The ink has hardly dried on the legislation, and already the champagne corks are popping in the DeFi universe. As a compromise, Congress did roll back the new digital asset reporting obligations for many DeFi brokers. Yet this move is being heralded as a breakthrough, a spark for innovation. If we can all admit the truth for just one second. In the process, are we prematurely celebrating a win for disruptive technology, or simply unlocking a new superhighway for tax avoidance? I suspect it’s a little of each, but heavily weighted on the latter. And here's why you should be concerned, even if you're not a crypto whale.

Innovation Unshackled Or Loophole Exploited?

Proponents of repeal based their argument on the assertion that all these reporting requirements were crippling innovation. Realistically applying traditional KYC and reporting standards to decentralized, permissionless protocols is a tall order. Such complexity might have otherwise greatly stunted the expansion of the budding DeFi environment. There’s a little bit of truth in that. It’s like trying to fit a square peg (traditional finance regulations) into a round deep hole (DeFi). It's messy. It's inefficient.

There’s a lot of enthusiasm behind this repeal, not only for what it means for developers. It further energizes entrepreneurship and innovation in the space of novel financial products. The allure of DeFi, for many, is the ability to operate outside the traditional financial system, largely free from the prying eyes of regulators. And that, quite frankly, leaves the door open for all kinds of shenanigans.

Think about it. The repeal as it’s currently written only applies to DeFi brokers that lack fiat on/off ramps. These are the platforms we would consider those that “live entirely downstream of the crypto curtain.” The benefit is that from a technology perspective you can easily move assets in and out of these platforms. Engage in commerce and even earn passive income, all while, of course, engaging outside of the traditional financial system and its many reporting obligations unlike Coinbase.

The question is: How can we avoid it becoming a giant black box?

Data Doesn't Lie Tax Evasion Looms

Here's where the "unexpected connection" comes in. Remember those Panama Papers? The Paradise Papers? What did those leaks reveal? The extremes to which people and corporations are willing to protect their assets from tax. Now, apply to this Harvard study the same incentives, but with the added anonymity and complexity that come hand-in-hand with DeFi.

We're not talking about small potatoes here. Even if the DeFi market is volatile, it is still a big pot of capital. And the tax evasion potential is huge.

Now, I’m not claiming that all participants in DeFi are tax evaders. Far from it. The elimination of these reporting requirements removes an important, albeit imperfect, obstacle to bad actors’ greed. If they become politicized, I worry this will quickly become a ticking time bomb.

The IRS is once again making it clear that taxpayers are required to report their gains and losses from digital assets. How meaningful will this new requirement actually be? Particularly when such information is not reported to them automatically?

  • Increased Anonymity: While blockchain transactions are public, linking those transactions to real-world identities can be challenging. This repeal makes it even harder.
  • Global Reach: DeFi protocols operate globally, making it difficult for any single jurisdiction to enforce tax laws.
  • Complexity: The intricacies of DeFi transactions, such as staking, lending, and yield farming, can make it difficult to determine taxable events and calculate gains and losses.

Beyond facilitating tax evasion, this unexpected repeal is still more problematic. Decreasing regulatory oversight may increase the volatility in an already-risky DeFi market, making it riskier for retail investors who may not fully understand it. Creating a digital currency would open the door to increased illicit activity, including money laundering and terrorist financing. Can we truly afford to trade economic certainty for the exciting promise of innovation?

Unintended Consequences Await Us All

Unlike DeFi, centralized exchanges—such as Coinbase—would be required to comply with extensive reporting requirements. Yet, they’re stifling innovation in ways that hurt U.S. users before they’ve even gotten their feet wet. Some have gone as far as broadening KYC requirements, others have gone as far as geofencing U.S. users, essentially banning them from key DeFi services.

The consequence? U.S. investors may find themselves pushed towards offshore platforms that operate in a far less regulated and thus more dangerous environment. And even if it were, is that really in anyone’s best interest?

Now, I'm not advocating for stifling innovation. I'm advocating for an approach that is less lopsided. We need to find a way to foster innovation in the DeFi space without creating a haven for tax evaders and criminals. The repeal, as currently crafted, does not achieve that balance.

What's the solution? Tough question. It begins with recognizing the dangers and having an honest dialogue about how to reduce them. To curtail distrust, we need to think about new reporting methods such as zero-knowledge proofs. These options can safeguard user privacy while still providing regulators the information necessary to enforce tax laws. We need to collaborate with our international counterparts to create a global playbook for regulating DeFi.

At the end of the day, the success of DeFi will hinge on creating trust and confidence in the system. That takes the transparency, accountability, and commitment to rule of law we have demonstrated thus far. The repeal of these disclosure requirements particularly sends the wrong message. This too threatens to sap the long-term health of the DeFi ecosystem.

So, is this a win for innovation? Maybe. But it’s equally the opportunity of a lifetime to evade taxes and a dangerous bet with the health of our new financial system. And that’s a risk we cannot continue to take.

Just to reiterate, recordkeeping is very important, even if you’re only lightly doing crypto on the side. The IRS hasn’t given up in this space, and you certainly don’t want to be anywhere near the IRS’s wrong side in terms of tax law. And if you're involved in DeFi, now is the time to consult with a tax professional to ensure you're in compliance with all applicable regulations. Don't say I didn't warn you.

Remember, recordkeeping is essential, even if you're just casually dabbling in crypto. The IRS is still watching, and you don't want to be caught on the wrong side of the law. And if you're involved in DeFi, now is the time to consult with a tax professional to ensure you're in compliance with all applicable regulations. Don't say I didn't warn you.