DeFi taxed? Learn everything about Gringotts on the Chain

Author: cmDeFi

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

• Expanded broker definition: Regulations believe that DeFi transactions are very similar to the securities trading process. 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 recognition or decentralize the project. The higher the degree of decentralization, the lower the possibility of being recognized 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.

research report

1/4 · Background and reasons

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

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

In the securities industry, brokers send clients' trading orders to trading centers (such as the New York Stock Exchange or Nasdaq), and these platforms are responsible for matching orders between buyers and sellers. In the DeFi industry, regulations believe that there is also such a "broker" role, and the broker needs to submit information reports to the IRS, help customers accurately declare taxes, and ensure compliance (KYC, anti-money laundering, etc.).

Therefore, we mainly discuss under what conditions which roles in DeFi will be recognized as “brokers”. Regardless of whether the regulation will be approved for implementation and in what form, our main analysis goal is the underlying logic and living space of decentralization and regulatory attitudes.

2/4 · Expand the definition of “broker”

Traditionally, the definition of "broker" has been limited to trading agents in the securities industry or intermediaries who 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 file returns with the Internal Revenue Service (IRS) detailing clients' trading information, including earnings and transaction details, in an effort to improve tax compliance, meaning the potential for tax payments.

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. It is classified as a security, but the core goal of the "broker" expansion proposed by this regulation is to establish an information reporting mechanism similar to securities trading, so essentially it can still return to the issue of how to define DeFi protocols and assets.

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

• Digital asset intermediary: An individual or entity that provides services to customers to complete digital asset transactions, including exchanges, custodial wallet service providers, etc.
• DeFi platform participants: Includes 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". Needless to say, individuals or entities that provide services to customers. Exchanges and custodial wallets are not particularly controversial. The controversy lies in how to define the "intermediary role" in DeFi activities. In summary, there are two key factors:

• Providing services to facilitate transactions
• Ability to obtain customer information

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

• Front-end service provider: Provides 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).
• Validator or settler: 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. For validators or settlers, if a participant only provides verification services for the distributed ledger (such as a blockchain node or miner) and does not directly participate in or facilitate transactions, it will not be considered a broker. So just discuss 1 and 2.

The entire analysis process will be carried out using Uniswap as an example, because it is the only case where every situation accounts for some.

• It is basically uncontroversial. Front-end service providers must belong to the "intermediary" role of brokers. Especially the current state of front-end fees like Uniswap will strengthen the tendency to be recognized as brokers.
• The protocol operators are more controversial because strictly speaking, non-upgradeable smart contracts are not controlled by any individual or entity. They require no permission and cannot be tampered with. Will the project parties/developers who provide such smart contracts be defined? As an agent?

Back to the two key defining factors: providing services to 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% services to facilitate transactions and charges for this service. At the same time, it has the ability to record and obtain user information (such as in Add KYC or transaction terms on the front end, etc.)

So let's assume a situation. If the Uniswap team gives up all services and completely withdraws from the project, then theoretically users can still complete the transaction purpose by directly accessing the AMM smart contract deployed by Uniswap. This is because the smart contract will exist forever once deployed. On the chain, AMM becomes a decentralized tool at this time. In a decentralized environment, the project party cannot obtain user information, which does not meet the second defining factor. Although Uniswap has deployed AMM The contract allows users to conduct transactions, but it no longer has the ability to "actively" promote transactions and obtain user information, so regulations may not be able to find applicable brokers.

Therefore, the conclusion is that the higher the degree of decentralization of a project, the lower the possibility of being identified as a broker.

To summarize, there are several core features of decentralized projects:

• Self-operating nature of smart contracts: The core transaction functions are implemented through smart contracts deployed on the blockchain. The contracts cannot be tampered with and anyone can interact with them without permission.
• Decentralized management: If the project side exits (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 customers’ identity information or transaction data.

3/4 · Impact on DeFi

In the early days of DeFi, the end point of most projects was decentralization, and the projects were eventually handed over to the community for self-governance and completely self-operated on the chain. However, with the development of the times, everyone has discovered that realizing this ideal is not as simple as imagined. Most projects gradually disappear from the market after leaving the project party. The main reasons are as follows:

• The project party itself left a lot of mess, soft Rug in the name of decentralization
• The overall market awareness is insufficient and requires centralized guidance and promotion
• There is no problem with the project itself, but it is not mature enough and the community does not have the ability to govern itself and promote project development.

(1) DeFi that requires centralized participation

Therefore, in this cycle, many ceDeFi projects have begun to rise. Since pure DeFi projects are currently unable to 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 compliance burden, open front-end charging or service charging

But it also means that "brokers" can carry out activities reasonably and legally, and the cost is burdened by compliance, and they need to increase their own earning capacity, such as charging customers.

(2) DeFi capable of decentralization

• Decentralized front-end
• Smart contracts are solidified and cannot be upgraded
• On-chain autonomy

If you achieve the above points, it is difficult to be judged as a "broker". Therefore, from this perspective, even if this regulation is implemented, it will mainly target projects that are relatively dependent on centralized leadership. Although such projects are not in the current market. It accounts for the majority, but in the long term it will also be a push for 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 before regulation and compliance are clarified for DeFi. Of course, this clarification may be advantageous during Trump's term, and the market expects a looser regulation. Here, based on the bills or drafts that have emerged, we discuss the optimal solution for a DeFi project to face supervision and compliance, and perfect export.

(1) Broker determination

This aspect is the focus of this discussion. The conclusion is to either turn this thing into a formal business, comply with the reporting requirements of the IRS and accept the identification of the broker, or gradually decentralize the project.

(2) Identification of the nature of tokens

In the context of the approval of the ETH spot ETF application, coupled with the previous content of the FIT-21st Century Financial Innovation and Technology Act, there is a basic basis for determining how project tokens define securities and commodities.

The current definition of ETH is more inclined to functional use. The nature of its pledge and governance is more to maintain network operation 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 a security, and if it is closer to functionality, technology upgrades, etc., it is defined It is more likely to be a commodity.

Let’s take Uniswap as an example. If you want to avoid the “broker” judgment and ensure that its tokens are defined as commodities rather than securities to the maximum extent, should you take this perfect exit?

• Remove the front-end and charge fees, rely on third-party front-ends for transactions, or educate users to interact directly with smart contracts
• Issue your own chain and gradually "ethereumize" the tokens as a functional use and network maintenance to avoid the identification of securities.

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, some projects that still require the participation and leadership of centralized entities exist in this process, and currently Most of them may need to face choices and balances. This is the need to adapt to the development of the times. Decentralization cannot be completed in a day.