Bitcoin may be in the limelight in recent months thanks to a combination of institutional investment and celebrity interest, but Ethereum is quietly powering a revolution in the financial services industry. Decentralized finance, or DeFi, is taking the financial world by storm with billions of dollars’ worth of transactions taking place each year.
Let’s take a closer look at DeFi adoption, how it has grown in popularity, future growth prospects and the risks and tax implications to keep in mind.
What is DeFi?
Decentralized finance is an umbrella term for financial services on public blockchains. Unlike a conventional financial institution, DeFi is a global, peer-to-peer, pseudonymous platform that’s open to everyone. The theoretical fees associated with financial services are also much lower since there’s no intermediaries involved in the process.
For example, a borrower is able to get a loan instantly without filling in paperwork while lenders can earn interest every minute rather than on a monthly or quarterly basis. Traders can also transact in crypto assets without using any kind of conventional brokerage account. It’s easy to see the opportunities to streamline operations and reduce costs!
DeFi has the potential to disrupt the full spectrum of financial services, including borrowing, lending, insuring and trading using its peer-to-peer model. Compound, Aave, Maker and other services already provide borrowers with access to billions of dollars’ worth of liquidity and lenders with an opportunity to earn an attractive interest rate on their crypto portfolio.
DeFi’s Growing Popularity
Decentralized finance has experienced significant growth since 2020. According to DeFi Pulse, the total U.S. dollar value locked in DeFi grew from $630 million in March of 2020 to $36 billion in March of 2021. While the largest DeFi projects are concentrated in lending and exchanges, assets, derivatives and payments have also seen significant growth.
The most popular DeFi markets include:
Many large institutions, such as J.P. Morgan and PayPal, have taken an interest in cryptocurrencies in recent months and years. These institutions may begin to realize the potential for DeFi to improve the way that their businesses operate and begin pilot projects in the space as a way to hedge against future competition.
The Future of DeFi
Decentralized finance has already reached into several corners of the financial services industry, but these areas are just scratching the surface of what’s possible. For example, tokenization will enable physical assets, such as real estate, to leverage the blockchain in order to reduce friction, eliminate intermediaries and lower transaction costs.
The launch of Ethereum 2.0 has also had an impact on the DeFi ecosystem. The upgrade fundamentally changed the structure of Ethereum—the most popular DeFi network—to use an energy-efficient proof-of-stake mechanism and a much more scalable sharding process. These changes significantly improved the performance and economics of the ecosystem.
The biggest barrier to mainstream adoption is the user experience. The descriptions for most DeFi projects are full of technical jargon that even finance veterans may not understand. User-friendly DeFi applications will be essential to encourage usage by mainstream customers whereas documentation and training will be essential for institutional users.
DeFi Risks & Tax Implications
The decentralized finance ecosystem may be experiencing tremendous growth, but there are some key risks that participants should keep in mind, according to BNC Research. In addition to these risks, most cryptocurrency transactions are subject to taxation by the IRS—and tracking each transaction can be a laborious process without the right tools.
Some significant risk factors include:
- Scalability: The Ethereum 2.0 mainnet is still several years away and network congestion could result in higher gas fees and failed transactions for DeFi applications. Last March, Bitcoin’s flash crash caused mass liquidations at MakerDAO.
- Security: Smart contract vulnerabilities, or errors in the code, can give attackers an opportunity to steal funds. There have been several instances of these kinds of losses from security breaches in recent history.
- Regulatory: New laws could affect how DeFi protocols operate or even shut them down. Since they operate in a gray area, investors risk disruption from regulatory maneuvers that could adversely impact their holdings.
The IRS requires anyone that received, sold, exchanged or otherwise acquired cryptocurrencies to indicate that they did so on Form 1040 and report the transactions on Form 8949. Unlike conventional financial institutions, most DeFi projects don’t provide specific tax guidance to help taxpayers fill out these forms and ensure accuracy.
The tax implications for DeFi are also somewhat confusing compared to conventional crypto transactions. For example, depositing to a platform that mints a token for your asset, such as ETH to aETH, may or may not be a taxable event. The same questions exist for entering and exiting liquidity pools—there’s no specific guidance from the IRS.
Crypto tax software, like ZenLedger, can help simplify the process. Rather than manually reconciling each transaction (and determining the cost basis in U.S. dollars by looking up historical prices), ZenLedger automatically connects to your wallets or exchanges, aggregates the data and pre-fills the IRS forms that you need for the year. Get started for free!
Of course, it’s usually a good idea to consult with a tax professional to verify that everything is correct and minimize the risk of an audit.
The Bottom Line
The decentralized finance ecosystem has experienced tremendous growth, having risen from $630 million to $36 billion in U.S. dollar volume in just one year. With the rise of Ethereum 2.0, DeFi projects could become more economical and scalable in the near future while developers continue to expand into new financial service sectors and improve the user experience.
Those interested in DeFi should keep in mind the risks involved, including the tax implications of different transactions. If you’re looking for a simple way to manage taxes, ZenLedger automatically aggregates transactions and computes your tax liability. Try it for free!