CeFi vs DeFi: Basics of Investing
Evolution or Revolution?
The main difference between these two terms lies in their definitions. While revolution presents a sudden or radical change in something, evolution refers to the gradual development of something over a certain period. When it comes to investment, many of us might think that DeFi revolutionised that field.
Decentralised finance (DeFi) became a significant tool to millions of people who decided to leave behind centralised finance (CeFi) that has dominated financial activities for a long time. DeFi aims to rethink the whole traditional financial system and build it on a novel foundation of decentralisation.
With DeFi, anyone with an Internet connection can access a wide range of financial services directly from their crypto wallet. DeFi platforms provide users with greater control over their funds, lower fees and improved security, without the meddling of any centralised financial institutions.
Twitter and Telegram chat references are positively correlated to DeFi returns.
Looking at basic terms and principles of investing, it becomes evident that this isn’t a quick turnaround, yet something that has been built gradually on the foundations laid down by traditional finance,
In this article we are going to present the fundamentals of investing, and how each term and principle of traditional investing plays its part within the DeFi ecosystem.
If you are a newcomer, we suggest getting to know DeFi a bit more by reading this article: ‘Getting started with DeFi’.
Is CeDeFi a thing?
When we talk about the digital economy, it somehow always comes down to a DeFi vs CeFi battlefield. On one side, we have a longstanding world of centralised finance typically built around a central authority. Governments and centralised financial institutions assumed the role of intermediaries a long time ago. Additionally, CeFi examples revolve around traditional investment firms, banking services and asset management.
On the other hand, the opponent presents a shift to a new financial system. Unlike CeFi services, DeFi examples encompass decentralised, permissionless, easily accessible and transparent financial services and products. DeFi smart contracts perform similar things that they would do within the traditional financial system such as borrowing, trading or making loans, yet without any intermediaries.
DeFi protocols, being built on Ethereum smart contracts, mitigate many risks posed by centralised finance (CeFi). Even though it is a part of crypto's new frontiers, it managed to cross roads with CeFi again through a newly coined term - CeDeFi.
In simple terms, CeDeFi includes any manner of improving traditional financial management through decentralised means. Many investors found themselves in a spot of confusion; DeFi isn’t yet predictable enough due to its reliance on the volatile crypto market, while CeFi is pretty stagnant given its rising inflation of fiat currencies and dominance of the ‘middle man’.
CeDeFi is not necessarily about improving traditional banking services with a few novel technological perks. At the moment, it simply represents a combo of both worlds; by combining principles of both DeFi and CeFi, new products and services can be developed to provide a more fertile ground for investing and other financial applications within the crypto industry.
What is an investment?
An investment refers to an asset or item purchased with the objective of generating income or appreciation. It can be viewed as another form of savings since it may generate a desired rate of return. An investment is always about putting capital, time and effort into work today in hopes of a bigger payoff in the future. For example, an investor acquires a monetary asset with the goal to sell it later at a higher price.
Both in crypto and traditional finance, the term investing may be confused with speculation and the other way around. Despite some similarities, they encompass key differences. To find out more, why not read this article: ‘Does crypto need speculation? Why crypto bettors aren’t all that bad?’.
Within the traditional financial system, investments are typically any medium used for generating future income such as stocks, bonds, precious metals, real estate and others.
People invest for various reasons, but the primary goal is to gain high returns and achieve financial stability. In most cases it is done through yield plus capital appreciation referring to the difference between the purchase and sale price. Additionally, investors can also invest for liquidity since liquid assets are easily convertible into cash.
DeFi investments
Conducting transactions within the digital decentralised realm based on blockchain technology and earning returns on investments based on slightly different matters amounted to DeFi assuming the role of an alternative financial system. Basic principles of investing remain – the main goal is to achieve high returns and gain a decent degree of financial stability.
Investing within DeFi revolves around the ease of using DeFi applications. Users can interact directly with DeFi protocols that mimic banking, investment and trading solutions. It soon became an alternative financial mechanism that has the potential to mitigate portfolio risk which is especially significant in times of uncertainty in financial markets.
Some DeFi protocols even provide automated and low-risk manners of generating return through the so-called ‘delta-neutral’ trading strategy with the goal to mitigate volatility. In simple terms, delta-neutral refers to a portfolio strategy utilising multiple positions with attempts to neutralise directional exposure.
DeFi investing helps users to diversify traditional portfolios by seeking returns that don’t depend on traditional asset classes such as stocks and bonds.
DeFi interest rates are mainly high due to the law of supply and demand and to less regulatory constraints in comparison with traditional finance.
Keep in mind that a CeFi approach is the first entry point into the cryptocurrency market as well. CeFi exchanges within the crypto market enable users to purchase digital assets with fiat currency. Additionally, the ability to execute transactions on margin, as well as the ability to directly provide loans are capabilities primarily associated with the CeFi model.
To find out more about key differences between decentralised and centralised exchanges within the crypto market, take a look at this article: 'What are the risks of using a decentralised exchange (DEX) vs a centralised exchange (CEX)?'.
Measuring DeFi investments
Digital assets within the world of decentralised finance are composed of divergent classes of contributed funds in DeFi protocols. For example, they involve liquidity pools and interest, along with many types of rewards resulting from the service provided in these DeFi protocols.
To measure DeFi investments, we use a metric known as ‘Total Value Locked’ (TVL); this metric is used to measure the total value of digital assets that are locked or staked in a certain DeFi platform or decentralised application (Dapp).
The whole process includes adding up to the virtual assets currently locked in a specific DeFi protocol or smart contracts such as cryptocurrencies, stablecoins or tokens being used as collateral for loans or to provide the platform with liquidity.
In simple terms, TVL is used to assess whether a particular DeFi protocol is worth investing in. Determining this value may involve complex maths. However, it is also affected by other parameters such as the value of the native token, protocol’s functionality, liquidity and trading volume, along with market valuations.
In contrast to traditional finance, the TVL metric is significant from the perspective of DeFi protocols. Basically, it enables them to function without deposited capital in the form of smart contracts. In terms of investing, it can be interpreted as an early indicator of potential gains.
Return on Investment (ROI)
When mentioning investing activities, it is almost impossible to disregard this term. Return of Investment (ROI) is a popular performance metric used to assess the efficiency or profitability of a particular investment. In simple terms, it is used to evaluate how an investment has performed.
ROI is expressed in the form of a percentage. To calculate it, you need to divide the return of an investment by its cost. For example, imagine that you have invested $1,000 in a particular company back in 2021 and sold the shares for a total of $1,200 in 2022. To calculate ROI, you need to divide $1,200 as the net profits with the investment cost of $1,000. The ROI here equals $200/$1,000 or 20%.Keep in mind that this is a very simple example that doesn’t include additional costs associated with the investment; just to demonstrate how it is done.
ROI is usually used to make apples-to-apples comparisons and rank investments in divergent projects. It encompasses particular limitations; for example, ROI doesn’t take into account the holding period or passage of time so particular opportunity costs of investing elsewhere are not taken into equation.
Additionally, the ROI calculation is susceptible to manipulation as it may differ between divergent people. For example, a marketing manager may calculate it without accounting for additional costs such as maintenance, sales fees, legal costs, and so on, while investors typically need to look at a true ROI that accounts for all possible costs incurred when each investment increases in value.
This metric is an important tool for investors and businesses due to a few reasons. Primarily, ROI is used to gain a clearer budgeting insight and conduct long-term planning. Keeping track of ROI can also help businesses meet the needs and expectations of customers.
What is an ROI within DeFi systems?
Typically, there are a few ways to earn returns within DeFi systems such as through platform or transaction fees, staking, interest by lending assets and inflationary token rewards.
There are a few factors that make it hard to calculate a usable and accurate ROI for DeFi assets manually. Since DeFi assets are purchased using cryptocurrency, a rudimentary calculation won’t do the work precisely.
In other words, when looking at the ROI of a crypto asset, an average investor wants to understand it in the context of their entire portfolio. However, a simple ROI calculation just isn’t enough to convert its value to an investor’s preferred currency.
Additionally, the volatile nature of cryptocurrencies is the second reason that makes manually calculating the return of a DeFi investment difficult. In addition to price volatility on DeFi assets, there is also volatility on the interest and financial transactions returned from the protocol.
Therefore, given that the payment cycle of DeFi investment return is usually short and valued in the block generation time, a simple cash-basis analysis doesn’t make the cut.
How to calculate ROI in DeFi then?
There are other ways to calculate ROI in DeFi more accurately by using a variety of tools. It has been also noted that, within the DeFi space, another calculation method should be used – the net asset value (NAV).
Mainstream financial methods can be still adopted to a large extent as long as key features of DeFi are taken into account. Primarily, we have to take into account capital investment, withdrawal and NAV.
While capital investment and withdrawal refer to the cash flow of DeFi investments, NAV represents the stock of DeFi investment at a specific point in time, amounting to the net value minus associated liabilities.
Secondly, collateral and leverage have to be recorded within the balance sheet. While collaterals belong to the equity section, leverage corresponds to liabilities. By calculating these two parameters, we are one step closer to getting a clear view on risk exposure.
Defining yield
The term yield refers to how much money investors can earn on a certain asset over a predetermined period. It accounts for the interest they earn and dividends they receive from a particular asset.
Within traditional finance, yield is often expressed as a percentage of the security’s market value or the initial investment. Even though yield can be calculated by using any period such as months or quarters, annual yields are the most common type.
Typically, riskier investments encompass a higher yield potential than those less risky. Within traditional finance, for example, stocks have a higher yield potential than bonds.
Yield vs return - what is the difference?
We have explained returns in the text above, and now we mention yields that really resemble returns. Many people mix these two terms or use them interchangeably, thinking they both refer to the money you get back if your investment performs well.
This is a misconception. While they are both measurements used to express earnings from an investment, they are different types of calculations.
ROI takes into account all gains an investor made from a particular investment over a predetermined period of time. It includes both income and capital gains. This metric looks at what has happened in the past; therefore, it is a retrospective measure.
On the other hand, yield is a prospective measure because it looks at what an investor will make in the future. It doesn’t take capital gains into account.
What is Annual Percentage Yield (APY)?
The annual percentage yield (APY) presents the real rate of return earned on an investment. It takes into account the effect of compounding interest. Let’s explain this further – in contrast to simple interest, compounding interest is calculated periodically, along with the amount being added immediately to the balance.
Therefore, APY refers to the actual rate of return that should be earned in one year if the interest is compounded. The more often interest is compounded, the higher the APY shall be.
This metric resembles the annual percentage rate (APR), yet APR is used for loans. The APR metric reflects the effective percentage that the borrower will pay in one year in interest and fees. It doesn’t take into account compound interest.
What is yield in the DeFi aspect?
DeFi yields can be defined as the interest or return generated from participating in DeFi protocols. A popular method of passive earning within the DeFi space is known as yield farming. Also known as liquidity mining, this activity includes staking or locking up assets in a smart contract in exchange for rewards in the form of tokens or fees generated by the DeFi protocol.
Throughout the years, DeFi yield farming has become more sophisticated by providing new strategies to earn passive income. The fast moving DeFi industry managed to achieve high yields briefly.
Keep in mind that the yield generated by DeFi systems may vary based on the protocol, the asset used for liquidity provision, and the current conditions of the crypto market. You always have to do your own research first; for example, some DeFi protocols provide fixed interest rates, while others encompass variable rates that are determined by the demand for liquidity.
Yield farming is typically constructed with two objectives in mind – bootstrapping liquidity and token distribution. By incentivising users to deposit and lock up their liquidity within a DeFi system, the TVL metric grows and enlarges the supply of the whole DeFi ecosystem. If such a system includes a broad supply, it can come off as superior to its market competitors, and extend the demand side of the story.
Other methods of generating yield within the DeFi realm include providing collateral to lending platforms and taking part in automated market makers (AMMs).
Understanding hedging
Investing brings along the risk of loss. Even though hedging may sound like something you should do in a garden, it presents a strategy cherished by many investors.
Therefore, hedging refers to an advanced risk management strategy that includes purchasing or selling an investment to reduce the risk of loss in terms of the existing position.
Let’s explain this by laying down a hypothetical example. Imagine you bought 100 shares of a particular stock at $30 per share in March. Several months later, the stock was trading at $27. You don’t feel like selling the stocks because you think it could still increase over time or you just don’t want to trigger a taxable event.
However, since the price of the stock went down, you understand that you need to reduce your risk exposure. In other words, you want to hedge your position. To hedge this situation, you thought of using a protective put strategy; deciding to purchase put options on a share-for-share basis on the same stock.
Now what does this mean exactly? Puts give you the right to sell the stock at a given price within a predetermined period of time. For example, you bought put options substantial enough to hedge your position with a strike price of $25. By doing this, you are protected from additional losses below $25.
As you can see, mitigating risks and obtaining protection includes paying money. You probably wonder why investors do this? The answer is quite simple – to handle overconcentration and postpone tax implications.
Instead of selling stocks panically, investors rather pay and hedge risks. Hedging gives them time to acquire a higher degree of certainty for the future.
Hedging can include a variety of asset classes, yet it is most commonly done using options, futures and other derivatives. As an advanced risk strategy, it comes with a trade-off – you are entering into another position and possibly losing out on a potential appreciation of the existing position.
Hedging your DeFi position
DeFi brings to the table a variety of benefits, but it includes a significant trade-off – managing risk exposure. Typically, DeFi interest rates were variable, but a change appeared on the horizon.
High variable rates can be a significant turn-off for investors seeking less risky opportunities. It has been stated that DeFi investors are similar to lobsters in boiling water; as price decreases lower, their capital is ready for liquidation. Many of them didn’t realise that.
There is a rise of risk-hedging DeFi protocols to mitigate such risks. Not being aware of the risk associated with capital locked into smart contracts led to uninformed decisions. DeFi investors needed to manage their account like an open position on margin.
Along with risk-hedging protocols within the DeFi space, risk tranching products have the potential to unlock new solutions as well. For example, traditional finance includes many fixed rate products such as the interest rate swap market or the bond market. Being able to access fixed rate lending and borrowing products could bring a lot of benefits to DeFi.
Decentralised finance is constantly evolving. Every new technology comes with its own challenges, and risk-hedging protocols and risk trenching products could be a way to resolve significant problems for DeFi investors.
CeFi and DeFi helping each other
Where CeFi fails, DeFi prospers and vice versa. For example, traditional centralised finance is pretty inefficient when it comes to fundraising and certain investing activities. It has been stated that it may take several weeks for a business to raise capital using traditional manners such as venture capital. DeFi is much faster and more efficient in this area.
Additionally, centralised finance is susceptible to corruption and manipulation. Centralised authorities have been engaging from time to time in malicious practices such as market manipulation or insider trading. DeFi brings to the table all perks of blockchain technology such as transparency and immutability.
A trustless system such as DeFi provides a much needed novelty. Banks assumed a vital role as intermediaries, yet bank collapses had far-reaching consequences for the wider economy. Just remember the 2008 financial crisis when the collapse of several big banks led to a credit crunch. If users lose trust in banks, they can withdraw deposits and start off a liquidity crisis.
Bank collapses can have far-reaching consequences for the wider economy. For example, during the global financial crisis of 2008, the collapse of several large banks led to a credit crunch and a severe recession. Many people lost their jobs, and governments were forced to step in and bail out the banks using taxpayers' money.
However, CeFi laid down foundations for DeFi to build on. The integration of traditional finance and DeFi is claimed to be a crucial step in the evolution of the crypto industry. Removing intermediaries, yet keeping fundamental principles and financial instruments could eventually lead to DeFi being the primary financial system.
As we said in the beginning, modern finance is on the path of evolution.