DeFi taxation? Insight into everything about Gringotts on the chain

Original author: CM (X: @cmdéfi)

Core point: Understand under what circumstances DeFi will be identified as a broker, explore the underlying logic and living space in decentralization and regulatory attitudes, and find the perfect exit.

• Expanding the definition of brokers: Regulations believe that DeFi transactions have great similarities with securities trading processes. DeFi brokers need to submit information reports to the IRS, help customers accurately declare taxes, and ensure compliance (KYC, anti-money laundering, etc.).

• Determine DeFi brokers: provide services to facilitate transactions and have the ability to obtain customer information.

• Impact on DeFi: Choose to accept broker identification or decentralize the project. The higher the degree of decentralization, the lower the possibility of being identified as a broker.

• The perfect exit for DeFi in the future: decentralized front-end, non-upgradeable contracts, on-chain autonomy, and token functionality to build your own network.

Rapport de recherche

1/4 Background and reasons

The regulation was initiated by the U.S. Treasury Department and the Internal Revenue Service. Due to decentralization and anonymity, digital asset transactions often lack information transparency in traditional financial systems, resulting in huge challenges for tax supervision. The regulation lists the similarities between the securities industry and the DeFi industry in terms of operational processes:

Trading instructions -> Trading matching and execution -> Trading settlement

In the securities industry, brokers send clients’ trading instructions to trading centers (such as the New York Stock Échange or Nasdaq), which are responsible for matching orders between buyers and sellers. In the DeFi industry, regulations also consider the existence of such a “broker” role, and brokers need to submit information reports to the IRS, help clients accurately declare taxes, and ensure compliance (KYC, anti-money laundering, etc.).

Therefore, we mainly discuss under what conditions, which roles in DeFi will be identified as brokers. Regardless of whether the regulations will be approved and implemented, and in what form, our main analysis target is the underlying logic and living space in decentralization and regulatory attitudes.

2/4 Expanding the definition of “agent”

Traditionally, the definition of broker is limited to trading agents in the securities industry or intermediaries that directly hold client assets. The main content of this regulation is to expand this definition to apply to the field of digital assets. The new regulations require brokers to submit returns to the U.S. Internal Revenue Service (IRS) to report detailed customer transaction information, including income and transaction details, in order to improve tax compliance, which means the potential for tax payment.

One layer of regulatory tendency that can be interpreted here is that although there was a preliminary definition and distinction between securities and commodities when the ETH ETF was passed, digital assets that meet the conditions are more likely to be defined as commodities and cannot be directly classified as securities, but the broker expansion proposed in this regulation has the core goal of establishing an information reporting mechanism similar to securities trading, so in essence it can still return to the question of how to define DeFi protocols and assets.

The regulations expand the definition of “broker” to include the following types of participants:

• Digital asset intermediary: An individual or entity that provides services to clients to complete digital asset transactions, including exchanges, custodial wallet service providers, etc.

• DeFi platform participants: include non-custodial platforms that do not hold customer private keys but provide transaction services through protocols or smart contracts.

The core here lies in the word intermediary. There is no need to talk about the individuals or entities that provide services to customers. There is no particular controversy about exchanges and custodial wallets. The controversy lies in how to define the intermediary role in DeFi activities. In summary, there are two key factors:

1. Providing services to facilitate transactions

2. Ability to obtain customer information

Keeping these two factors in mind, let’s further break down the roles of the various parties in a DeFi project:

• Front-end service provider: Provide users with a friendly interactive interface so that they can interact or trade conveniently.

• Protocol Operator: Provides core protocols or smart contracts for executing transactions (such as Uniswap, Curve and other AMMs).

• Validators or settlers: Responsible for recording transactions on the distributed ledger (blockchain).

The regulations pay special attention to front-end service providers and protocol operators because their services directly facilitate the completion of transactions. As for validators or settlers, if a participant only provides distributed ledger verification services (such as blockchain nodes or miners) and does not directly participate in or facilitate transactions, it will not be considered a broker. So only 1 and 2 will be discussed.

I will use Uniswap as an example throughout this analysis, as it is the only case where some of each scenario applies.

1. It is basically undisputed that front-end service providers must belong to the intermediary role of brokers, especially the current front-end charging status of Uniswap, which will increase the tendency to be identified as brokers.

2. There is much controversy over protocol operators because strictly speaking, non-upgradeable smart contracts are not controlled by any individual or entity. They are permissionless and cannot be tampered with. Will the project party/developer that provides such smart contracts be defined as a broker?

Back to the two key defining factors: providing services that facilitate transactions + having the ability to obtain customer information

If we take the current Uniswap as an example, the front-end service is provided and maintained by the project party. It provides 100% transaction-facilitating services and charges for such services. At the same time, it has the ability to record and obtain user information (such as adding KYC or transaction terms on the front end).

Let us assume a situation where the Uniswap team gives up providing all services and completely withdraws from the project. In theory, users can still complete their trading purposes by directly accessing the AMM smart contract deployed by Uniswap. This is because once a smart contract is deployed, it will always exist on the chain. At this time, AMM becomes a decentralized tool. In a decentralized environment, the project party cannot obtain user information. This does not meet the second defining factor. Although Uniswap has deployed an AMM contract to enable users to trade, it no longer has the ability to actively promote transactions and obtain user information. The regulations may not be able to find applicable broker objects.

So, the conclusion is that the more decentralized a project is, the less likely it is to be identified as a broker.

In summary, there are several core features of decentralized projects:

• Self-operation of smart contracts: The core transaction functions are implemented through smart contracts deployed on the blockchain. The contracts are tamper-proof and anyone can interact with them without permission.

• Decentralized management: If the project party withdraws (for example, stops maintaining the front-end interface), the smart contract can still run and does not rely on any centralized entity.

• Front-end service independence: Even if the official front-end (such as Uniswap’s official website) is offline, third-party developers can build their own front-end to interact with smart contracts.

• Unable to control customer information: Since on-chain interactions are completely trustless, project parties usually cannot obtain customer identity information or transaction data.

3/4 Impact on DeFi

In the early days of DeFi, the goal of most projects was to decentralize, and eventually hand over the projects to the community for self-governance and run completely on the chain. However, with the development of the times, everyone found that it is not as easy as imagined to realize this ideal. Most projects gradually disappeared from the market after leaving the project owners. There are mainly the following reasons:

• The project itself left a lot of mess, and soft Rug in the name of decentralization

• The overall market awareness is insufficient and centralized guidance and promotion are needed.

• The project itself has no problems, but it is not mature enough, and the community does not have the ability to govern and promote the development of the project.

(1) DeFi that requires centralized participation

Therefore, in this cycle, many ceDeFi projects have begun to rise. Since pure DeFi projects cannot currently achieve the goal of decentralized finance, it is better to directly introduce relatively professional and compliant centralized entities and strategies. In this case, there is a high possibility that these centralized entities will be identified as brokers. If this regulation is approved and implemented, it means that these projects may

• Require users to provide KYC

• Under the compliance burden, open front-end charges or service charges

But at the same time it means that brokers can carry out activities reasonably and legally. The cost is under the compliance burden, and they need to increase their own income capacity, such as charging customers.

(2) DeFi with the ability to be decentralized

• Decentralized front end

• Smart contracts are fixed and cannot be upgraded

• On-chain autonomy

If you can do the above, it will be difficult to be judged as a broker. So from this perspective, even if the regulation is implemented, the main target is projects that rely more on centralized leadership. Although such projects account for the majority of the current market, in the long run it is also a boost to the decentralization of DeFi, and the requirements for centralized entities entering this industry are becoming increasingly high.

4/4 DeFi Exit

First of all, it is only a matter of time for DeFi to have clear regulation and compliance. Of course, this clarification may be advantageous during Trumps term, and the market expects a more relaxed regulation. Here, based on the bills or drafts that have already appeared, we discuss the optimal solution for DeFi projects to face regulation and compliance, a perfect export.

(1) Broker determination

This aspect is the focus of this article. The conclusion is that either this should be turned into a formal business, comply with IRS reporting requirements and accept broker certification, or the project should be gradually decentralized.

(2) Identification of the nature of tokens

With the approval of the ETH spot ETF application, combined with the previous content of the FIT-21st Century Financial Innovation and Technology Act, there is a basic basis for determining how project tokens are defined as securities and commodities.

The current definition of ETH is more inclined towards functional use. The nature of its pledge and governance is more about maintaining network operations rather than economic returns. In this case, it is more inclined to be defined as a commodity rather than a security.

From this perspective, for DeFi protocols, if the governance direction is closer to obtaining economic returns or dividends, its positioning is more likely to be defined as securities. If it tends to be more functional, technological upgrades, etc., it is more likely to be defined as a commodity.

Let’s take Uniswap as an example. If it wants to avoid being judged as a “broker” and at the same time maximize the guarantee that its tokens are defined as commodities rather than securities, should it take this perfect exit?

• Remove the front-end and charge fees, and rely on third-party front-ends for transactions, or educate users to interact directly with smart contracts

• Develop your own chain and gradually Ethereumize the tokens as a functional use and network maintenance to avoid securities recognition.

Regardless of whether these regulations will be approved and promoted, DeFi will not be affected if it always keeps moving towards the goal of decentralization. Of course, in this process, there are some projects that still need the participation and leadership of centralized entities, and currently they are the majority. They may need to face choices and balances. This is in line with the needs of the development of the times. Decentralization cannot be completed in one day.

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