Original author: Chen Mo cmDeFi
Reprint: Luke, Mars Finance
Core Viewpoint: Understanding under what circumstances DeFi will be considered 'broker-dealer', exploring the underlying logic and survival space in decentralization and regulatory attitudes to find the perfect solution.
Expanding the definition of broker-dealer: the regulation sees significant similarities between DeFi transactions and securities transaction processes, requiring DeFi brokers to submit information reports to the IRS, assist clients in accurately reporting taxes, and ensure compliance (KYC, anti-money laundering, etc.).
Determining DeFi brokers: providing services that facilitate transactions and possessing the ability to obtain client information.
Impact on DeFi: choosing to accept broker-dealer designation or decentralizing the project; the higher the degree of decentralization, the lower the likelihood of being classified as a broker-dealer.
DeFi's future perfect solution: decentralized front end, non-upgradable contracts, on-chain governance, token functionality to build its own network.
Research Report
1/4 · Background and Reasons
This regulation is initiated by the U.S. Department of the Treasury and the IRS. Due to decentralization and anonymity, digital asset transactions often lack the information transparency found in traditional financial systems, leading to significant challenges in tax regulation. The regulation outlines the similarities in operational processes between the securities industry and the DeFi industry.
Trade instruction -> Trade matching and execution -> Trade settlement
In the securities industry, brokers send client trade instructions to trading centers (such as the New York Stock Exchange or Nasdaq), which are responsible for matching buy and sell orders. In the DeFi industry, the regulation also sees a 'broker' role, requiring brokers to submit information reports to the IRS, assist clients in accurately reporting taxes, and ensure compliance (KYC, anti-money laundering, etc.).
Thus, we mainly discuss under what conditions which roles in DeFi will be recognized as 'broker-dealer'. Regardless of whether this regulation will be approved and implemented, our main analytical goal is to explore the underlying logic and survival space in decentralization and regulatory attitudes.
2/4 · Expanding the definition of 'broker-dealer'
Traditionally, the definition of 'broker-dealer' is limited to trading agents in the securities industry or intermediaries that directly hold client assets. The main content of this regulation is to expand this definition to apply to the digital asset field. The new regulation requires brokers to submit reports to the IRS, detailing client transaction information, including profit situations and transaction details, with the aim of improving tax compliance, implying potential tax liabilities.
One layer of regulatory inclination that can be interpreted here is that, although a preliminary definition and distinction between 'securities' and 'commodities' was established when the ETH ETF was approved, qualifying digital assets are more inclined to be defined as commodities and cannot be directly classified as securities. However, the proposed 'broker-dealer' extension's core goal is to establish an information reporting mechanism similar to that of securities trading, so it fundamentally returns to the question of how to define DeFi protocols and assets.
The regulation expands the definition of 'broker-dealer' to explicitly include the following types of participants:
Digital asset intermediaries: individuals or entities that provide services to clients to complete digital asset transactions, including exchanges, custodial wallet service providers, etc.
DeFi platform participants: including those who do not hold client private keys but provide trading services through protocols or smart contracts on non-custodial platforms.
The core here lies in the word 'intermediary'. Providing services to clients, individuals or entities, does not need further explanation. Exchanges, custodial wallets, etc., are not particularly controversial. The debate lies in how to define the 'intermediary role' in DeFi activities. In summary, the following two key factors 🚩
Providing services that facilitate transactions
Possessing the ability to obtain client information
Remember these two judgment factors, let's further analyze the roles of various parties in a DeFi project:
Front-end service providers: provide users with a friendly interactive interface, enabling them to conveniently interact or trade.
Protocol operators: provide core protocols or smart contracts that execute transactions (such as Uniswap, Curve, etc. AMM).
Validators or settlers: responsible for recording transactions on a distributed ledger (blockchain).
The regulation especially focuses on front-end service providers and protocol operators, as their services directly 'facilitate' the completion of transactions. However, for validators or settlers, if a participant only provides distributed ledger verification services (such as blockchain nodes or miners) and does not directly participate in or facilitate transactions, they will not be considered a broker-dealer. Therefore, only discussions of 1 and 2 are needed.
The entire analysis will revolve around Uniswap as an example, as it is the only case that encompasses various scenarios.
1 This is basically undisputed; front-end service providers will inevitably belong to the 'intermediary' role of broker-dealer, especially under the current state of front-end charges like Uniswap, which will strengthen the tendency to be recognized as a broker-dealer.
2 Protocol operators are more controversial because, strictly speaking, non-upgradable smart contracts are not controlled by any individual or entity. They are characterized by being permissionless and immutable. Will the project party/developer providing such smart contracts be defined as a broker-dealer?
Returning to the two key defining factors: providing services that facilitate transactions + possessing the ability to obtain client information.
Taking the current Uniswap as an example, front-end services are provided and maintained by the project party. It fully provides services that facilitate transactions and charges for these services, while also having the ability to record and obtain user information (such as adding KYC or trading terms on the front end).
Now let's assume a scenario where the Uniswap team abandons all services and completely withdraws from the project. Theoretically, users can still achieve their trading goals by directly accessing the AMM smart contracts deployed by Uniswap. This is because once deployed, smart contracts will forever exist on-chain. At this point, the AMM becomes a decentralized tool; in a decentralized environment, the project party cannot obtain user information, which does not satisfy the second defining factor. Although Uniswap has deployed the AMM contract to allow users to trade, it no longer possesses the ability to 'actively' facilitate trades and obtain user information, making it possible that the regulation may not find applicable broker-dealer subjects.
Therefore, the conclusion is that the higher the degree of decentralization of a project, the lower the likelihood of being recognized as a broker-dealer.
In summary, the core characteristics of decentralized projects are as follows:
The self-executing nature of smart contracts: core trading functions are achieved through smart contracts deployed on the blockchain, which are immutable, allowing anyone to interact with them without permission.
No centralized management: if the project party withdraws (for example, stops maintaining the front-end interface), the smart contract can still run and does not rely on any centralized entity.
Independence of front-end services: even if the official front end (such as Uniswap's official website) goes offline, third-party developers can build their own front ends to interact with the smart contracts.
Inability to control client information: due to the fully trustless nature of on-chain interactions, the project party usually cannot obtain clients' identity information or transaction data.
3/4 · Impact on DeFi
In the early days of DeFi, most projects aimed for decentralization, ultimately handing the project over to community governance, fully operating on-chain. However, as time has progressed, people have realized that achieving this ideal is not as simple as imagined, with most projects gradually disappearing from the market after leaving the project party due to several reasons:
The project party itself leaves behind a mess, soft rugging under the banner of decentralization.
Overall market perception is insufficient, requiring centralized guidance and promotion.
The project itself is not problematic but is not mature enough, and the community lacks the ability to govern and promote project development.
(1) DeFi requiring centralized participation
Thus, during this cycle, many ceDeFi projects began to emerge. Since pure DeFi projects currently cannot achieve the goal of 'decentralized finance', it is better to directly introduce relatively professional and compliant centralized entities and strategies. In this case, these centralized entities are highly likely to be recognized as 'broker-dealers'. If this regulation is approved and implemented, it means that these projects may...
Requiring users to provide KYC
Opening front-end or service charges under compliance burdens
But this also means that 'broker-dealers' can engage in activities reasonably and legally, with the cost being compliance burdens, necessitating an increase in their income capabilities, such as charging clients.
(2) DeFi with the ability to decentralize
Decentralized front end
Smart contracts are fixed and non-upgradable.
On-chain governance
Achieving the above points makes it difficult to be classified as a 'broker-dealer'. Thus, from this perspective, even if this regulation is implemented, it mainly targets projects that rely heavily on centralized leadership. Although such projects currently dominate the market, in the long term, this is also a push towards the decentralization of DeFi, and the requirements for centralized entities entering this industry are becoming increasingly stringent.
4/4 · DeFi Exit
First, the clarity of regulation and compliance for DeFi is just a matter of time. Of course, this clarity may benefit from the political landscape during Trump's administration, with market expectations leaning towards a more lenient regulation. Here, we discuss an optimal solution for DeFi projects facing regulation and compliance based on existing bills or drafts.
(1) Broker-dealer determination aspects
This aspect is the focus of this discussion, and the conclusion is to either turn this into a formal business, comply with IRS reporting requirements and accept the designation as a broker-dealer, or gradually decentralize the project.
(2) Regarding the determination of token nature
In the context of the ETH spot ETF application being approved, along with the contents of the previous FIT-21 Century Financial Innovation and Technology Act, there is now a basic judgment basis for how to define project tokens as securities or commodities.
Currently, the definition of ETH is more inclined towards functional use, and its staking and governance nature is more about maintaining network operation rather than economic returns. In this case, it is more inclined to be defined as a commodity rather than a security.
From this perspective, for DeFi protocols, if governance tends to focus on obtaining economic returns or dividends, it is more likely to be defined as securities. If it leans towards functionality, technological upgrades, etc., it is more probable to be defined as commodities.
Let's still take Uniswap as an example. If it wants to avoid the 'broker-dealer' designation while maximizing the chances of its tokens being defined as commodities rather than securities, what perfect exit should it take?
Removing front-end and charging fees, relying on third-party front ends for transactions, or educating users to interact directly with smart contracts.
Launching a chain, gradually 'Ethereumizing' the tokens, as a form of functional use and network maintenance to avoid being classified as securities.
Regardless of whether these regulations will be approved and promoted, DeFi will not be affected if it continues to strive towards decentralization. Of course, there are still some projects that require centralized entities to participate and lead during this process, and currently, these are the majority. They may need to face choices and balances, which is a necessity in response to the needs of the times; decentralization is not achieved in a day.