As decentralized finance (DeFi) continues to make headlines, attract capital, and grow rapidly, two truths are developing in parallel; numerous opportunities exist alongside significant risks that can come from this still emerging sector of the cryptoasset space.
For the purposes of this discussion DeFi can be defined as the process by which borrowing, lending, and other financing activities are completed by blockchain and crypto native organizations. In other words, blockchain and crypto firms are seeking to replicate products and services that have traditionally been connected to banks and other financial institutions. Implications of this, especially given the tremendous growth in terms of both investment and investor attention, are far-ranging; one can simply review recent legal and enforcement actions around this space for evidence of this fact.
Legal issues aside, of which there certainly are many, investor appetite for the returns and yields generated by these organizations has been strong. Billions of dollars have been allocated to projects in this space, and hardly a week (or even a day) goes by without a multi-million fundraising transaction being completed. As with any red-hot space, there are going to be successes and failures, but the trend toward decentralized financial services is well underway. As always, with an area that is so multi-faceted and fast moving, every project will need to be assessed on an individual basis.
That said, there are several considerations that potential investors should always keep in mind when considering DeFi projects, investing in said projects, or utilizing their products and services.
What specific DeFi it is. The term decentralized finance is quickly becoming similar to the term cryptocurrency in the following manner – it is an umbrella that term that can be tossed around quite a lot, but can mean multiple different things. Prior to any other research or investment actions, a potential investor should understand what exactly are the products and/or services being offered?
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Decentralized exchanges, yield farming, staking, borrowing and lending crypto, setting up a decentralized autonomous organization (DAO), and even some stablecoins can all be classified as DeFi activities. Given the sheer scope and variety of DeFi possibilities it is extremely important that any potential investors understand 1) what exactly is being offered, 2) how this product or service is being managed, and 3) what marketplace exists for this specific application.
Tax implications are going to be different. Crypto taxes are already a complicated and fast moving, with tracking, compiling, reporting, and paying the correct taxes a process that can easily consume large amounts of investor time. DeFi, unfortunately, can further complicate this conversation because depending on the specific (that word again) DeFi application in question the tax treatment can vary.
A brief example of this is as follows. For traditional DeFi lending and borrowing platforms, the interest and other income generated from these activities is treated and taxes as ordinary income. If an investor lends ether (ETH) and earns ether (ETH) these earnings will most likely be taxed at the ordinary income rate for that investor. If, however, the DeFi platform has developed and is issuing native tokens – known as liquidity pool tokens (LPTs), this income might end up being treated as capital gains. This treatment is due to the fact that the process of adding/removing liquidity to these platforms can be structured as a trade or token swap. Upon exiting of the position, and converting the LPTs back into the original crypto assets, any accumulated gain can be documented and treated as a capital gain.
As always, be sure to conduct due diligence on the platform itself and work with a tax professional familiar with the platform and the specifics of the proposed investment plan.
Reporting is still developing. One common issue that exists across the blockchain and crypto sector is that – despite significant advances in some areas – auditing and confirming the results of operations is still a work in progress. Even for well established organizations, including crypto-native firms and organizations that are integrating crypto into operations, generating consistent and comparable audited financials can be an uphill battle.
DeFi can compound this since, by the nature of some of the specific applications, there is no singular point of contact or control to audit. Conversely, one common complaint against purportedly decentralized finance applications is the centralized nature of how some of these organizations operate. For example, with firms like Coinbase gradually building out DeFi offerings, the question should be asked – how can a centralized corporation also offer DeFi products?
In any event, obtaining consistent and comparable data is still a work in progress, but should be a question asked prior to any investment decisions being completed.
DeFi is an absolutely red-hot aspect of the crypto space, and continues to develop in innovative ways on an almost daily basis. This innovation has been rewarded by financial markets in the form of increased attention and investment, and this sector continues to attract new investors. Similar to any new asset class, however, and similar to cryptocurrencies in prior years, there are several commonalities and core trends that exist no matter which specific application is selected. Investors, large and small, have the resources and capability to make well-informed decisions, and understanding these integral items can make substantial differences in investment results moving forward.