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Decentralized Finance Investment Opportunities and Challenges

By: Marisa Melliou, Group Audit Director, OPAP

In the post pandemic era, the commitment by governments and central banks to do whatever it takes has led in a global stimulus of more than $10T with central banks expanding money supply, leading to a parallel decrease in our spending power and money losing its meaning.

While the global financial-economic system is measured in trillion dollars, the digital assets that were born in the last financial crisis grow fast due to their characteristics and approach the total value of 1,7trillion dollars with approximately 9000 crypto currencies, exchanged in more than 500 virtual currency exchanges. Furthermore, last year the Decentralized Finance (DeFi) space has grown rapidly giving high yields. The total value (TVL) locked in DeFi protocols grew over 2,500 percent  in 2020, from around $700 million in January 2020 to over $20 billion in December 2020. The TVL represents the equity that investors are willing to commit to these protocols, which this year alone, more than doubled, reaching $40 billion in March 2021.

Several company examples indicate that digital assets have gathered investors’ attention. For example, the 10b Stoneridge asset management institutional Investment Company allocated$100 million in bitcoin as primary reserve asset. In addition, MicroStrategy Inc. announced that it had made more than $1 billion in total bitcoin purchases in 2020, since it would “provide the opportunity for better returns and preserve the value of [their] capital over time compared to holding cash”. The investment giant Fidelity is offering wealthier customers a Bitcoin index fund and Coinbase, one of the biggest centralized crypto-exchanges, is listed in Nasdaq. Investing in digital assets seems to be a unique opportunity and at the same time a significant challenge for CFOs, Treasurers, Risk Managers,  Accountants and Auditors.  

Some critical factors that CFOs, Treasurers should consider before they invest in bitcoin or other digital assets, which the AC members should also challenge, are listed below:

What is the nature and classification of asset investment? The digital assets that have value and for which there is a lot of trading are not more than 30. Moreover, most of these assets fall into one of the following different categories : a) cryptocurrencies, b) platforms, c) utility tokens, d) security tokens, e) natural assets, f) recreational crypto libraries with collections of works of art or intellectual property rights, g) stable coins, and h)  central based digital currencies, which are government-issued currencies.  Today there is no commonly accepted international classification and even in the UK it has been modified in the last three years. EU via its recent MICA draft regulation, classify them based on their characteristics and use as investment tokens, payment/exchange/currency tokens, and utility tokens. Thus, company leaders need to be comfortable with the characteristics. the nature and the functions of the financial asset.

In what type of capital increase implementation to participate in? Investment tokens provide rights similar to those of financial instruments (eg voting rights, dividends) and are issued as part of an increase capital implemented through an ICO (Initial Coin Offering), or STO (Security Token Offering) or IEO (Initial Exchange Offering). It is important to take into account that each type of offering has its own risks, and that the treasurer, CTO,CRO, CEO, and board of directors perform their own research to have a clear assessment and understanding of the asset’s risk profile before taking the decision to invest.

What is the type of Exchange the selected listing takes place: The vast majority of coin trading volume is recorded by centralized exchanges (CEX) with the largest stable coins in value to be Tether/usdt, Circle/usdc and Maker/dai. Decentralized Exchanges (DEX) account for a small percentage of trading volume in the alternative finance world. Numerous centralized exchanges are regulated by jurisdiction, and abide with the moral and ethical principles stipulated by the specific law. On the other hand decentralized exchanges are not regulated yet globally. To ensure compliance, it would be wise to seek advice from informed legal counsel.

Stablecoin investments’ specific considerations: Out of more than 100 stablecoin-projects, currently there are 57 Stable coins active on the market and can be used as an alternate store of value. Stablecoins are associated with a traditional asset, e.g. a national currency (usually 1: 1 with USD, gold, or asset baskets) and seek to minimize their price volatility. The aim is for them to be more widely accepted and used as a means of payment and value storage for faster and cheaper transactions. Nevertheless, attention is required, because their prices are volatile, despite they try to reduce their volatility by their association to traditional assets. Also, they have no intrinsic value and may carry liquidity risk (except in cases where the asset is controlled by audit firms) and their reliability depends on private companies and not governmental organizations.         

DeFi investment challenges: The Defi applications include decentralized lending services, exchanges, derivatives, insurance and hybrid assets. They operate via distributed open source code, which is used publicly and is not currently regulated. The stack of applications are automatically executed mainly using the smart contracts blockchain technology, and they have unlocked the liquidity of cryptocurrencies that were trapped without any transaction. In 2020, Uniswap represented the largest user base of all DeFi protocols. It is important to point out that the person (legal or physical) is the sole custodian of these assets (that become collateralized, and are borrowed as a result of which they get a higher yield than interest rate deposits).

The specific challenges in this space that should be taken under consideration relate with a)market liquidity risks, due to the over- pledging of funds, or the fact that the securities are based on volatile assets, b) the concentration of liquidity in an automated code chain and not in a legal entity, c) the lack of a corresponding industry body for the development of standards for these assets (ISO/TC-307 Standards are expected), d) security risks, due to oracle attacks and lack of continuous security auditing of smart contractsand e) the fact that the KYC/AML rules only apply to CEXs at the moment and it may take governments a few years to regulate the Defi transactions.      

Accounting and Tax Considerations

Several national accounting standards bodies have published discussion papers regarding the treatment of digital asset transactions, and while there is still confusion, some commonly accepted assumptions emerge. Three categories of assets are widely accepted as applicable to digital assets: financial instruments, inventories and intangible assets. However, discussions on the application of accounting standards have so far focused on digital currencies and less on the broader concept of digital-assets. As mentioned before there are a variety of digital assets with different functions and purposes that one needs to take into consideration. In addition, one must consider why an interested party acquired th

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