.
We can also add governance tokens to this classification. Often used within the DeFi space, governance tokens represent digital assets that confer the token holder the right to vote on governance issues facing the decentralised autonomous organisation (DAO) they belong to.
Whether governance tokens should fall within the regulatory scope is unclear because they encompass genuine features that are not in line with the Howey test. For example, they can be issued solely to reward loyalty, and they are usually not distributed with an expectation that they will appreciate in value.
Traditional assets vs crypto assets
Crypto assets and traditional financial assets represent, at the same time, two divergent yet linked worlds within the realm of finance. While they possess significant differences, they share particular similarities within the spheres of investments and stores of value.
Decentralised finance introduced a novel disruptive element by enabling financial services that combine the benefits of these asset types while leveraging blockchain technology to recreate traditional financial services in a decentralised manner.
Apart from eliminating intermediaries and the use of smart contracts to automate financial transactions, DeFi enabled users to earn passive income or yield by providing liquidity or participating in a wide range of DeFi protocols. In other words, in the DeFi and CeFi match, DeFi managed to get some extra points by providing a new revenue stream.
Differences between traditional and crypto assets
The most evident distinction refers to ownership and control. Traditional financial assets, such as bonds and stocks, usually include ownership of a physical or digital representation of the asset in question, issued by the relevant central authority. On the other hand, crypto assets are decentralised and ownership is determined by cryptographic keys.
There are some market features that differ; while cryptocurrency markets operate 24/7 and enable continuous crypto trading without using intermediaries, traditional financial markets generally follow determined trading hours and require ‘middlemen’ for the transactions to go through.
Lastly, traditional financial markets are subject to regulatory frameworks and oversight to ensure the stability of the market and protect investors. Centralised finance has its advantages and disadvantages; while its purpose is to protect investors, it includes a significant role of the central authority which is a thing the new digital landscape aims to change.
Similarities between traditional and crypto assets
CeFi and DeFi share a number of similarities as well as crypto and traditional financial assets. Starting off with investment possibilities, both of these asset classes provide a wide range of investment opportunities. The common investment goal of generating returns by purchasing assets with the expectation of future value appreciation unites traditional and crypto assets.
Another common feature refers to the risk-return issue. Higher returns are typically associated with higher risk. This trade-off is common to both crypto and traditional financial assets. Potential investors need to check out all economic and market conditions before making any financial decisions.
Finally, market sentiment is a trait that plays a significant role in both of these asset classes. Market sentiment influences prices since investors’ subjective perceptions of value and future potential impact their financial decisions.
Key terms associated with assets
Whether we are talking about centralised or decentralised finance, there are some common terms used to describe assets in terms of constantly evolving market conditions. To navigate DeFi systems more efficiently, it is important to understand basic concepts.
In general, asset value represents its fair market value. Asset valuation is based on subjective and objective methods of measurement. By using absolute value models assets are valued on the features of that asset such as residential income, discounted divided, and others. On the other hand, relative valuation ratios are used by investors to determine asset valuation by comparing similar types of assets.
When it comes to crypto assets, their value essentially depends on their nature, and the distinction of whether the asset in question grants its holder the right to access future revenue flows or not. If we take into account three asset types: utility tokens, security tokens, and cryptocurrencies, the best valuation method would be different for each of them.
While the pure income approach might be a conceptually good method for security tokens, a market approach could also be taken into account depending on its stage of development and liquidity. On the other hand, valuing utility tokens can be done by using the opportunity cost of the utility method by determining the token’s purchasing power in terms of goods and services.
A crypto asset that can be mined, such as Bitcoin, might be valued by calculating the cost of generating the asset through mining. However, a suitable method depends on the specific circumstances and facts of each case.
Whether we are talking about traditional or crypto assets, appreciation means the same thing – an increase in the value of a particular asset over time. This increase may happen due to various reasons such as expanded demand or weakened supply, along with the change of market conditions or interest rates.
Depreciation refers to an accounting method that represents how much of an asset’s value has been used. It is mainly used for tangible assets as it enables companies to earn revenue from the assets they own by paying for them over a determined period.
Since we are discussing investment and financial instruments, it is important to mention that these cannot be depreciated, along with purely intangible assets.
Assets that can be depreciated are, for example, building, leasehold improvements, machinery, equipment, and vehicles. You probably wonder what all this talk has to do with the crypto space.
Interestingly, a 2023 study of Metaverse land prices concluded that Metaverse property prices have depreciated by up to 90% since 2022. The study in question made a comparison of land prices on popular Metaverse platforms.
What are derivatives?
This term describes a type of financial agreement whose value is determined on the basis of the underlying asset, benchmark, or group of assets. When it comes to traditional financial services, a derivative is concluded between two or more parties that can trade on an exchange or Over-The-Counter (OTC).
Derivatives’ prices stem from fluctuations in the underlying asset. These contracts are usually used to access particular markets, to mitigate risk by hedging, or for speculation. Traditional derivatives include forwards, futures contracts, swaps, and options.
A crypto derivatives contract refers to a tradable financial instrument that derives value from the underlying crypto asset. As you can see, cryptocurrency derivatives mirror traditional types of derivatives.
In simple words, parties conclude a contract that specifies the terms for the trade of an underlying asset. Crypto derivatives enable traders to gain exposure to the price movement and execute advanced trading strategies using leverage, along with the possibility to hedge portfolios.