The advent of the blockchain has enabled the creation of many permissionless protocols and systems. A great use case of this distributed ledger technology is the Decentralized Financial System, in short, called DeFi. Let us explore what is DeFi, applications in real life, various activities in this space and how to jump into it. Also, the financial transactions and their tax implications – DeFi taxes.
What is DeFi
DeFi stands for Decentralized Finance and deals with tools, resources, and platforms that allow anyone, anywhere to access financial services without the need for a third party. At its core, DeFi is an ecosystem that aims to eliminate the necessity of intermediaries such as banks, brokers, etc in the financial world. Thus, it provides a globally inclusive financial system for all. Decentralized finance aims to create a permissionless, transparent, and open-source financial system by using the blockchain technology.
Currently, Ethereum is the most popular platform for developing and deploying DeFi applications. However, this does not mean that it is the only platform where you can build decentralized finance systems. For instance, the Lightning Network, which is a payment protocol, is a DeFi platform built on Bitcoin. Besides these two, other platforms that you can use to build DeFi include EOS, Cosmos, Plasma, and Tezos.
To understand DeFi, you need to look at how the traditional system works.
Picture banks, insurance companies, investment advisors, traditional funding platforms. What do they have in common? They’re all intermediaries or third parties – managing our assets, keeping our money, helping us raise funds, etc. In return, they take a cut for providing such services. Beyond the fees, the existence of these intermediaries leads to delays, either in sending and receiving money, raising capital or doing an investment.
Thanks to the blockchain, a great discovery was made. What if we can do away with all these intermediaries? And that’s exactly what Decentralized Finance is doing – to a lot of fields, including banking, crowdfunding, investments, lending, and borrowing, to mention just a few.
How is it possible?
Blockchain technology or the distributed ledger technology (DLT), is a system that proves the occurrence of a transaction without needing an intermediary to vouch for it. This way, you can prove the ownership, transfer of value and much more using these autonomous systems powered by DLT.
Instead of traditional institutions such as banks and insurance companies, DeFi systems do intermediate with smart contracts. These are digital contracts that contain rules and regulations to an agreement and permanently recorded on the blockchain.
Why is DeFi such a big deal?
Looking at these traditional institutions now, we may find them to be problem-free. However, we may just have gotten comfortable with these systems because there were no options. And now that DeFi is enabling a whole new possibility, traditional financial systems can’t keep up. This is why we need DeFi:
True ownership: traditional financial intermediaries usually hold our assets. All we get is a document saying we own assets at a particular institution. With DeFi, you’re the true owner of your assets, be it money or stocks. You store your assets and enter into trades with others using smart contracts. This freedom is thanks to DeFi.
Eliminates cumbersome processes: going through traditional financial systems has its own headache. For instance, one has to provide a lot of documents, which are mostly irrelevant, in order to get a loan. Making an investment or opening a bank account comes with the provision of a lot of information. For the ordinary Joe, these requirements are a waste of time. They also prevent many people from being part of the financial system. However, with DeFi, the use of smart contracts allows anybody in the world to invest, borrow, or store their own assets.
Great security. DeFi platforms use the blockchain as their backbone. Data is kept on thousands of nodes or computing systems. This makes DeFi platforms highly secure and less prone to single points of failure.
Cost-effective. Using traditional intermediaries in the financial system comes with a lot of fees and charges. With DeFi, users keep their own assets and serve as their own intermediaries thanks to smart contracts. This prevents participants from paying processing or security costs for third parties.
Areas that DeFi is currently revolutionizing
Decentralized finance is sweeping across different sectors within the finance realm and beyond. However, these are the most promising areas DeFi is changing.
1.Borrowing and lending
Lending and borrowing DeFi platforms exist to connect lenders and borrowers without a bank. These platforms allow borrowers to easily access capital without the cumbersome processes of traditional financial institutions. Also, they enable anyone to earn interest by lending out their money to borrowers. This eliminates the extra charges, unnecessary processes, and the documentation that traditional lending and borrowing platforms offer. Popular DeFi applications in this category include CoinLoan, BlockFi, Compound, ETHlend, Salt, to mention just a few.
2.Payments and remittances
Payments and transactions such as remittance to other countries are highly centralized. Banks manage transfers – leading to delays, charges on transactions, and expenses on exchange rates. DeFi payment platforms solve these problems by providing a peer to peer marketplace for payments. Some use cryptocurrencies and others blend both crypto and fiat.
Their focus is developing an open finance world for mostly the unbanked and underbanked individuals and institutions. Some of the popular DeFi payment and remittance platforms include Everex, Lightning Network, OmiseGo, and Celer Network among others.
Unlike centralized crypto exchanges that are no different from traditional ones, decentralized exchanges provide more freedom to users. DeFi exchanges allow for peer to peer trading of crypto assets, and users have control over their private keys. A breach on these platforms does not expose details or assets of a trader. Examples of these platforms include AirSwap, DeversiFi, IDEX, Oasis, StellarX, Switcheo Network, TronTrade, and more.
Other sectors where DeFi platforms are growing include:
- Tokenization of assets
- Prediction markets
- Margin trading
- Asset management tools
DeFi taxes and how to file yours
Crypto taxation is still a discussion topic among authorities. In this regard, much is not done yet, especially on DeFi taxes. This industry is still just starting and authorities will need time to inculcate it into their tax laws. However, there are DeFi activities that fall under general crypto tax regulations and we would be exploring them here.
DeFi taxes – Lending and borrowing
For lenders, making money available to borrowers doesn’t attract taxes. However, the interest you earn from an investment or lending activity creates a taxable event. Another important thing to note is to identify the purpose of your lending activities.
For Tax purposes, lending activities are classified either as a hobby or business. If you’re keeping proper books of records, investing a chunk of your time, and devising strategies to make a profit, then you’re doing business. Therefore, under IRS regulations, you have to file taxes under “Profit or Loss from Business”. This falls under Section C, Form 1040. This also means that you will pay tax as a self-employed or sole proprietor, which puts you in the 15.3% tax bracket of your reported income.
However, lending becomes a hobby if you’re just investing little amounts for some profit. Also if you’re lending out your money as a side hustle, then it’s classified as a hobby. In this instance, you will file taxes under “Additional Income”.
Borrowing money using crypto as collateral doesn’t attract taxes. Think of this as using your house as collateral to borrow money from a bank. The IRS classifies crypto as property and using it as collateral is not a taxable event.
Please read our full guide on taxation of crypto lending and borrowing and how to file your taxes.
DeFi taxes – decentralized exchanges
Like any crypto exchange, some activities on decentralized exchanges attract taxes while some don’t. For instance, moving money from one exchange to another or buying crypto on an exchange doesn’t attract tax. However, when you exchange your crypto for another crypto or sell crypto for fiat, you’re liable to pay capital gains tax. Read a full guide on crypto taxation.
What next for DeFi taxes and platforms.
DeFi is still a growing market. From insurance and investment to crowdfunding and lending, the sector is huge. Therefore, tax authorities are still testing the waters and there are no hard rules on what constitutes a taxable event or otherwise. We’ll bring you updates on DeFi taxes and any updates from tax authorities.