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An accountant's introduction to decentralised finance (DeFi)
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What is DeFi and why should accountants care?

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Dudley Gould explains how decentralised finance (DeFi) is likely to play an increasingly influential role in the activities of accountants and auditors.

8th Dec 2021
VP of Business Development Circit
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Bitcoin is likely to be on most accountants’ radars. However, many are unlikely to be familiar with decentralised finance (DeFi), a blockchain-based form of finance already disrupting traditional financial services and set to play an ever-increasing role in the day to day activities of accountants and auditors.

DeFi is a new layer of financial services that leverages blockchain technology to facilitate a whole range of financial services, including exchanges and lending. 

Unlike traditional financial services, DeFi is decentralised, meaning that buyers and sellers of services can transact without requiring an intermediary such as a bank or financial institution.

The value of cash locked up in DeFi has now reached over $117bn and is predicted to hit $800bn next year. This highlights its increasing importance and that its use will soon be commonplace.

Accountants and auditors should equip themselves with the knowledge to understand what DeFi is, along with its potential benefits and risks.

Compound: lending through DeFi

As DeFi is a somewhat tricky concept to grasp for newcomers, let's illustrate it with an example before taking a deeper dive. 

Compound is a decentralised blockchain-based protocol that allows users to lend and borrow a range of cryptocurrencies. It is different from centralised lending, as it directly connects lenders and borrowers rather than using a bank to facilitate transactions. 

Lenders have to first lock in their crypto by holding it in a Compound wallet on the blockchain before it is made available for lending. Once funds are locked in, lenders are rewarded with Compound tokens (cTokens), a crypto in its own right. 

Decentralised governance 

A key element of DeFi’s decentralised nature is how it is governed. Unlike centralised incumbent financial institutions, which are governed by management and shareholders, the governance of DeFi is enacted by token holders, who propose and vote on upgrades to protocols.

Tokens are similar to shares in that they have value and can be traded on crypto exchanges such as Coinbase and Binance. They are sought after due to their ability to make changes to protocols.

Why use DeFi services?

Cheaper and better returns

Taking third parties out of the loop allows lenders to benefit from higher returns and borrowers to access funds more cheaply due to an intermediary not taking a cut and having to cover for their overheads.

On Compound, interest rates are set by the value held in liquidity pools for specific cryptocurrencies. In simple terms, the larger the liquidity pool, the cheaper the associated interest rate is. 

Easy to use

DeFi is easy to use as its decentralised nature means that it is simple to get up and running and use services. Unlike traditional financial services that use intermediaries, DeFi does not require users to undergo credit checks or AML processes.

This means that lenders registering for the first time on Compound can lend out funds quickly and start enjoying returns. 

Enhanced security

As DeFi is emerging tech it does have short term security issues. For example, a bug on Compound in October led to around $22m being lost.

However, over the longer term and once these bumps are ironed out, it will be more secure and less prone to security breaches due to its decentralised nature and blockchains being more secure. This will allow users to transact more confidently on the basis that their data is less likely to be misappropriated than traditional centralised financial services. 

Why should accountants care about DeFi?

For the first time, DeFi represents a shift to genuinely digital services. This will allow for many financial services processes to become fully automated. This has not been possible until now due to needing to access and maintain paper audit trails.

DeFi creates significant time savings due to its digital nature meaning accountants and auditors do not have to key in data manually. Use of the blockchain means separate ledgers do not have to be reconciled due to De-Fi record-keeping being performed on a single digital ledger across all participants.

DeFi significantly reduces the risk of fraud, such as the failure of Wirecard and its associated cash balances, because auditors can verify transactions and balances directly on the blockchain. 

This can be performed by directly verifying assets held in a wallet on the blockchain or exchange or by using more user-friendly audit tools such as Circit that automate this process for the auditor across various client wallets and exchanges. 

Conclusion 

The growth and use cases of DeFi are compelling, so it's important for accountants and auditors to educate themselves about its development to serve their clients and benefit from its adoption, streamlining workflows.

Additionally, it is imperative for auditors to understand and upskill their knowledge of DeFi so they can treat related transactions correctly (i.e. whether they are of a capital or income nature), identify new areas of risk and sign off accounts.

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By Hugo Fair
08th Dec 2021 20:59

Utter hogwash ... the only saving grace being that most of it is unintelligible!

Apparently from the same generic source as the attempted justification of MTD:
"DeFi creates significant time savings due to its digital nature meaning accountants and auditors do not have to key in data manually."

It may be news in some quarters, but accountants don't spend much time keying in data manually!

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By D V Fields
10th Dec 2021 12:59

Yawn yawn.

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