DeFi, or decentralised finance, represents the infrastructure required to innovate current, traditional financial systems. This umbrella term covers a host of financial applications in cryptocurrency or blockchain. It relates to the movement aiming to create an open-source, permissionless and transparent financial market that works without intermediaries.
Continue reading to learn more about this innovative technology and how it will revolutionise financial markets in the future.
In 2018, the concept of decentralised finance emerged when a group of Ethereum developers came together with the aim of developing an independent, secure and open financial system.
DeFi marks a shift from traditional financial systems to peer-to-peer finance. It challenges the centrally-governed institutions like banks by empowering ordinary people and removing the middlemen.
Running on software built on a public blockchain, the system’s USP is that it gives control back to the users while reducing operational risks and unnecessary fees.
Management
With DeFi, no single entity or person dictates operations. Instead, smart contracts manage the transactions, meaning there’s little to no human intervention. Traditional financial systems have centralised control, with the central bank overseeing financial activities.
Transparency
DeFi works on Ethereum or other public blockchains, meaning it’s transparent. All transactions are publicly verifiable but pseudonymous. This feature helps to mask the real identities of the parties. Meanwhile, traditional financial systems are confidential. You deal directly with your banker, agent, or broker using your true identity.
Control
In the DeFi system, you only need internet access and smart contracts to be in full control of your funds. However, in traditional systems, you pass control to various other parties, like the central bank, your personal bank and the agent that serves you.
Decentralised finance uses key principles of the Ethereum blockchain to increase financial security and support a standardised economic system:
- Immutability — Blockchain’s decentralised infrastructure stores tamper-proof data, which increases security and auditability while eliminating the risk of human error.
- Permissionless — Unlike traditional finance, anyone with a crypto wallet and an internet connection, regardless of their location and financial situation, can access DeFi applications built on Ethereum.
- Fast with reduced fees — DeFi offers instant transfers at any time and at a lower cost. Traditional banking customers are growing frustrated with increasing transaction fees, making DeFi an attractive option.
Although DeFi promises high-yield opportunities for users, the road to decentralised finance has not been smooth. Users need to be aware of certain risks involved with this innovative technology:
Financial Risks
Losing control of assets: One of the most common reasons for losing access to crypto assets is forgetting or misplacing a wallet file or private key. In addition, some crypto exchanges have unexpectedly closed or disappeared with deposited assets.
Scams: As DeFi grows in popularity, it also grows more vulnerable to scams. In 2020 alone, cyberattacks against DeFi caused $129 million-worth damage (£92 million) in comparison to no damages recorded in 2019.
Technical Risks
Hacks: Ethereum’s smart contract system is not invulnerable to hacks. If a threat actor learns how to exploit a smart contract, it can put all the funds involved at risk.
Admin keys: Many DeFi smart contracts are controlled using admin keys. Keyholders can use these if they need to make changes to the code. However, users must trust that these key holders will adopt adequate security measures to keep these keys safe. A lapse in security could jeopardise users’ funds.
Regulatory Risks
Uncertainty: The DeFi industry is currently experiencing an uncertain regulatory environment. As there’s never been an attempt to stray from the traditional financial system before, blockchain is under intense scrutiny from regulators.
Regulators don’t fully understand the technology due to its complexity, making them wary. However, it’s expected as the demand for DeFi grows, these concerns will be alleviated.
Learning the basics of DeFi is essential for any CPA to reliably offer advice to their clients and conduct solid audits.
A Growing Financial Market
Cryptocurrency, in general, is set to revolutionise the current financial market, transforming it into an autonomous and open environment.
Accountancy calls for versatility, especially when new technologies come into play. As more and more people decide to switch to crypto-based assets, accountants need to understand the ins and outs of DeFi to grow their practices and future-proof their firms.
Tax Implications
Cryptocurrencies have a substantial place in the investing world. Every cryptocurrency ever invented has a digital coin that can be used as a store of value — the most well-known example being Bitcoin. However, with investment gains (even in crypto) come tax implications that users — and their accountants — need to be aware of.
In addition, every cryptocurrency gain could be subject to income or corporation tax, according to HMRC. As the DeFi industry is new and always evolving, it’s vital to stay on top of new developments to offer the most sound advice to your clients.
Auditing
Auditing is a big part of many CPAs’ yearly work cycle. As more people turn to decentralised finance, the number of companies requiring audit services for this niche grows, and with a vast array of coins available, accountants must learn how to accurately report on these assets.
Staying ahead of the curve on DeFi could give your firm the flexibility needed to meet ever-adapting accounting needs surrounding crypto.
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