The Dilemma of "Compliant DeFi"

Cryptocurrency regulation

Decentralized finance (DeFi)

IRS crypto guidance

Written by

Grant Matik

Published on

Oct 29, 2023

In the ever-evolving world of cryptocurrency, the tension between regulation and decentralization has come to the forefront once again. The recent release of proposed regulations by the US Treasury Department has ignited a debate over the future of decentralized finance (DeFi) and whether complying with these rules would fundamentally change the essence of DeFi.

To understand this dilemma, we must delve into the historical context. The 1970s marked a significant turning point when the Bank Secrecy Act was enacted in response to mounting concerns about money laundering and financial secrecy. This legislation empowered law enforcement to access bank records for financial transactions without needing a court order. The doctrine of "third-party disclosure" was established, suggesting that information voluntarily shared with third parties, such as banks, was not protected by the Fourth Amendment.

Fast forward to the present, where cryptocurrencies have emerged as a revolutionary financial innovation. Unlike traditional financial transactions, crypto transactions bypass intermediaries, and users interact directly with one another. From a legal standpoint, cryptocurrencies should enjoy the same Fourth Amendment protections as physical cash.

However, Senator Elizabeth Warren has voiced concerns about what she labels a "giant loophole" in crypto transactions. Her argument revolves around the potential for crypto transactions, which are often associated with transparency, to be exploited for money laundering. While most cryptocurrencies, like Bitcoin, offer transparency, privacy-focused coins like Zcash and Monero provide users with greater anonymity, albeit with less liquidity.

The recent guidance from the Internal Revenue Service (IRS) ostensibly targets tax evasion within the crypto space. The Joint Committee on Taxation estimates that these rules could enable the IRS to collect up to $28 billion in taxes from crypto holders. However, some critics argue that crypto holders are more likely to claim capital losses, potentially making the $28 billion estimate overly optimistic.

The true impact of this guidance, whether intentional or not, lies in its treatment of DeFi. The proposed rules would subject "digital asset brokers" to the same reporting requirements as traditional financial brokers. A closer examination of the 282-page document reveals that the term "decentralized" appears eight times. Herein lies the heart of the issue.

The IRS's guidance implies that it may require operators of platforms often referred to as decentralized exchanges to collect customer information and report sales data about their users. In other words, DeFi users would be classified as "customers," and their transactions would fall under the purview of the Bank Secrecy Act.

This development would bring platforms like Metamask and Uniswap into the regulatory framework, making them the "third parties" from which law enforcement could demand records without a warrant. Consequently, these platforms would need to keep records and perform Know Your Customer (KYC) checks on their users, effectively introducing a third party into the peer-to-peer DeFi protocols.

The circular logic is evident: Complying with IRS rules would transform DeFi into something that resembles traditional finance, with compliance requirements, records, and KYC checks. But the critical question arises: Can compliant DeFi still be considered genuinely decentralized finance?

Ultimately, the push for compliance and transparency in the crypto space may clash with the fundamental principles of DeFi, which prioritize decentralization and user anonymity. While the IRS's guidance could enhance anti-money laundering efforts and tax collection, it also challenges the core tenets that have defined the DeFi movement.

Some observers view this regulatory development as an attempt to stifle the digital asset ecosystem in the US, echoing the impact of the Bank Secrecy Act on financial privacy. Striking the right balance between regulation and decentralization in the crypto world remains a subject of ongoing debate, and its resolution will shape the future of crypto and DeFi.