The decentralized finance (DeFi) space is growing at an exponential rate. According to DeFi Pulse, the total value locked in DeFi protocols has increased from $1 billion to over $13 billion in just over two years. With this growth comes the need for new accounting standards for DeFi transactions. In this post, we’ll drill into why accounting for DeFi is continuously evolving.
First, it’s important to understand that DeFi transactions are different from traditional financial transactions. With traditional finance, there is a central authority that controls the flow of funds. With DeFi, there is no central authority; instead, the community controls the financial ecosystem. This decentralization offers many benefits, but it also comes with some challenges. One of those challenges is accounting.
When accounting for DEFI transactions, there are a few things that you need to keep in mind. First, you need to track the value of the assets. Second, you need to track the fees associated with the transaction. Third, you need to track the performance of the transaction over time. And finally, you need to track the volume and price of all these asset categories.
Traditional accounting methods aren’t well-suited for DeFi transactions. That’s because traditional accounting relies on double-entry bookkeeping, which assumes that there is a central party (i.e., a bank) that tracks and records all transactions. With DeFi transactions, there is no central party; instead, each transaction is recorded on a blockchain.
Two examples of DeFi transactions:
- Lending – one of the most popular DeFi applications. With lending, users can earn interest on their digital assets by providing them as collateral to borrowers. Lending protocols offer a variety of benefits, including high-interest rates (often in excess of 10%), automated risk management, and instant liquidity. However, lending also comes with risks, such as the risk of liquidation (if the value of your collateral falls below a certain threshold) and the risk of smart contract vulnerabilities.
- Staking – a process whereby users can earn interest on their digital assets by holding them in a staking pool. Staking pools allow users to pool their resources together and earn rewards proportional to their share of the pool. Staking requires you to receive and hold onto a temporary LP Token which requires pricing and tracking, while your assets being staked in the background are rising or falling in value.
DeFi protocols can also be divided into several categories further complicating the use cases:
- Yield farming
- Decentralized Exchanges (DEXs)
Within each category, there are a number of popular protocols that facilitate trustless transactions between parties. Lending protocols include MakerDAO and Compound; payment protocols include 0x and Kyber Network; trading protocols include 0x, EtherDelta, IDEX, and Bancor. All of these protocols are built on the Ethereum blockchain. As DeFi continues to grow in popularity, we can expect to see more innovative applications emerge in each of these categories.
DeFi protocols and transactions are becoming increasingly commonplace—but that doesn’t mean they’re always easy to account for from a traditional standpoint. The good news is that with a little bit of creativity (and maybe some help from your accountant! OnChain Accounting), it is possible to find workable solutions for even the most complex DeFi scenarios.