DeFi: Defining the

future of finance

DeFi: Defining the Future of Finance 1

 Contents

Foreword 4

Regulating DeFi 10

Governance 16

Taxation 21

Glossary 27

DeFi: Defining the Future of Finance 2

 Introduction
Decentralised Finance (DeFi) has experienced tremendous growth since
mid-2020. While it is still in its early days, DeFi has shown us that offering
decentralised financial services at scale is possible. In this report, we
have set out to share some key considerations in the areas of
governance, security, tax and regulatory that we believe the DeFi
ecosystem should take note. We hope that the insights in this document
will be a positive contribution to the collective efforts to build the future of
finance and money.

DeFi: Defining the Future of Finance 3

 Foreword
Bitcoin and Ethereum

When the original whitepaper on Bitcoin was ledger. However, because Bitcoin is written
published in October 2008, it demonstrated using code, conditions can be attached to the
that we were finally able to conduct peer-to- transfer of value, creating a framework for the
peer transactions without any intermediaries. electronic settlement of contracts. This type of
This ground-breaking capability was the framework opens up the potential for perfect
product of decades of work in disciplines execution of an agreement between parties,
ranging from cryptography and programming where payment is released simultaneously
to economics and finance. upon the delivery of goods or services. Such a
capability has some very direct and relevant
In 2008, as the world stared into the abyss of
use cases in commerce generally – but more
the global financial crisis then playing out,
especially in financial services.
Bitcoin enthusiasts saw it as presenting the
possibility of a new, wholly independent Ethereum very much heralded the advent of
ecosystem of electronic cash. Advocates DeFi, by providing a trusted framework upon
made bold claims about how Bitcoin would not which computer code can be deployed,
only change the operation of the financial executing instructions exactly as written. This
system, but also impact previously accepted framework can be linked to the control of
ideas around data, privacy, and government. digital assets, which in turn can be used to
create financial products. The providers of
The Bitcoin concept was further extended in
financial services, such as mortgages, do
2013 with the launch of Ethereum, which
exactly the same. The difference is that, to
provided improvements to a range of the
date, it’s been down to the financial
original Bitcoin features. One of these was the
intermediaries and regulators to ensure the
concept of the smart contract. Bitcoin is
products operate as intended. In DeFi, by
principally known as a transmissible store of
contrast, it’s down to trusting the code.
value, recorded on a decentralised, shared

DeFi: Defining the future of finance 4

Decentralised Finance, “DeFi”

in the years following the launch of Ethereum, interference. While there was no single
many developers started to realise that project that established the term “DeFi”,
financial services is a natural use case for the MakerDAO was probably one of the first to
technology. This was because the garner a lot of attention. Subsequent projects
decentralised nature of its operation could be built on this, by seeking to leverage
used to provide the inherent security a blockchain to deliver financial services without
financial ecosystem needs to prevent a need for centralised intermediaries.

DeFi Total Value Locked

80
Billions

70

60

50

40

30

20

10

Source: The Block, Data as of 24 June 2021

Since then, the DeFi ecosystem has gradually up continually as people explore further how
gathered momentum. Those early projects to improve interoperability or bring the existing
started to mature, having launched their finance system into the blockchain, while also
mainnets, (fully developed versions of their innovating on use cases that were never
code), while new projects have continued to possible before.
emerge. According to The Block, the Total
Value Locked grew substantially in 2020 from
$1 billion to $37 billion as of end of June
2021. This is, of course, a small number
relative to the value of the entire financial
services ecosystem. But it’s continuing to see
headlong growth, with new projects springing

DeFi: Defining the future of finance 5

What Makes DeFi unique?

Non-reliance on Facilitates Experimentation

centralised innovation in with decentralised
intermediaries digital payments governance

One of the biggest draws to the whole idea of sending or receiving funds, or even the
using blockchain technology to reinvent the execution of other smart contracts. This type
finance space lies in how the market can of automation enables the delivery of existing
become permissionless and open to anyone. financial services over blockchain networks
A further attraction is the concept of and allows for the creation of new services
composability, which means anyone can mix where the rules and conditions of execution
and match any existing DeFi offering to build a are guaranteed by the network itself. The
new one. The composability of such a implications of using smart contracts in this
network, effectively made of blocks of way are incredibly profound for financial
interlocking components, also means that services.
newer innovations and needs in the finance
With smart contracts being key to DeFi
space can be easily built on top of the network
applications, most DeFi projects are currently
and plugged together, with everything being
built on the Ethereum network. This is due to
governed by smart contracts.
the widespread availability of developer
Smart contracts are programmes that capability to work with Ethereum’s Solidity
automatically execute an action when a programming language that supports the
certain event occurs. This allows users to creation of the necessary smart contracts.
define rules governed by technology. However, there are now many other
Conditions can be defined, which, if met, will blockchain networks that allow DeFi
automatically trigger other actions such as applications as well.

DeFi: Defining the future of finance 6

Differences between DeFi and CeFi

• Autonomy: DeFi applications don’t have • Transparency: Most of the time, the code
restricted access and the operations are of the DApp is publicly available for
not managed by an institution or a central anybody to look at or audit. In other words,
authority. Instead, everything is done anyone has the opportunity to understand
through a smart contract and the storage is the contract’s functionality or find bugs and
carried directly in the blockchain, making it report them. Furthermore, all the
impossible to interrupt these applications. interactions with the DApp which are
Once the smart contract is deployed on the represented by transactions are also public
blockchain, the DeFi applications can run for anyone to view. As a reminder, receiver
with little to no human intervention, but in and sender are pseudo-anonymous on
practice developers build and maintain most of the blockchain;
applications on top of the smart contract. If
• Disintermediation: Everybody can build
you don’t like the service offer by a DApp
an application on top of smart contracts for
you can easily switch to a competitor DApp
DeFi or interact directly with smart
without a paper burden;
contracts from their crypto wallets without
• Availability: DeFi applications are having to go through a third-party
available from anywhere in the world, at intermediary;
any time of the day and from your living
• Interoperability: DeFi applications can be
room. The only requirement is an internet
run on several blockchains and
connection;
applications can be built or composed by
combining other DeFi applications.

DeFi: Defining the future of finance 7

The DeFi landscape

DeFi projects continue to be lucrative correct operation of the protocol, earning it

ventures. For many of these projects, the rewards for effectively securing the proper
development teams retain a significant portion operation of the network. This further
of the token supply, or the electronic shares encourages developers to continue improving
used to control and secure the operation of on their protocols to entice more users onto
the mainnet. This not only means that the the network.
team can benefit from speculation on prices,
but also allows the firm to be party to the

Below are some areas currently covered in DeFi space:

Stablecoins Decentralised exchanges Lending and borrowing

Digital assets whose price is Exchanges that enable users One of the key functions in
pegged to the value of the to trade their digital assets today’s current financial
underlying reserve assets to peer-to-peer without any system. With blockchain
offer a cryptocurrency with centralised intermediaries technology, users are now
little volatility in the price of (Uniswap, SushiSwap, able to carry out such
the coin itself (DAI, sUSD) Balancer, IDEX, Loopring, activities without
Bancor) intermediaries (MakerDAO,
Compound)

Insurance Derivatives DeFi aggregators

Allows users to get coverage (Synthetic assets) These aggregators connect to
for certain risks (mainly Contracts whose value is the various protocols,
against smart contract failures derived from the performance allowing users to get the
and the risks related to their of underlying assets. optimal yield/market rates for
deposited crypto assets) Cryptocurrency-based their transactions and
without any centralised synthetics allow users to creating more efficient
insurance intermediary trade the values of various markets in the DeFi
(Nexus Mutual) assets on the blockchain ecosystem (yEarn Finance,
network without having the Harvest Finance, ValueDeFi)
need to hold the underlying
assets (Synthetix, dYdX)

DeFi: Defining the future of finance 8

The emergence of a strategy widely referred The current customer base of the various DeFi
to as Yield Farming, or Liquidity Mining, has protocols has often been made up of users
also spurred growing interest as it further who are looking to maximise their returns on
encourages users to support various DeFi digital assets using Yield Farming, or to
protocols. Yield Farming is the idea of locking speculate on the potential upside of this new
up capital in different protocols, in exchange and growing market. To date, one of the
for which a return is provided. For many of the biggest barriers to the mainstream adoption of
DeFi protocols, liquidity within the protocol is DeFi has been simply how new the ecosystem
crucial to the proper functioning of the protocol is; there are still areas that need to be
itself. One such example is the lending and addressed – not least the big question around
borrowing ecosystem, where lenders are what form regulation should take when
essential in providing funds for borrowers. As applied to a decentralised protocol, not
such, many of these DeFi protocols provide necessarily having a legal entity or even
rewards for liquidity providers that lock up their originating jurisdiction. This is just one issue
cryptocurrencies on their platform. While the among many, sitting alongside others such as
rewards have traditionally consisted of a share coding risk, taxation, governance,
of the platform usage fee, some protocols cybersecurity, money laundering compliance,
have recently begun to further incentivise asset valuation and interoperability
users to provide liquidity by rewarding them requirements.
with tokens. These tokens are often
governance tokens, which are not only used
for trading but also grant rights for holders to
vote on governance proposals within the
protocol.

What the future of DeFi holds

In recent years, an array of macro and This report is a high-level guide to some of the
technological trends have been contributing to most important considerations that are now
the exponential growth of DeFi. Whether in the emerging around DeFi. While it has been
form of decentralised exchanges, lending and tailored for decentralised exchanges and DeFi
borrowing of different asset types or through project owners, it has also been written for
insurance products, DeFi is evolving and those with a general interest in this space, as
expanding swiftly to mirror the traditional well as those working in financial services.
financial services ecosystem. This new form of
decentralised financial technology may
eventually have an impact on the future of
centralised finance entities, with DeFi
potentially being seen as an alternative that’s
cheaper, quicker and more relevant.

DeFi: Defining the future of finance 9

 Regulating DeFi

The crypto industry has been on the radar of Many in the industry see the growing
regulators worldwide for several years. Many regulatory scrutiny as positive for its future
jurisdictions have developed their own local development. But with the principles of DeFi
frameworks to regulate the sector or amended potentially being at odds with the principles of
their existing regulatory legislation to regulation, it makes for an interesting future
encompass crypto activities. Larger bodies relationship between DeFi and regulation.
have released wider ranging requirements:
Given the decentralised nature of blockchain
examples include the Financial Action Task
technology and the borderless nature in the
Force’s (FATF) recommendations requiring
way its services can be delivered, the
countries to implement measures and controls
jurisdictional applicability of the relevant laws
to combat money laundering and terrorist
and regulations is currently open to question.
financing, and the European Commission's
However, the existence of a smart contract
recently-published Regulation of Markets in
might enable technical functionality to be
Crypto-assets (MiCA) proposal1. MiCA is an
implemented within DeFi products to impose
EU-wide regulatory initiative that aims to
jurisdictional restrictions. For example, the
regulate crypto-asset issuers and crypto-asset
technology could block access by IP
service providers (CASPS).
addresses from certain countries. The
These regulatory developments, along with effectiveness of such measures, particularly in
the ever-increasing involvement of relation to regulatory or security issues, is
institutional players, underline the extent to likely to depend on specific local legislation.
which the crypto-industry is becoming As such, the need for an umbrella regulatory
mainstream – in turn making further framework may be greater than ever before.
intervention from regulators inevitable.

1 https://eur-lex.europa.eu/legal-content/EN/TXT/?uri=CELEX:52020PC0593

DeFi: Defining the future of finance 10

The development of this type of legislation convert the stolen US$200 million, essentially
would need to take the following areas into “cleaning” the “dirty” crypto. While the use
account: cases for DeFi are effectively endless and its
evolution could have significant positive
• Legal enforceability and conflict resolution;
impacts, events such as this have the
• Consumer, or end user, protection; potential to plunge the crypto industry back
• Data privacy considerations, especially into the dark days of Silkroad2 and the like.
under the EU framework of GDPR; This possibility reinforces the need for a
proper regulatory framework.
• AML/CFT/KYC issues.
In combination, all the issues we’ve set out
The currently limited nature of the Anti-Money here serve to make DeFi regulation a hot
Laundering (AML) and Know-Your-Client topic. It is also one that currently raises more
(KYC) checks performed by DeFi platforms questions than answers – and we will now
creates the potential for DeFi projects to be explore some of these questions.
used for money laundering purposes. The
industry saw an example of this risk emerge
earlier this year, when KuCoin suffered a
cyber breach and the hackers used
decentralised exchanges (DEXs) to attempt to

Who to regulate?

Traditional regulation focuses on a centralised As outlined earlier, single, global regulators

party, a legal entity and the people behind that are few and far between – and the ones that
legal entity. Regulators approve and supervise regulate aspects of our lives that are global in
the decision makers behind an entity and the nature require coordination across the
operations that the entity undertakes. This governments of all countries. One of the few
approach poses several challenges when examples of a truly global regulator is the
considering the regulatory aspects of a DeFi Geneva-based International
project, because in a truly decentralised Telecommunications Union (ITU), which
protocol there is arguably no centralised party. regulates the standards associated with
The decisions and operations are performed telecommunications. In the case of the ITU, it
by computer code that is programmed at the is transmitters of radio telecommunications
outset to perform a set task, meaning no services that are regulated. For DeFi, where
single entity or individual has centralised there is no physical component to regulate,
control over the protocol. In cases where the there may not be a legal entity, and the reality
project utilises a governance token to direct is that effective control lies with lines of
and make changes to the platform, the executable code, then who should be
decisions are presumed to be made by a regulated?
collective body of participants in a democratic
way: this model too lacks the centralised
control that is at the heart of traditional
financial regulation.

2 https://www.bbc.co.uk/news/technology-54833130

DeFi: Defining the future of finance 11

To address this question, let’s consider controls or is behind the DeFi platform, then
whether all DeFi projects are fully that regulator is likely to want to regulate that
decentralised. Factors that regulators may party to ensure that the platform applies
focus on include: regulatory principles – even though identifying
the party and where that party is centralised is
• If any party has the ability to control the
likely to be a challenge.
protocol by modifying, disabling or halting
the code at any time, this suggests that Meanwhile, if genuine decentralisation is
there is a central party that controls the achieved, further questions arise. Assuming
protocol; that a DeFi project is truly decentralised,
would regulators seek to regulate the
• If any party owns a majority of governance
developers, to ensure that they embed
tokens and can therefore influence the
regulatory principles into their code? At the
protocol, it could be seen to be controlling
very least, regulators would want to make sure
as a central party;
that any protocols that allow the transfer of
• If a protocol employs individuals to provide significant value and the use of financial
some form of customer service, investor products, conduct AML and CFT checks on
relations or promotion, then there must be their users.
someone behind the protocol.
The use of governance tokens within DeFi
While many DeFi projects aim to become fully protocols raises another interesting question:
decentralised, it may be difficult to actually should governance token holders bear some
achieve this at the outset. Decentralisation responsibility for that platform's application of
requires the ecosystem of participants to AML guidance? Arguably, the governance
actively govern, contribute and take forward token holders are driving the direction of the
the protocol – and this depends on having a protocol. So, if they are knowingly allowing
large volume of active users. Until a project their platform to circumvent globally accepted
reaches this critical stage, the developers and AML requirements, such as those of the
initial promoters behind the protocol could still FATF, are they responsible for turning a blind
be seen to be controlling the project, therefore eye and not cracking down on money
making them the target for regulators. If a laundering?
regulator is able to identify a central party that

Who could regulators seek to regulate?

Centralised parties Governance token holders Developers or promoters

Factors that may generate Governance token holders drive Could regulators target
a degree of centralisation: the direction of the protocol, developers, forcing them to
• Ability to control the should they also be responsible build regulatory principles,
protocol by modifying for ensuring that the platform such as AML checks, into
the code; complies with AML requirements? their code?
• Influence the code
through owning the In the early stages before the Promoters could be in the
majority of governance platform achieves mass adoption, spotlight, where regulators
tokens; or does a small number of could aim to supervise the
• Employment or individuals, usually the people who distribute and
individuals or developers or promoters hold the advertise DeFI platforms.
fundraising activities majority of governance tokens.
suggest a centralised
party.

DeFi: Defining the future of finance 12

DeFi and AML

Various authorities around the globe are transactions. Although there would be some
expanding and enhancing the existing technical challenges (as well as many
AML/CFT/KYC regulatory frameworks to cope ideological ones raised by the DeFi
with the rising demand for financial services community), such a mechanism – if
and the pressing need for increased security practicable – could filter a large number of
and protection against fraud. The European suspicious transactions. Following an analysis
Commission, through its MiCA consultation, is by CipherTrace, researchers found that over
proposing several changes to existing 90% of DEXs within a clearly domiciled
financial services laws to capture technology country had deficient KYC, with 81% having
changes arising from blockchain and DLT. little to no KYC whatsoever4. This lack of KYC
These changes include: illustrates the vulnerabilities in the DeFi
architecture that could be targeted by bad
• Amending MiFID II to clarify the
actors wanting to use the technology to
circumstances in which crypto-assets
launder money. The question here is that if
qualify as ‘financial instruments’;
regulators were to crack down on these
• Creating a regime for securities tokens; platforms, and they were truly decentralised,
• Establishing a bespoke regime for the new could regulators actually shut them down to
asset class that is not covered under stop them from providing the service?
existing regulation (e.g. stablecoins, Furthermore, since a DeFi application is
payment tokens and utility tokens); and controlled or operated by a community of
• Issuing AML directives for crypto assets. miners, nodes and users with no central entity,
it would be difficult to attribute responsibility to
Furthermore, the FATF recommendations3 set any one person on the network. Given the
out a comprehensive and consistent difficulty of identifying a single person to
framework of measures that countries should regulate DeFi protocols, we could see the
implement to combat money laundering and development of innovative supervisory and
terrorist financing. monitoring technologies – “Smart RegTechs”
At the same time, DeFi products – given their – which would harness blockchain and smart
decentralised nature – are available to anyone contracts to carry out supervisory and
in any country without any regulatory monitoring functions without relying on the
compliance framework. As a result, DeFi can regulation of intermediaries or institutions.
easily become a tool in the hands of criminal
actors. It remains to be seen how authorities
would regard potential solutions to this risk. A
very simple example could be that smart
contracts may be programmed to perform
AML/KYC checks prior to the execution of

3 http://www.fatf-gafi.org/publications/fatfrecommendations/documents/fatf-recommendations.html
4 https://www.linkedin.com/pulse/future-money-developments-you-need-know-week-issue-11-henri-arslanian/

DeFi: Defining the future of finance 13

DeFi tokens – securities or not?

Decentralisation is often achieved using the Tokens held by liquidity providers on DeFi
DeFi platform’s native token. This allows the protocols, often referred to as Lending Pool
participant to contribute to the effective tokens, allow token holders to earn returns by
operations, such as staking to mine a block, providing liquidity to lending pools. Are they
and also to govern the platform through its solely generating interest peer-to-peer using
governance mechanisms. These DeFi tokens the DeFi protocol as a facilitating mechanism?
take us back to a question often asked during Or is there an element of token holders
the ICO era of 2017: are these tokens pooling their resources to generate returns, in
securities? a way that has similar characteristics to a
collective investment scheme?
Many DeFi tokens offer the holder the
opportunity to participate in the governance DeFi tokens are certainly an area of focus for
process, by essentially giving them a say in regulators, who would aim to ensure
the growth and direction of the platform and consumer protection by targeting token
the ability to vote democratically on the issuers. Whether a specific DeFi token is
project’s strategy. This sounds all too similar considered to be a security would depend on
to shares in a company, where shareholders the terms of that token compared to the
can vote at general meetings. regulatory principles in the jurisdiction of
issuance – assuming this could be
Another use of DeFi tokens is participating in
determined.
the staking mechanism used to mine a block,
a mechanism that generates a return for the
holder. Is this return like the dividends or
coupons that traditional security interest
holders receive? Or could the fact that token
holders are participating in the staking and
therefore validation of transactions, mean that
they are performing a service for their reward
and are not solely receiving the return for
holding the token?

DeFi: Defining the future of finance 14

Current regulatory status

While more and more territories and Even though the current regulatory
regulators are issuing guidelines for the crypto frameworks do not specifically encompass
industry, very few regulators have yet tackled DeFi, should the developers and other
DeFi. However, given the significant increase participants be seeking to ensure their
in usage, the lack of KYC on most protocols protocols are compliant in regulatory terms?
and the potential for retail users to access The crypto industry in general has seen
complex financial products, it may not be long significant moves towards regulation in recent
before DeFi is brought into the crypto years. Given DeFi’s recent growth and hype, it
regulatory environment. would be consistent with the industry’s
direction of travel for developers and
The European Commission’s MiCA
participants to build in regulatory principles
consultation proposes a far-reaching EU-wide
such as AML and KYC. Furthermore, should
framework aimed at crypto asset issuers and
DeFi projects want to attract investment from
service providers. Whilst the regulation is
large mainstream institutional investors, they
aimed at the crypto market in general, it has
may find that it becomes a requirement from
been reported that its impact on DeFi could be
investors that the projects they invest in
significant due to the interpretation that each
contribute to combating money laundering.
crypto asset issuer should be an entity, and
hence a centralised party. However, the draft With the speed of change in the crypto
MiCA regulation does not specifically cover industry running way ahead of the regulation
DeFI. setters, it is likely that by the time MiCA – or
any other regulation – provides guidance on
There is also an argument that the EU’s 5th
DeFi projects, then DeFi and the crypto
Anti-money laundering directive (5AMLD)
landscape will already be significantly different
should already be applied to DeFi protocols,
from what we see today. So it’s a moving
depending on the private key storage of each
target: one with which regulators will continue
protocol.
to struggle to keep pace.

DeFi: Defining the future of finance 15

 Governance
For all organisations – be they businesses or To date, DeFi and digital currencies have
other types of entity – governance is crucial remained largely unregulated, relying on an
for achieving goals and ensuring that all existing package of frameworks covering Anti-
stakeholders can interact with that Money Laundering or Counter-Terrorism
organisation reliably and securely. Funding. This reflects the fact that, as yet, the
Governance is about making sure the right degree of risk posed by this technology to
decisions are made, at the right time, using large parts of society has been too small to
the right data. As such, the efficacy of an warrant greater intervention. Therefore there
organisation’s governance is a key regulatory is still no explicit definition, in a regulatory
parameter in ensuring it is run effectively and context, of governance frameworks for digital
in a way that balances the interests of three currencies or of DeFi as a technical derivative.
groups of stakeholders; those that benefit from Nevertheless, regulators are making headway;
the services offered by the organisation; those for example, the MiCA consultation includes a
that run the organisation; and those that range of principles for governing digital assets,
represent the interests of society. That last such as:
group – those who represent the interests of
society – are represented by regulatory
bodies, who will typically only intervene when
the risk of material harm is significant. For
example through the mis-selling of financial
products.

DeFi: Defining the future of finance 16

Governance Framework Suitability
Issuers of asset-referenced tokens5 should The management body of such issuers and
have robust governance arrangements, their shareholders should have good
including a clear organisational structure repute and sufficient expertise and be fit
with well-defined, transparent and and proper for the purpose of anti-money
consistent lines of responsibility, and laundering and combatting the financing of
effective processes to identify, manage, terrorism
monitor and report on the risks to which
they are or might be
exposed

Business Continuity Internal Control Framework

Issuers of asset-referenced tokens should Issuers of asset-referenced tokens should
also employ resources proportionate to also have a strong internal control and
the scale of their activities and should risk assessment mechanism, as well as a
always ensure continuity and regularity in system that guarantees the integrity and
the performance of their activities. For this confidentiality of information received
purpose, issuers of asset-referenced
tokens should establish a business
continuity policy aimed at ensuring, in the
event of an interruption to their systems
and procedures, the continued
performance of their core payment activities

These principles are very similar to those such as medical devices – into society. In
found in the regulatory requirements for many ways MiCA seeks to impose
establishing and maintaining MiFID II-licensed responsibility for ensuring the integrity of the
operations in Europe, for example. digital assets upon the management body,
Interestingly, the MiCA guidance does not with the requirement to establish ‘effective
extend to governance requirements processes to identify, manage, monitor and
associated with the blockchain technology report the risks to which they are or might be
itself. Technology is typically not regulated, exposed’. This implies a requirement to
except where it is used to deliver services, undertake some level of technical due
such as radio-telecommunications with the diligence on the assets themselves.
ITU as previously mentioned, or a product –

5 Article 3.1(3) of MiCA: ‘asset-referenced token’ means a type of crypto-asset that purports to maintain a stable value by
referring to the value of several fiat currencies that are legal tender, one or several commodities or one or several crypto-
assets, or a combination of such assets;

DeFi: Defining the future of finance 17

It needs to be noted that the MiCA document Nevertheless, there are some difficult
is, at this juncture, a consultation, with the UK questions ahead for the regulators. For
expected shortly to issue its own consultation. example, what is decentralisation – and how
It will be the responses themselves that will can it be achieved and managed?
determine the look and feel of the relevant
A governance token is a token whose
legislation and how it is applied to digital asset
decisions about the way of operating, key
businesses. As a reminder, the MiCA
features and major changes such as
document makes no reference to DeFi – so it
"monetary" policy is voted by its holders. This
will be interesting to see the extent to which
is a real revolution compared to the traditional
the responses treat DeFi as something
financial system where – for example – the
separate, or as an emanation of digital assets,
euro is managed by the Eurosystem, which is
and what the inherent obligations are. In broad
a body of the European Union composed of
terms, well-run businesses will adhere to the
the European Central Bank and the national
four regulatory principles listed above, so such
central banks of the Eurozone.
benchmarks are a good starting-point when
examining any kind of De-Fi. Further
references, as they relate to best practices
governing the development of open source
software, can be found in initiatives such as
Linux. Similarly, adherence to international
standards covering quality and cyber hygiene,
as defined by ISO 9001 or ISO 270001, also
provide robust guidelines as to what you
would expect to see in a well-run business
that uses technology.

DeFi: Defining the future of finance 18

In practice, most projects are not 100% governance token (MKR, COMP, AAVE) to
decentralised, and the degree of centralisation propose, vote and make decisions to develop
changes from the inception of a project. As at the protocol/platform. Other projects are also
10 December 2020, several of the most progressing toward decentralisation:
popular DeFi projects have finished their examples include Balancer, which allows BAL
transition to a Decentralised Autonomous holders to vote on the future features of the
Organisation (DAO6). Examples here include protocol even if these are proposed and
MakerDAO, Compound and Aave, all of which implemented by the core team. Depending on
have been autonomous since March 2020, the level of decentralisation, each project has
June 2020 and September 2020 respectively. its own features development process, as
Behind each of these protocols there is native shown in the table below:

What needs A proposal A proposal from the core A proposal from the core team and
to be from the team or users developers
governed? core team
Example Augur Balancer Compound
Vote No vote • The core team submits a • Any address with more than 100,000
processes call for voting to improve COMP delegated to it may propose
the protocol based on governance actions;
their work or from the
• Any proposal made has a three-day
community feedback
voting period;
received;
• Any address which has voting power
• Most of the time the
can vote for or against the proposal;
proposal has a 24-hour
voting period; • If the proposal receives at least
400,000 votes, it’s queued in the
• Any address holding BAL
Timelock and implemented after two
Tokens can vote;
days;
• There is no obligation to
• If it doesn’t receive the appropriate
implement the feature
amount of votes, the proposal is
voted within X days. But
rejected.
it must be done as soon
as possible.
Action taken Action not Voting for core team • List a new cToken market;
by token relative to propositions such as
• Update the interest rate model of the
holders the protocol implementing new
market;
evolution functionality, introducing a
itself protocol level fee. • Update the oracle address;
• Withdraw a cToken reserve.

6 DAO is a complex type of DApp. It can best be understood as a new kind of organisation that is similar to a digital company
or investment fund but not a legal entity. The DAO was created as a self-governing body operating on democratic principles
that is not influenced by outside forces.
The DAO’s by-laws are embedded in the Ethereum blockchain. The DAO concept builds on smart contracts which are:
• Immutable (from the perspective of individual participants): only a majority of DAO token holders can decide by vote to
adapt the code (and thus the DAO itself);
• Unstoppable: the programme runs on the Ethereum blockchain, which consists of thousands of independent nodes. In
order to stop the programme, you would require a majority of these nodes, which is all but impossible in actual practice;
• Irrefutable: all actions executed by the programme are transparent and recorded on the Ethereum blockchain for eternity.

DeFi: Defining the future of finance 19

The table highlights the opportunity for • How is the provenance and quality of the
participation, as well as the shift from a underlying asset validated? How are the
centralised structure to one that is underlying assets, on-boarded onto the
decentralised, or democratised. Meanwhile, DeFi platform? What are the necessary
the ideas around governance tokens are controls around onboarding and
continuing to mature and there is still a long enforcement of governance rules that must
way to go. Other questions that need to be be applied and during the lock-up time of
addressed, whether as a DeFi project or in the the assets?
context of the regulatory position, include:
• What role do Stablecoins have in the DeFi
• How is the minting and burning of tokens, ecosystem? How are Stablecoins attested
whether internal or those related to the and governed, especially where a DeFi
governance of the platform, controlled project is using its own Stablecoin?
transparently?
• How are smart contracts governed when
• How is platform development governed and used in a DeFi protocol?
controlled?
• What controls and defenses are applied to
• Who monitors and controls the need to prevent attack by third parties?
address security flaws?
• How is the underlying blockchain protocol
• How are access management controls, governed?
such as those required for voting,
• To what extent can a DeFi protocol be self-
borrowing, lending and exchanging
governing? Or can it be – or does it need to
applied? How can smart contracts be used
be – governed by an external third party?
to manage these?

DeFi: Defining the future of finance 20

 Taxation
The application of conventional tax rules to As highlighted above, there is currently no
DeFi results in some novel challenges – and, guidance on the tax treatment of DeFi
at the time of writing, there has been little to transactions. However, as the use of DeFi
no guidance provided by tax authorities on protocols increases and as tax authorities
how DeFi transactions should be taxed. To become more familiar with the transactions
narrow down the scope of the issues and involved, we fully expect that they will modify
provide an overview of the possible the application of current tax law towards
considerations in the DeFi tax landscape, it’s DeFi, or even introduce entirely new
helpful to consider tax from the viewpoints of legislation as DeFi moves from “experimental”
the various transaction participants, as each to mainstream. In this report we have sought
has its own unique concerns. to highlight some of the key questions that
may need to be considered as these events
To examine the tax issues that may arise, we
play out. The relevance of the comments
start by dividing up the participants in
below may vary in different tax jurisdictions, so
DeFi protocols into the following categories:
it is always important to seek local advice.
Developers, Liquidity Providers, Liquidity
Takers, and Governance Token Holders.
Then we outline the possible tax
considerations each of these participants
might face when engaging in DeFi
transactions. We also consider whether there
may be tax implications to consider at the
protocol level itself in certain situations.

DeFi: Defining the future of finance 21

 Transfer of risks / control

• "Initiators" • May be entitled to a share

• What are the tax of fee income / profits
responsibilities? i.e. - VAT, Developers Governance • Timing considerations and
Income taxes token implication of transfer of
• Centralised control holders risks/control from
developers

Protocol

• Classification of income • Classification of payments

earned on activities - interest Capital / Liquidity - allowable deductions
income, or something else? Liquidity takers
Providers • Use of losses
• Timing of income recognition • Business vs non-business
activities

Taxation at a protocol level

From a tax perspective, a decentralised If a protocol, or DApp, goes from having a

protocol is unlikely to be viewed as a legal central governance model (e.g. control by
entity in its own right. This raises the question initiator or developer) but then undergoes a
of who bears legal responsibility for claims transition to becoming fully decentralised,
against it and who has legal ownership of what are the tax implications of this change?
assets held on the platform. For example, For example, is it a form of disposal? And how
it could be argued that the users and/or does the initiator or developer disavow itself of
governance token holders are operating in future responsibilities for tax or other
partnership. liabilities?
The level/degree of decentralisation should be A successful protocol, or DApp, could quickly
considered: applications that are more grow to a size where exemptions and
centralised could be seen as being operated simplifications for small and medium-sized
or controlled by the developer or some other businesses cease to be available. This could
project initiator or sponsor, which may pass on expose the protocol, or its users or
the accountability for tax, compliance, filing governance token holders, to more complex
obligations and other reporting responsibilities international tax reporting and filing
to the developer. How can the level of requirements.
decentralisation be measured – and at what
point would a protocol become fully
decentralised for tax purposes?

DeFi: Defining the future of finance 22

Taxation at the level of capital/liquidity providers

Key questions that need to be considered for For example, should these earnings be
those providing liquidity to a protocol include: regarded as income or a capital gain from
an appreciation of an asset?
• How should returns be treated in cases
where a cryptocurrency loan is made to a • Many platforms require users to stake
lending platform? Should they be treated as Ether, DAI or some other asset to take out
interest or as some other form of income? a loan or participate in a liquidity pool,
being offered a new token in exchange.
• How should returns be treated in cases
Does this staking crystalise a taxable
where a protocol issues Liquidity Pool
disposal of the original asset for the new
Tokens or some other digital representation
token, potentially subjecting the resulting
of collateral representing a portion of the
gain or loss to tax? Or should it be treated
provider’s stake in the liquidity pool? As the
more like a deposit or a pledge of
liquidity pool earns returns or interest on
collateral?
the lending transactions (or the liquidity
pool tokens increase in value), how are
these treated for tax and at what point?

Taxation at the level of capital/liquidity takers

Key questions that need to be considered for • How are business versus non-business
those taking liquidity or borrowing from a activities distinguished and treated with
protocol include: respect to the corresponding ability to deduct
expenses/claim losses?
• Can a “borrower” – i.e. a participant paying
the pool for the use of Tokens or other • What is the nature of any payment for tax
benefits such as insurance – secure a purposes as it relates to the location of the
deduction for their economic cost? payor and whether withholding of tax is
required under local law?
• How are expenses categorised for tax? Are
these in the form of interest or some other
category?

DeFi: Defining the future of finance 23

Taxation at the level of governance token holder

Key questions that need to be considered for and how does this impact the
governance token holders in a protocol categorisation of income versus return?
include:
• Are transfers of governance tokens or other
• Holders of governance tokens may be interest in the protocol subject to stamp
entitled to a share of fee income or profits taxes or other capital transfer taxes?
of the platform, and are also able to vote on
and control the future of the protocol. As
such, given the element of control and
decision-making, are governance token
holders similar to equity investors –

Taxation at the level of VAT/GST taxation

developers/initiators
VAT/GST are taxes levied on consumption of
There is a need to understand the degree of taxable goods and services. The local law
responsibility and liability on taxes that applicable in the country where the consumption
developers may have for the protocols they is deemed to take place dictates which
goods/services are subject to VAT/GST and who
develop and how they manage this, along with
the process of transitioning governance to a is obliged to collect the tax and remit it to the tax
decentralised community. authorities. Depending on the local rules and the
types of supplies in question, it can be either the
Developers will often build in a mechanism vendor (service provider) or the buyer (service
whereby they share in the success of the recipient) who is liable for VAT/GST towards the
platform, typically through an allocation of the local VAT/GST authorities.
native governance token. Since these token
allocations are likely to be taxable in most Therefore, the VAT/GST implications of DeFi will
currently depend on the following key factors:
jurisdictions, it is important to seek advice on
structuring such allocations for tax purposes. • Nature of the supply;
• Who the service provider is; and
• Who the service recipient is.

Other considerations

Further questions to consider include how to

attribute a jurisdiction to payments/transactions
if the participants are located across different
jurisdictions. There may also be uncertainties
around the applicability of digital services taxes.

DeFi: Defining the future of finance 24

While identifying the nature of the supply framework. After consultation with tax and
should not be that difficult, identifying the legal experts and many industry
service provider and service recipient is likely representatives, it has been concluded that
to be more complex in DeFi. It requires a the existing legislative framework
case-by-case analysis supported by a careful accommodates blockchain technology. On this
review of the legal agreements governing the basis, it is more likely than not that the local
protocol and – most importantly – the tax authorities will try to apply the current tax
relationships between the protocol, its rules to DeFi, which would mean considering
developers, and users. To date, there is no the developer or the user as the person liable
jurisdiction that considers the protocol itself to for tax. If this is the case, legal arrangements
be an entrepreneur and/or the person liable and contractual documentation – including
for tax. Therefore, either the developers or the terms of use – will be key in determining who
users are likely to be liable for tax under the is liable for tax. Such arrangements should be
rules of the current VAT/GST systems. carefully drafted and worded before they are
published.
In Switzerland, the federal tax authorities have
recently launched an initiative aiming at It is likely that the local tax authorities will
identifying whether the developments in eventually introduce specific GST/VAT rules
blockchain technology, crypto and digital for DeFi. However, this will take time – and will
assets require changes in the existing tax happen once and only if DeFi becomes a
legislation framework or a new legislative more commonly-used product.

Conclusion: Advice is key

Guidance on tax issues related to DeFi is sparse7,

with few jurisdictions having any guidance at all on
this area.
This makes it vital that DeFi participants seek
advice on the tax implications of transactions they
are entering into so these can be proactively
managed, and they don’t create unexpected tax
liabilities.
In addition, for those involved in the design of
DeFi protocols and DApps, it is critical to
understand the tax implications for users in key
jurisdictions as well those for any income/tokens
earned from the platform, as these may impact the
demand and administrative burden on participants
– especially as the market matures.

7 https://www.pwchk.com/en/research-and-insights/fintech/pwc-annual-global-crypto-tax-report-2020.pdf

DeFi: Defining the future of finance 25

 Let’s talk

Contact us for further information on any of the topics contained in this paper:

Crypto Team Governance Tax

Henri Arslanian Haydn Jones Peter Brewin
henri.arslanian@hk.pwc.com haydn.jones@pwc.com p.brewin@hk.pwc.com

Galen Law-Kun Yohan Maurin Graham Robinson

galen.s.lawkun@hk.pwc.com yohan.maurin@pwc.com graham.x.robinson@pwc.com

Chan Wei Jie Regulation Marcella Dzienisik

wei.jie.chan@pwc.com Luke Walsh marcella.dzienisik@pwc.com
luke.walsh@pwc.com
Mazhar Wani
Marios Charalambides mazhar.wani@pwc.com
marios.charalambides@pwc.com

DeFi: Defining the future of finance 26

 Glossary

DeFi - Decentralised Finance – DeFi is the delivery of financial services without any centralised intermediaries using
features of blockchain technology

CeFi - Centralised Finance – CeFi is the delivery of financial services

AirDrop – An AirDrop is when a company offers its native tokens to people

DApp – Decentralised application - A DApp is an application built using smart contracts and running on a DLT

Yield farming – Yield farming is the process of making your assets available, and in exchange gaining an additional
percentage of assets on a hebdo or monthly basis. Similar to a savings account in the traditional financial system.

Staking – Staking is the process of locking and put at risk several crypto-assets to show good faith to assist blockchain
operations

MiCA – Market in Crypto-Assets - Pilot regime regulations proposals published by the European Commission on 23rd
Sept 2020

FATF – Financial Action Task Force - An intergovernmental organisation that sets international standards which aim to
prevent global money laundering and terrorist financing

KYC – Know your customer

AML – Anti-money laundering

Flash-loan – A flash-loan is a no-limit loan of crypto-assets (within the limit of available assets) for a single transaction.
The transaction encompasses the action to be taken and the repayment to the lender. It’s therefore a zero-risk loan

The information contained in this publication is of a general nature only. It is not meant to be comprehensive and does not constitute the
rendering of legal, tax or other professional advice or service by PricewaterhouseCoopers International Limited ("PwC"). PwC has no
obligation to update the information as law and practices change. The application and impact of laws can vary widely based on the
specific facts involved. Before taking any action, please ensure that you obtain advice specific to your circumstances from your usual
PwC client service team or your other advisers.

The materials contained in this publication were assembled in June 2021.

© 2021 PricewaterhouseCoopers International Limited. All rights reserved. PwC refers to the Hong Kong member firm, and may
sometimes refer to the PwC network. Each member firm is a separate legal entity. Please see www.pwc.com/structure for further details.