DeFi taxation? Insights into everything in the on-chain Gringotts

Author: cmDeFi

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

• Extended definition of broker: Regulations consider that DeFi transactions have significant similarities with the securities trading process. DeFi brokers need to submit information reports to the IRS, assist clients in accurately reporting taxes, and ensure compliance (KYC, anti-money laundering, etc.).
• Determining DeFi brokers: Provide services that facilitate transactions and have the ability to obtain client information.
• Impact on DeFi: Choosing to accept broker recognition or decentralizing the project; the higher the degree of decentralization, the lower the likelihood of being recognized as a broker.
• Perfect exit for DeFi in the future: Decentralized front-end, non-upgradable contracts, on-chain autonomy, and token functionality to build their own network.

Research Report

1/4 · Background and Reasons

This regulation was initiated by the U.S. Department of the Treasury and the IRS. Due to decentralization and anonymity, digital asset transactions often lack the information transparency found in traditional financial systems, leading to significant challenges in tax regulation. The regulation lists the similarities in operational processes between the securities industry and the DeFi industry:

Trade instructions -> Trade matching and execution -> Trade settlement

In the securities industry, brokers send clients' trade instructions to trading centers (such as the New York Stock Exchange or NASDAQ), which are responsible for matching buy and sell orders. In the DeFi industry, the regulation also identifies a "broker" role, which requires brokers to submit information reports to the IRS, assist clients in accurately reporting taxes, and ensure compliance (KYC, anti-money laundering, etc.).

Therefore, we mainly discuss under what conditions and which roles in DeFi will be recognized as "brokers." Regardless of whether this regulation will be approved and implemented, and in what form, our primary analytical goal is to explore the underlying logic and survival space in decentralization and regulatory attitudes.

2/4 · Expanding the Definition of "Broker"

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 digital asset field. The new regulation requires brokers to submit reports to the IRS detailing clients' trading information, including profit situations and transaction details, with the aim of improving tax compliance, implying potential tax obligations.

One regulatory inclination that can be interpreted here is that although there has been a preliminary definition and distinction between "securities" and "commodities" when the ETH ETF was approved, qualifying digital assets are more likely to be defined as commodities and cannot be directly classified as securities. However, the proposed expansion of "brokers" in this regulation aims to establish an information reporting mechanism similar to that of securities trading, so it essentially returns to the question of how to define DeFi protocols and assets.

The regulation expands the definition of "broker" to explicitly include the following types of participants:

• Digital asset intermediaries: Individuals or entities that provide services to clients to complete digital asset transactions, including exchanges, custodial wallet service providers, etc.
• DeFi platform participants: Including those who do not hold client private keys but provide trading services through protocols or smart contracts on non-custodial platforms.

The core here lies in the term "intermediary." Individuals or entities that provide services to clients need no further explanation; exchanges and custodial wallets are not particularly controversial. The debate lies in how to define the "intermediary role" in DeFi activities. In summary, there are two key factors:

• Providing services that facilitate transactions
• Having the ability to obtain client information

Remember these two judgment factors as we further break down the roles in a DeFi project:

• Front-end service providers: Provide users with a friendly interface to facilitate interaction or transactions.
• Protocol operators: Provide the core protocol or smart contract (such as Uniswap, Curve, etc.) that executes transactions.
• Validators or settlers: Responsible for recording transactions on a distributed ledger (blockchain).

The regulation particularly focuses on 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 validation services for the distributed ledger (such as blockchain nodes or miners) and does not directly participate in or facilitate transactions, they will not be considered brokers. Therefore, we only need to discuss 1 and 2.

The entire analysis will use Uniswap as an example because it is the only case that covers all situations.

• It is generally undisputed that front-end service providers must belong to the "intermediary" role of brokers, especially in the current state of front-end fees for Uniswap, which strengthens the tendency to be recognized as brokers.
• The controversy surrounding protocol operators is greater because, strictly speaking, non-upgradable smart contracts are not controlled by any individual or entity. They have the characteristics of being permissionless and immutable. Will the project party/developer providing such smart contracts be defined as brokers?

Returning to the two key defining factors: providing services that facilitate transactions + having the ability to obtain client information.

If we take the current Uniswap as an example, the front-end service is provided and maintained by the project party. It fully provides services that facilitate transactions and charges for such services, while also having the ability to record and obtain user information (for example, by adding KYC or trading terms on the front end).

Now, let's assume a scenario where the Uniswap team abandons all services and completely withdraws from the project. Theoretically, users can still achieve their trading purposes by directly accessing the AMM smart contract deployed by Uniswap because once a smart contract is deployed, it will exist on-chain forever. At this point, the AMM becomes a decentralized tool, and in a decentralized environment, the project party cannot obtain user information, which does not satisfy the second defining factor. Although Uniswap has deployed the AMM contract to allow users to trade, it no longer has the "active" ability to facilitate transactions and obtain user information, so the regulation may not find applicable broker subjects.

Thus, the conclusion is that the higher the degree of decentralization of the project, the lower the likelihood of being recognized as a broker.

In summary, several core characteristics of decentralized projects:

• Self-operating nature of smart contracts: Core trading functions are realized through smart contracts deployed on the blockchain, which are immutable and can be interacted with by anyone without permission.
• No centralized management: If the project party withdraws (for example, stops maintaining the front-end interface), the smart contracts can still operate and do not rely on any centralized entity.
• Independence of front-end services: Even if the official front-end (such as Uniswap's official website) goes offline, third-party developers can build their own front ends to interact with the smart contracts.
• Inability to control client information: Since on-chain interactions are completely trustless, project parties typically cannot obtain clients' identity information or transaction data.

3/4 · Impact on DeFi

In the early days of DeFi, most projects aimed for decentralization, ultimately handing the project over to community governance and operating entirely on-chain. However, as time has progressed, it has become apparent that achieving this ideal is not as simple as imagined. Most projects gradually disappear from the market's view after leaving the project party, primarily for the following reasons:

• The project party leaves behind a mess, soft rugging in the name of decentralization.
• Overall market awareness is insufficient; centralized guidance and promotion are needed.
• The project itself is not problematic but is not mature enough, and the community lacks the ability to govern and promote project development.

(1) DeFi Requiring Centralized Participation

Thus, during this cycle, many ceDeFi projects have begun to emerge. Since pure DeFi projects currently cannot achieve the goal of "decentralized finance," it is better to directly introduce relatively professional and compliant centralized entities and strategies. In this case, these centralized entities are likely to be recognized as "brokers." If this regulation is approved and implemented, it means these projects may:

• Require users to provide KYC.
• Open front-end fees or service fees under compliance burdens.

But at the same time, it means that "brokers" can conduct activities reasonably and legally, with the cost being the compliance burden, which requires increasing their revenue capabilities, such as charging clients.

(2) DeFi with the Ability to Decentralize

• Decentralized front-end
• Solidified, non-upgradable smart contracts
• On-chain autonomy

Achieving the above points makes it difficult to be determined as a "broker." Therefore, from this perspective, even if this regulation is implemented, the main targets will be projects that rely more on centralized leadership. Although such projects currently account for a large portion of the market, in the long run, it will also promote the decentralization of DeFi, and the requirements for centralized entities entering this industry will become increasingly high.

4/4 · DeFi Exit

First of all, the clarification of regulation and compliance for DeFi is only a matter of time. Of course, this clarification may have geographical advantages during Trump's term, and the market expects a more relaxed regulatory environment. Here, based on the existing bills or drafts, we discuss an optimal solution for a DeFi project facing regulation and compliance, a perfect exit.

(1) Regarding Broker Determination

This aspect is the focus of this discussion. The conclusion is that either make this a legitimate business, comply with the IRS reporting requirements, and accept broker recognition, or gradually decentralize the project.

(2) Regarding Token Nature Determination

In the context of the ETH spot ETF application being approved, along with the content from the previous FIT-21 Century Financial Innovation and Technology Act, there is now a basic basis for determining how project tokens are classified as securities or commodities.

Currently, the definition of ETH leans more towards functional use, with its staking and governance nature primarily aimed at maintaining network operation rather than economic returns. In this case, it is more likely to be defined as a commodity rather than a security.

From this perspective, for DeFi protocols, if the governance direction is more inclined towards obtaining economic returns or dividends, it is more likely to be defined as a security. If it leans towards functionality, technological upgrades, etc., the probability of being defined as a commodity is greater.

Let’s still take Uniswap as an example. If it wants to avoid being classified as a "broker" while maximizing the chances of its token being defined as a commodity rather than a security, what perfect exit should it pursue?

• Remove the front-end and fees, relying on third-party front-ends for trading, or educate users to interact directly with the smart contracts.
• Launch its own chain, gradually "Ethereum-izing" the token, using it as a functional use and network maintenance to avoid being classified as a security.

Regardless of whether these regulations will be approved and promoted, as long as DeFi continues to move towards the goal of decentralization, it will not be affected. Of course, during this process, some projects still require the participation and leadership of centralized entities, and currently, this is the majority. They may need to face choices and balances, which is a necessity in line with the development of the times; decentralization is not achieved in a day.