By Darren Parkin
by Frederik Gregaard, CEO of the Cardano Foundation
UK regulators have been stepping up activity around crypto and blockchain. In just the past four months, the country has launched three consultations, one on a broad regulatory regime for crypto assets, one on a potential digital pound, and a third on the taxation of decentralised finance, or DeFi transactions.
This last consultation focuses on how to tax DeFi activities such as liquidity provision, yield farming, and staking. These activities are central to the DeFi ecosystem, yet their tax treatment remains a grey area in most jurisdictions. Any tax proposals related to these activities should be nuanced, taking into account existing tax structures as well as the possibilities for more tailored approaches.
DeFi has the potential to transform traditional financial services by cutting out intermediaries and reducing transaction costs. The £11 billion global DeFi market is forecast to grow at an annual rate of 46% over the next several years.
Very few jurisdictions have so far taken a real stab at solving the thorny problems raised by DeFi. In fact, DeFi activities tend to be difficult to pin to a specific jurisdiction. Getting this right could reap real rewards for the City and the UK more broadly.
There is no doubt that the lack of regulatory clarity in this area has hindered wider institutional adoption. So it is welcome that the Treasury intends to “create a regime that better aligns the taxation of cryptoassets used in DeFi lending and staking transactions with the underlying economic substance, whilst reducing the administrative burden on users.”
As the UK gets to grips with setting rules for the taxation of staking and DeFi, there are a few principles regulators should keep in mind.
Firstly, policymakers must take a coordinated approach to the many questions posed by the technology, including those around transparency, privacy, financial market regulation, as well as taxation. Only then can a stable framework that will promote growth in the sector, while safeguarding users, be achieved.
Secondly, it is crucial that we acknowledge DeFi’s unique traits. DeFi is not simply a digital version of traditional finance, but often represents a fundamentally new way of organising economic activity. DeFi transactions differ significantly from traditional financial transactions. They are usually concluded and settled in a peer-to-peer fashion, often automated, and conducted through smart contracts on the blockchain.
Any proposal should recognize these unique characteristics. It seems likely that this will involve creating specific categories for DeFi transactions and defining their tax treatment accordingly.
Thirdly, we must consider DeFi in the context of the wider ecosystem. No DeFi application exists in a vacuum and the degree of interconnectedness is particularly high in DeFi. Clarity on only some types of DeFi activities within the ecosystem could result in even more confusion and stifle innovation.
Finally, regulators need to ensure that new policies provide real clarity and certainty for the industry. Regulatory ambiguity has been stifling growth across the industry in a range of jurisdictions: we cannot thrive and innovate without ground rules.
Specifically on DeFi taxation clarity is needed on subjects such as yield farming, liquidity provision, staking, and other forms of DeFi participation. This will level the playing field for actors in this space and, if pursued concurrently with the other ecosystem components, make the UK a highly competitive environment for the next wave of digital innovations.
As with all regulatory debates, stakeholders involvement and buy-in is key. As Sarah Pritchard, the Executive Director of Markets at the FCA recently said, it is imperative that communication and cooperation between regulators and the blockchain industry is prioritised.
The DeFi landscape is rapidly evolving and continuous engagement with industry allows for regulators to better understand emerging trends, products, and technologies. This is why the Cardano Foundation is actively engaging with policymakers on multiple fronts.
If DeFi is given the regulatory framework to succeed, it could usher in a new era of financial inclusion and efficiency. This approach should take the form of a forward-looking, adaptable framework that can accommodate DeFi applications, technologies and integrations that are yet to be invented.
The intersection of DeFi and taxation is largely uncharted territory and the UK now has the opportunity to develop and implement a truly agenda-setting approach.
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