US Treasury’s Battle Against DeFi: Taxation and Regulation

In the ongoing crusade against everything crypto, the US Treasury department has long set its sights upon decentralized exchanges and AMMs such as Uniswap and Pancakeswap. Since April of this year, the treasury department has issued a 42 page-long document assessing the risks of illicit financial activity within decentralized finance. The document alludes to the typical well-known risks within the DeFi ecosystem, like rugpulls or security compromises, and even goes so far to warn users that cyber-agents from North Korea are active within DeFi. The report has largely gone under the radar in the decentralized community, as its concluding regulatory recommendations — only 1 page out of the 42 — scarcely mentions any substantial actions.

4 months later on Aug 25th, the US Treasury Department appears to have followed through on their threat, and released a 282 page long tax guidance document for reporting requirements towards decentralized crypto exchanges, hosted wallet providers, and payment processors. To the dismay of the DeFi community, the IRS announced that these laws are expected to come into effect 2025. The IRS projects these new regulations, combined with its overall legislation called the infrastructure bill, would generate $28b in taxes over 10 years.

A Dissection of the Proposal

The most notable aspect of the proposal is the classification of centralized and decentralized crypto exchanges, crypto payment processors, and even some hosted crypto wallet providers as brokers. The treasury would then require these “brokers” to file a new digital-asset specific form, 1099-DA to both the IRS and US-based customers. As of today, the treasury department has yet to release a copy of the new form, and the document has only partially revealed what could be on the form. For instance, similar to the requirements for stock brokers, the new 1099-DA requests the cost basis of acquired digital assets. For centralized exchanges, this would be a heavy administrative cost; for decentralized exchanges, it appears neither to be possible nor applicable, as funds are transferred through an AMM in a p2p manner without custodians or intermediaries.

The main problem of the treasury department’s new tax guidance appears to be a fundamental, and perhaps willful ignorance of the core functionalities of DeFi. The term “broker” in itself often implies the existence of a third-party, yet the purpose and spirit of decentralization is to cut out the third-party and have no middleman. Even stranger, the treasury document acknowledges this fact, recognizing that in the case of wallets, “only the user of an unhosted wallet has access to both the public and private keys necessary to effect transactions in the digital assets associated with those keys.” Yet in only a few short pages later, the proposal also attempts to find third parties “responsible for effectuating transfers on behalf of” a wallet user. As a result, the 282 page tax guidance is ripe with self-refuting and conflicting guidelines. It is full of attempts to forcefully define an intermediary broker in DeFi where none exists, ultimately creating a really confusing and long document.

So what’s gonna happen now?

Should the tax guidance be finalized, then the largest regulatory burden would likely fall upon the centralized exchanges. For dApps, it is possible that the treasury department realizes that their regulations towards decentralized exchanges are illogical and inapplicable, but nonetheless attempt to dissuade or limit the ability for US citizens to easily use dApps. The largest decentralized exchange, Uniswap, may also likely shift its roots from the United States to other countries.

It is difficult to imagine how the treasury department would be able to enforce tax reporting for a decentralized DeFi user in the US. After all, metamask doesn’t actually hold your assets, but rather serves as more of an identity-management tool, where your key phrases simply allow you access to an account holding your assets within web3. The largest inconvenience to retail users in the US would likely be off-ramping earnings or trades from DeFi into CeFi, as that transfer of funds would be monitored by the IRS.

A recent court ruling saw the dismissal of an investor-led class action lawsuit against Uniswap. The lawsuit claimed that Uniswap should be held liable as a broker in its listing of questionable scam tokens, yet judge Katherine Polk Failla claimed that Uniswap is merely a platform that facilitates the sale and exchange of tokens, not the issuer of scam tokens and thus not responsible for any alleged misconduct. Furthermore, Failla was unwilling to stretch the federal securities law to include ETH as a security, rather directly calling it a commodity. Judge Failla is currently also overseeing SEC’s case against Coinbase, indicating a potential similar favorable ruling for the crypto sphere.

Overall, with new treasury laws that don’t make much sense and court cases seeming to lean in DeFi’s favor, DeFi enthusiasts likely wouldn’t need to worry much currently. So fire away and start earning on Diamond Protocol’s newly introduced pairs on Pancakeswap and come participate in our trading competition starting September 1st!

Who We Are

Diamond Protocol is a leveraged liquidity provision platform that operates on top of DEXs. It allows liquidity providers on platforms like Uniswap to hedge their LP positions by borrowing and shorting volatile assets.

Our philosophy has always been to give the DeFi and crypto community a product that allows systemic earnings in a volatile market. From the beginning of our product design, we grappled with the question of how to earn profit in a market that is so unpredictable — our result was Unibot. This product aims to significantly increase our user’s odds of winning. We aim to create a scenario where a trader can accrue fees earned and wait for an ideal exit price even if they guess the market wrong.

Our approach has since been appreciated by seasoned traders within the crypto and DeFi ecosystem like Joshua, and we welcome everyone to join our discord, where we regularly host trading competitions and events with rewards. Come on by and meet the team and other veteran traders eager to discuss and share strategies!

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