Decentralized finance (DeFI) Offshore accounts evolution? Part I

INTRODUCTION

The boom in cryptocurrencies has established itself as a phenomenon of these times and is advancing inexorably along a straightforward path that will lead them to become major players in the financial market.

Although most investors prefer them for “hodling” [1] (long-term holding), “trading” operations (buying and selling for speculative purposes) are consolidating thanks to the use of “bots” or programs that allow seeking arbitrage between different markets, define the entry and exit amounts, leverage and even hedge futures.

Both the immobilization and the trading of these assets have given rise to a wide range of financial offers whose characteristics are similar to the products of the traditional markets. In this way, it is possible to finance itself with loans, obtain interest on deposits, cover the risk of volatility with purchase and sale options, conduct swaps, liquidity pools, etc.

In the end, investors can make a profit from owning their virtual currencies, just as they would with their fiat money holdings in traditional markets.

Unlike the latter, if the holder of crypto assets so wishes, operations can be carried out within a framework of anonymity and decentralization, using protocols known as DeFi (Decentralized Finance), where the person who executes the financial orders is not a person nor a company, but smart contracts (programs) that execute orders in an absolutely autonomous way, without the centralization of a financial company or state entity and validated by thousands of nodes thanks to the “blockchain” technology

Paradoxically, the characteristics of anonymity and decentralization that attract investors are the greatest challenge that governments and tax administrations will have in the future, in order to prevent and act in the face of evasion maneuvers and other financial crimes, in a comparable way to what It has happened with tax havens and offshore accounts.

In a New York Times interview, US Senator Elizabeth Warren said that the crypto industry offers “many of the same services” as shadow banks, but still lacks “consumer protections or the financial stability that supports the traditional system.”[2]

In this paper, we will describe the basic operation of these decentralized protocols, the tax and money laundering risks that they entail, and the challenges for a specific regulation of the activity.

THE EXCHANGES

The most common way to exchange fiat money for cryptocurrencies is through an exchange.

The virtual trading platform with virtual currencies is called an exchange, which allows clients to conduct operations of purchase / sale of cryptocurrencies and / or exchanges of one type of cryptocurrency for another, or for fiat money and even for merchandise in various cases.[3]

There are two types of exchanges: Centralized (CEX) and Decentralized (DEX).

In CEX, centralization is given by the participation of the exchange in the intervention between buyers and sellers. They set the exchange rates and the commission rate that must be paid for transactions conducted through the platform.

They generally comply with the “Know Your Client” and “Anti Money Laundering” standards known as KYC and AML respectively, since the clients must be fully identified prior to using the services offered by the Exchange. Therefore, except for OTC operations, they are not platforms that give privacy and anonymity to internal negotiations.

DECENTRALIZED AGENTS (DEX) AND DeFi

A decentralized exchange bases its operation on the blockchain, through smart contracts or Smart contracts. These are autonomous programs that allow executing a series of instructions or clauses according to the fulfillment of pre-established conditions. The most important feature is that these contracts, once programmed, are executed automatically and in a decentralized way.[4]

Unlike CEXs, no funds are held in DEXs and there is no company or entity that acts as an intermediary between the parties, who conduct their transactions in a P2P mode (person-to-person). However, the use of Smart Contracts is infinite, in terms of the use of variables to guarantee operations.

This circumstance provides a high degree of anonymity, one of the advantages most valued by users in cryptocurrencies. This is due to the fact that a DEX only uses addresses to conduct transactions and exchanges, it is not necessary for users to provide data and personal information.

From the DEX, new forms of business known as DeFi or Decentralized Finance have been developed, considered as the evolution of FinTech. Its objective is to offer a series of services built on a decentralized infrastructure.

In this way, users are able to save, borrow or earn interest as if it were a traditional bank, but with the characteristic anonymity of cryptocurrencies.

However, DEXs do not allow users to cash in fiat currencies. Transactions are only made in stable coins, and mostly executed on the Ethereum blockchain.

To enter, it is necessary to have the stable coins that each DeFi requires, which implies that the user interacts with a traditional CEX exchange or obtain the virtual currencies of a P2P operation.

Regarding the size of the market[5], private estimates place it in the order of 95.3 trillion dollars in funds withheld as of October 2021, with a marked boost from mid-2020.

Consequently, the high valuation of the anonymity that users grant to DEXs configures the greatest risk of tax compliance in terms of asset concealment and taxed income.

WHAT FINANCIAL SERVICES ARE OBTAINED IN THE DEFI?

The University of Pennsylvania study “DeFi beyond Hype” details the[6] various financial activities that DeFi performs. They identify six DeFi categories, in addition to auxiliary services such as price oracles and wallets.

  • Stablecoins. This type of cryptocurrency with underlying assets in fiat money, can be incorporated into DeFi services in custody.
  • Exchanges. It allows users to exchange digital assets. DeFi exchanges avoid taking custody of user assets, either through a decentralized order or by matching orders and setting prices using algorithms.
  • Credit. Creation of loan instruments at an interest rate and determined and for a limited time, and the union between borrowers and lenders to issue them.
  • Derivatives. Creation of instruments whose value is based on the value of other assets in the future, such as futures and options.
  • Insurance. Provision against risks through the payment of a premium.
  • Management of assets. Search for the maximization of the portfolio value, based on risk preferences, time horizons, diversification or other conditions.

However, due to the rapid development that has been observed in DeFi, these categories may vary, in view of the almost infinite options offered by the programming of smart contracts.

DeFI AND TAXATION

Without a doubt, decentralization and anonymity can be a cognate vehicle for concealing holdings and earnings of digital assets. This is because, although the protocols are open, the addresses do not directly identify the client, making it difficult to know the tax residence and thus reducing the powers of control of the TAs, for the application of the source and residence criteria of each jurisdiction.

In this sense, the World Economic Forum has warned about five potential risks derived from DeFi:[7]

  1. Financial risks
  2. Technical risks
  3. Operational risks
  4. Legal Compliance risks
  5. Emerging risks

While in general terms the need to protect investor funds is noted, the legal compliance risk indicated refers to the potential use of these platforms to engage in illicit activity or to evade regulatory obligations.

According to the report, DeFi can be used to circumvent legal or regulatory standards. While a DeFi structure may not increase the likelihood of such breaches per se, it could contribute to that endeavor, given the decentralized, non-custodial, and composable nature of DeFi services that make difficult to identify a responsible party.

In addition, it is mentioned that DeFi transactions can be difficult to regulate through traditional MLC/ TFC (Money Laundering and Terrorist Financing controls, because users are pseudonyms by default, the transactions are resistant to blocking, the assets are resistant to seizure, and various transactions involve non-custodial wallets that are not visibly linked to individuals.

For its part, the International Financial Action Task Force (FATF) has developed several approaches to comply with the 2019 anti-money laundering guide, for digital asset service providers, and a new guide proposed in March 2021, which could request information – your customer compliance (KYC) – from DeFi services.

In part II of the blog, we will address the challenges for a regulation that mitigates these risks.

[1] The term “hodl” is a deformation of the English word “hold” used to refer to purchases of cryptocurrencies with the intention of not selling them in the short term. The origin of the word can be traced back to a misspelling that a user made on a cryptocurrency forum in 2013, while explaining why he kept his virtual currencies while the price plummeted. In new posts he kept the misspelling knowing the error, leading to the use of the term in a massive way. In 2016 and 2017, the reference to the English expression “Hold on for Dear Life” was attributed to mean that investors have no intention of selling their cryptocurrencies.
[2] https://www.nytimes.com/2021/09/05/us/politics/cryptocurrency-banking-regulation.html
[3] Source: https://es.cointelegraph.com/explained/what-is-an-exchange
[4] Source: https://academy.bit2me.com/exchange-descentralizado-dex/
[5] Source: https://defipulse.com
[6] https://wifpr.wharton.upenn.edu/wp-content/uploads/2021/05/DeFi-Beyond-the-Hype.pdf
[7] https://www3.weforum.org/docs/WEF_DeFi_Policy_Maker_Toolkit_2021.pdf

Disclaimer. Readers are informed that the views, thoughts, and opinions expressed in the text belong solely to the author, and not necessarily to the author's employer, organization, committee or other group the author might be associated with, nor to the Executive Secretariat of CIAT. The author is also responsible for the precision and accuracy of data and sources.

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