Editor’s Note
Dr. Rajib Bhattacharya, teaches Finance at Globsyn Business School – one of Kolkata’s best colleges for MBA in international business. Dr. Bhattacharya has over 14 years of experience in middle and senior level positions in various industries including the banking sector. In his academic career extending over 11 years, he has been associated with reputed business schools as faculty member, paper setter and examiner. He had also been a guest faculty at Universitas Pelita Harapan, Jakarta, Indonesia. He has provided corporate training to middle and senior level executives of many MNCs. He has many research papers (including a best-paper award winning paper) to his credit, published in peer-reviewed indexed journals and presented in national & international conferences including some at IITs and IIMs. He is a member of The Institute of Cost Accountants of India, All India Management Association, Operational Research Society of India and Analytics Society of India.
What is DeFi?
Decentralized Finance (DeFi) is a revolutionary and disruptive financial system built on Blockchain technology which aims to eliminate intermediaries and thereby provide open, inclusive, and permissionless access to financial services. In sharp contrast to traditional centralized systems that rely on trusted third parties, e.g. banks and exchanges, DeFi operates on decentralized platforms, basically leveraging smart contracts, which are self-executing agreements with the terms of the transaction directly written into code, on public blockchains through Decentralized Applications (dApps) built on blockchain platforms like Ethereum.
DeFi offers a wide range of financial services, including lending and borrowing. Users can lend their cryptocurrencies and earn interest or borrow funds by collateralizing their assets without the need for credit checks or complex approval processes. These services are facilitated by decentralized lending platforms or protocols, which connect lenders and borrowers directly.
Interestingly, DeFi has also introduced innovative concepts like yield farming and liquidity mining where users provide liquidity to decentralized protocols in exchange for rewards, often in the form of additional tokens or fees generated by the platform. DeFi can also contribute to trading, asset management, insurance, and many more, without the need for intermediaries. Smart contracts, self-executing agreements with predefined rules, facilitate these transactions and ensure transparency, security, and automation.
One of the most distinguishing features of DeFi is its open nature, which allows anyone with an internet connection and a compatible wallet to participate. This inclusivity has the potential to empower the unbanked and underbanked populations, particularly in developing countries, who previously had limited access to traditional financial systems. DeFi can thus herald financial inclusion.
As another unique feature, DeFi brings enhanced transparency to the financial system. As all transactions and activities are recorded on the blockchain, they are visible to anyone and thus promotes trust and accountability. Users have full control over their assets and can verify the integrity of the system at any time, reducing the risk of fraud or manipulation.
Another notable feature of DeFi is decentralized exchanges (DEXs), which enable users to trade cryptocurrencies directly with each other without the need for a centralized intermediary. These DEXs utilize liquidity pools and automated market-making algorithms to provide efficient and secure trading.
Furthermore, DeFi promotes composability i.e. different DeFi applications can be combined and integrated to create more complex financial products and services. This paves the way for the development of innovative solutions that were previously not feasible in the traditional financial sector.
Disruptive Effects of DeFi
DeFi introduces a new financial system involving complex financial transactions and instruments such as decentralized exchanges, lending platforms, yield farming, and liquidity pools. The disruptive nature of DeFi in ushering a new era in financial systems may be summed up in the following points.
Disintermediation: DeFi eliminates the need for intermediaries such as banks and financial institutions. It allows users to directly interact with financial services and applications, reducing reliance on centralized entities. This disintermediation lowers costs, removes barriers to entry, and increases accessibility for individuals who were previously excluded from traditional financial services.
Financial Inclusion: With just an internet connection, individuals, specially the unbanked and underbanked ones, can access a wide range of financial tools and services. This promotes financial inclusion.
Democratization of Investing: Through decentralized exchanges and lending protocols, individuals can participate in previously exclusive investment opportunities e.g. a variety of digital assets including cryptocurrencies and tokenized assets, without needing approval from intermediaries. This democratization of investing allows for greater financial empowerment and wealth creation for individuals.
Enhanced Transparency: The blockchain technology used in DeFi promotes trust and accountability. All transactions and activities are recorded on the blockchain, providing an immutable and auditable record. This transparency reduces the risk of fraud and manipulation, ensuring a more secure and trustworthy financial ecosystem.
Programmable Money: DeFi leverages smart contracts, which are self-executing agreements with predefined rules. These smart contracts enable the automation of financial processes and the creation of programmable money. It allows for the development of innovative financial products and services, such as decentralized lending and borrowing platforms, automated market makers, and tokenized derivatives.
Global Accessibility: DeFi operates on a global scale, without the limitations of geographical borders. It enables seamless interactions in financial services across the globe. This global accessibility promotes financial integration, facilitates cross-border remittances, and fosters economic collaboration on a global scale.
Innovation and Experimentation: DeFi encourages innovation and experimentation by providing an open and permissionless platform for developers and entrepreneurs. This has led to the emergence of a vibrant ecosystem of decentralized applications (dApps) and protocols, each offering unique financial services. The ability to combine and integrate these services, known as composability, allows for the creation of novel and innovative financial solutions.
Specific Effects of DeFi on Accounting and Auditing
Real-Time Financial Reporting: With the instantaneous nature of DeFi transactions, accounting information can be updated and reflected in real-time financial reports. This allows for more accurate and up-to-date financial statements, which, in turn, enables enhanced decision-making processes.
Smart Contracts and Revenue Recognition: Smart contracts in DeFi can automate revenue recognition based on predefined conditions, thereby enhancing accuracy and reducing the lag in recording revenue.
Auditing and Assurance: Auditors may utilize the Blockchain’s transparency to verify the accuracy of financial records and transactions, reducing the reliance on manual testing and sampling. provide real-time assurance to stakeholders. Continuous auditing enables auditors to monitor transactions and identify potential risks or anomalies promptly. It also enables auditors to provide stakeholders with more up-to-date and relevant information.
Challenges and Way Forward
DeFi introduces complexities in taxation due to its decentralized and borderless nature. This presents challenges for tax authorities in enforcing taxation rules and ensuring compliance with international tax regulations. Tax evasion risks may increase as individuals and businesses engage in cross-border DeFi transactions, taking advantage of the decentralized and pseudonymous nature of the technology. Transactions conducted on DeFi platforms often involve cryptocurrencies, which can be challenging to track and value for tax purposes. The lack of centralized intermediaries and the use of smart contracts make it difficult for tax authorities to monitor and enforce tax compliance. DeFi platforms and transactions may not provide traditional tax reporting mechanisms, making it harder for individuals and businesses to accurately track and report their taxable events. The decentralized nature of DeFi can lead to fragmented financial records across multiple platforms and wallets, requiring individuals to consolidate and report their transactions manually. As DeFi relies heavily on cryptocurrencies for transactions, and tax authorities face the challenges of treating and taxing these digital assets. Taxation principles that apply to traditional assets may need to be adapted or revised to encompass cryptocurrencies used in DeFi activities. Determining the fair market value of cryptocurrencies, calculating capital gains and losses, and addressing issues like wash sales and cost basis tracking can be challenging in the context of DeFi. Taxation authorities across the globe have to develop regulatory frameworks specifically tailored to DeFi. They need to address questions surrounding the classification of DeFi activities, the tax treatment of different DeFi protocols and tokens, and the enforcement of tax compliance in a decentralized ecosystem.
DeFi heavily relies on cryptocurrencies for transactions, and this introduces challenges and complexities in accounting. Accountants need to navigate the unique aspects of cryptocurrency accounting, such as valuations, recognition, and disclosure requirements. Additionally, the accounting treatment for tokens issued in DeFi projects needs to be carefully considered, as they may have characteristics of equity or debt instruments.
As DeFi removes intermediaries and relies on decentralized platforms, it poses new challenges for internal controls and risk management. Accountants need to adapt to the decentralized nature of DeFi and develop strategies to assess and mitigate risks associated with smart contracts, cybersecurity, and compliance. Strong internal control frameworks and robust risk management processes are crucial to ensure the integrity of financial information in a decentralized ecosystem.
DeFi operates across jurisdictions, and navigating regulatory compliance becomes a complex task. Accountants need to stay updated with evolving regulations and guidelines related to cryptocurrencies, decentralized exchanges, and other DeFi activities. Compliance with Anti-Money Laundering (AML) and Know-Your-Customer (KYC) requirements is also essential to mitigate regulatory risks and to address related taxation issues.
DeFi relies on decentralized data sources, such as oracle networks, to provide external data for various financial calculations. Auditors face challenges in verifying the accuracy and reliability of these data sources. Ensuring the integrity of data inputs becomes crucial to maintain the reliability of financial reporting. Auditors may need to develop new approaches and tools to validate decentralized data and ensure its accuracy.
DeFi transactions can be intricate and rapidly evolving, making it challenging for auditors to understand and assess the associated risks. Auditors need to develop a deep understanding of DeFi protocols and their underlying technologies to effectively evaluate the completeness, accuracy, and valuation of transactions.
DeFi introduces new financial instruments and complex transactions that may require auditors to expand their audit scope. Auditors need to understand the unique features and risks associated with DeFi platforms, including decentralized exchanges, liquidity pools, and yield farming. They must adapt their audit methodologies to adequately assess the risks, control environment, and financial reporting of DeFi projects.
Auditors may need to collaborate with blockchain experts, cybersecurity specialists, and DeFi developers to gain a comprehensive understanding of the risks and intricacies of DeFi. This collaboration ensures auditors have the necessary expertise to assess the risks and controls unique to DeFi platforms.
Auditors must address cybersecurity and privacy concerns related to DeFi platforms. As auditors access and examine sensitive financial data, they must ensure the security and confidentiality of information. Auditors may need to collaborate with cybersecurity experts to assess the effectiveness of security controls implemented within DeFi platforms and the trustworthiness of the underlying blockchain infrastructure.
Introduction of Students to DeFi at GBS
The edifice of the legacy of Globsyn Business School (GBS) rests on the tripod of Innovation, Research, and Technology. The B-School is guided by the mission of transforming young minds to become responsible leaders through various human-value-enhancers of which a very significant one is technology.
Hence, at Globsyn Business School, students are introduced to the latest technologies, which can transform this world to be a better place to live in. Students at Globsyn, are exposed to the concept of DeFi in a gradual manner throughout their semesters so that they become compatible with the latest trends in the industry from day one.
Dr. Rajib Bhattacharya
Faculty – Finance
Globsyn Business School