One of the few paths forward for U.S.-based decentralized crypto exchanges is to move overseas as the IRS seeks to use proposed new rules to strengthen reporting requirements.
These rules amount to “a potential death sentence for decentralized exchanges created by U.S. persons,” said Mark DiMichael, a partner at Citrin Cooperman and head of the digital assets practice.
Under the proposed project regulations, crypto exchanges would be required to track and report information about their customers’ transactions, including their identities, which would go directly against the philosophy and sales pitches of many decentralized exchanges.
Many may simply choose not to start DeFi exchanges in the face of the new requirements, said Jonathan Jackel, managing director in EY’s financial services organization.
“It will really weigh on people who are considering doing these projects, and some may choose not to participate because they feel the risk is too high,” he said. “It’s a discouragement of innovation that we’ve seen in this area.”
For those who persist, the cost could be high.
While centralized exchanges, such as Coinbase and Kraken, frequently build the infrastructure necessary to meet these tax reporting requirements and have the staff to operate and maintain them, decentralized exchanges, such as Uniswap and dYdX, use smart contracts to execute cryptocurrency transactions without intermediaries to provide. liquidity or verification.
This means that no one is employed to verify transactions, track their details or monitor the identity of users on the platforms.
The lack of anyone in place to control a decentralized exchange raises the question of who in the network would be held responsible for meeting the requirements and who would be held responsible for failing to do so or transmitting false information. This is called being the “can-know” person, defined as anyone who can make changes to the network.
DiMichael said threats of fraud or users misreporting their identity and other information will likely mean exchanges will have to add infrastructure and staff to get it right — and nothing it is not very decentralized.
“Users of decentralized exchanges could simply provide false information to the decentralized exchange,” he said. “Is the software developer supposed to report this erroneous information to the IRS? Or is the software developer supposed to review the identification documents? If an exchange collects identification documents and fills out 1099 forms, it starts to look more like a centralized exchange than a decentralized exchange.
There may be ways around the reporting requirements.
Some say a shift in this direction could force DeFi exchanges to prove which are truly decentralized and which are simply structured that way while being owned and operated by an individual or small group through majority token ownership or another. mechanism.
Truly decentralized exchanges have no one in a position to know this, the thinking goes.
“My view is that if you’re truly decentralized, you don’t have to worry about it,” said Shehan Chandrasekera, head of tax strategy and CPA at CoinTracker. “Maybe this is a good incentive for us in the industry to look at what we’re doing and become truly decentralized.”
One way to achieve this could be for coders to make decentralized exchanges and then lock themselves out of the system, leaving it to run on its own without anyone being able to change things or control any part of the network and eliminating any possibility that a person is able to know. .
“I’ve never seen a decentralized system where the original coders can’t access and see the code, but it could happen,” said Anthony Tuths, leader of KPMG LLP’s digital assets practice and director of the taxation of alternative investments. “And you could incentivize someone to do that and have someone lock themselves outside of the protocol and be truly decentralized. These regulations almost encourage someone to do it.
This approach has obvious drawbacks. Software is generally an iterative process in which adjustments, upgrades, and fixes are frequently added as the need arises and unseen problems are detected. Locking the encoders would mean it would not be possible to do this.
Another option: Exchanges that want to continue operating could be able to set up operations abroad and exclude users based in the United States.
However, this option may disappear as more countries adopt crypto reporting regulations. Jessalyn Dean, Ledgible Crypto Tax & Accounting’s vice president for tax reporting, said Europe appears poised to adopt similar rules and other countries are also looking into the issue.
“You can run, but you can’t hide,” she said.