Original author: Chen Mo cmDeFi
Reprinted from: Luke, Mars Finance
Core viewpoint: Understanding under what circumstances DeFi will be recognized as 'broker', exploring the underlying logic and survival space in decentralization and regulatory attitudes, and finding a perfect exit.
Expanding the definition of broker: The regulation believes that DeFi trading has significant similarities with securities trading processes. DeFi brokers need to submit information reports to the IRS, assist clients in accurately declaring taxes, and ensure compliance (KYC, anti-money laundering, etc.).
Determining DeFi brokers: Providing services that facilitate transactions and possessing the ability to obtain customer information.
Impact on DeFi: Choosing to accept broker recognition or decentralizing the project. The higher the degree of decentralization, the lower the likelihood of being recognized as a broker.
The perfect exit for DeFi in the future: decentralized front-end, non-upgradable contracts, on-chain autonomy, and token functionality to build its own network.
Research Report
1/4 · Background and Reasons
This regulation was initiated by the U.S. Treasury Department and the IRS. Due to decentralization and anonymity, transactions of digital assets often lack the information transparency found in traditional financial systems, posing significant challenges for tax regulation. The regulation lists similarities in operational processes between the securities industry and the DeFi industry.
Trading instruction -> Trading matching and execution -> Trading settlement
In the securities industry, brokers send clients' trading orders 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 recognizes a 'broker' role, which must submit information reports to the IRS, assist clients in accurately declaring taxes, and ensure compliance (KYC, anti-money laundering, etc.).
Thus, we mainly discuss under what conditions which roles in DeFi will be recognized as 'brokers'. Regardless of whether the 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'
Traditionally, the definition of 'broker' is limited to trading agents or intermediaries who directly hold client assets in the securities industry. 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 tax forms to the IRS, detailing clients' trading information, including profit situations and transaction details, with the aim of enhancing tax compliance and indicating potential tax liability.
One layer of regulatory inclination that can be interpreted here is that although there was an initial definition and distinction between 'securities' and 'commodities' when the ETH ETF was approved, digital assets that meet the criteria are more inclined to be defined as commodities and cannot be directly classified as securities. However, the 'broker' expansion proposed in this regulation aims to establish an information reporting mechanism similar to that of securities trading, thus essentially returning to the question of how to define DeFi protocols and assets.
The regulation expands the definition of 'broker' to explicitly include the following types of participants:
Digital asset intermediaries: Individuals or entities that provide services to customers to complete digital asset transactions, including exchanges, custodial wallet service providers, etc.
DeFi platform participants: Including those who do not hold customer private keys but provide trading services through protocols or smart contracts on non-custodial platforms.
The core here lies in the term 'intermediary'. Individuals or entities providing services to clients are straightforward, such as exchanges and custodial wallets, which do not present significant controversy. The dispute lies in how to define the 'intermediary role' in DeFi activities. In summary, the following are the two key factors 🚩
Providing services that facilitate transactions
Possessing the ability to obtain customer information
Remember these two judgment factors, and let’s further dissect the roles of each party in a DeFi project:
Front-end service providers: Providing users with a friendly interactive interface, allowing them to conveniently interact or trade.
Protocol operators: Providing the core protocol or smart contract (such as Uniswap, Curve, etc.) that executes transactions.
Validators or settlement agents: Responsible for recording transactions on the distributed ledger (blockchain).
The regulation specifically focuses on front-end service providers and protocol operators because their services directly 'facilitate' the completion of transactions. As for validators or settlement agents, 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 brokers. Therefore, only discussing 1 and 2 is sufficient.
The entire analysis process will use Uniswap as an example because it is the only case that encompasses all scenarios.
1 It is also largely undisputed that front-end service providers must belong to the 'intermediary' role of brokers, especially in cases like Uniswap's current front-end charging status, which will strengthen the tendency to be recognized as brokers.
2 Protocol operators are contentious because, strictly speaking, non-upgradable smart contracts are not controlled by any individual or entity. They possess characteristics of permissionless and immutability. Will the project party/developer providing such smart contracts be defined as brokers?
Returning to the two key defining factors: providing services that facilitate transactions + having the ability to obtain customer information.
Taking the current Uniswap as an example, the front-end service is provided and maintained by the project party. It fully provides transaction facilitation services and charges for such services. At the same time, it has the ability to record and obtain user information (for example, by adding KYC or trading terms on the front-end).
Now, let's assume a situation where the Uniswap team abandons all services and completely exits the project. In theory, users can still achieve their trading purposes by directly accessing the AMM smart contracts deployed by Uniswap. This is because once a smart contract is deployed, it will always exist on-chain. At this point, the AMM becomes a decentralized tool, and in a decentralized environment, the project party cannot obtain user information, which does not satisfy the second defining factor. Although Uniswap deployed the AMM contract to enable users to trade, it no longer possesses the 'active' ability to facilitate transactions and obtain user information, so the regulation may not find applicable broker subjects.
Thus, the conclusion is that the higher the degree of decentralization of the project, the lower the likelihood of being recognized as a broker.
In summary, the core characteristics of decentralized projects are several:
Self-running nature of smart contracts: Core trading functions are realized 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 exits (for example, stops maintaining the front-end interface), the smart contract can still operate 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-end to interact with smart contracts.
Inability to control customer information: Due to the fully trustless interaction on-chain, project parties usually cannot obtain customer identification information or transaction data.
3/4 · Impact on DeFi
In the early days of DeFi, most projects aimed for decentralization, ultimately transferring the project to community governance and running entirely on-chain. However, as time has passed, it has become clear that achieving this ideal is not as simple as imagined. Most projects gradually disappear from the market view after leaving the project party, primarily due to the following reasons:
The project party left behind a mess, using decentralization as a pretext for a soft rug pull.
The overall market cognition is insufficient, requiring centralized guidance and promotion.
The project itself is not problematic, but it's not mature enough, and the community lacks the capacity to govern and promote the project's development.
(1) DeFi requiring centralized participation
So in this cycle, many ceDeFi projects have begun to rise. 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 'brokers'. If this regulation is approved and implemented, it means these projects may face significant changes.
Requiring users to provide KYC
Under compliance burdens, open up front-end fees or service fees
But this also means that 'brokers' can reasonably and legally conduct activities, with the cost being the compliance burden, which requires increasing their own income capacity, such as charging customers.
(2) DeFi with the capacity to decentralize
Decentralized front-end
Smart contracts are solidified and non-upgradable.
On-chain autonomy
Meeting the above points makes it difficult to be classified as a 'broker'. Therefore, from this perspective, even if the regulation is implemented, the main target will still be projects that heavily rely on centralized leadership. Although this type of project currently occupies a large part of the market, in the long run, it will also promote the decentralization of DeFi. Furthermore, the requirements for centralized entities entering this industry are becoming increasingly stringent.
4/4 · DeFi Exit
First of all, the clarification 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 term. The market expects a more relaxed regulatory environment. Here, we discuss an optimal solution for a DeFi project facing regulation and compliance based on already proposed bills or drafts.
(1) Aspects of broker determination
This aspect is the focus of this discussion. The conclusion is to either make this a legitimate business, comply with IRS reporting requirements, and accept broker recognition, or gradually decentralize the project.
(2) Regarding the identification of token nature
Against the backdrop of the approval of the ETH spot ETF application, combined with the previous content in the FIT-21 Century Financial Innovation and Technology Act, there is a foundational basis for defining how project tokens are classified as securities or commodities.
Currently, the definition of ETH leans more 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 the governance direction leans more towards obtaining economic returns or dividends, it is more likely to be defined as securities; if it leans towards functionality, technical upgrades, etc., it is more likely to be defined as commodities.
Taking Uniswap as an example, if the goal is to avoid broker classification while maximizing the likelihood of the token being defined as a commodity rather than a security, how should one achieve this perfect exit?
Removing the front-end and charging fees, relying on third-party front-ends for transactions, or educating users to interact directly with smart contracts.
Launching their own chain, gradually 'Ethereum-izing' the tokens as a form of functional usage and network maintenance, to avoid being classified as securities.
Regardless of whether these regulations will be approved and promoted, as long as DeFi continues to strive for decentralization, it will not be affected. Of course, in this process, some projects still require the participation and leadership of centralized entities, and currently, this is the majority. They may need to face choices and balances, which is a necessity for the development of the times. Decentralization is not achieved in a day.