Why we need to engage with decision makers on the importance of crypto, blockchain and DeFi for the future of finance

of Frederik GregaardCEO of the Cardano Foundation

British regulators have stepped up activity around crypto and blockchain. In the past four months, the country has launched three consultations, one on a broad regulatory regime for cryptoassets, one on a potential digital pound, and a third on the taxation of decentralized finance, or DeFi, transactions.

This latest consultation focuses on how to tax DeFi activities such as liquidity injection, yield farming and staking. These activities are central to the DeFi ecosystem, but their tax treatment remains a gray area in most jurisdictions. Any tax proposals relating to these activities should be nuanced, taking into account existing tax structures as well as the possibilities for more tailored approaches.

DeFi has the potential to transform traditional financial services by cutting out intermediaries and reducing transaction costs. The £11 billion global DeFi market is forecast to grow at an annual rate of 46% over the next few years.

Very few jurisdictions have so far made a real move to address the difficult issues DeFi has raised. In fact, DeFi activities tend to be difficult to pin down to a specific jurisdiction. Getting this right can reap real rewards for the city and the wider UK.

There is no doubt that the lack of regulatory clarity in this area has hindered wider institutional adoption. So it is welcome that the Treasury intends to “create a regime that better aligns the taxation of crypto-assets used in DeFi lending and staking transactions with the underlying financial substance, while reducing the administrative burden on users.”

As the UK grapples with setting rules for the taxation of staking and DeFi, there are a few principles regulators should keep in mind.

First, policymakers need to take a coordinated approach to the many questions that technology poses, including the issues of transparency, privacy, financial market regulation, as well as taxation. Only then can a stable framework be achieved that will promote growth in the sector, while at the same time taking care of the users.

Second, it is critical that we recognize DeFi’s unique characteristics. DeFi is not just a digital version of traditional finance, but often represents a fundamentally new way of organizing economic activity. DeFi transactions differ significantly from traditional financial transactions. They are usually entered into and settled in a peer-to-peer fashion, often automated, and executed through smart contracts on the blockchain.

Any proposal should recognize these unique characteristics. It seems likely that this will involve creating specific categories for DeFi transactions and defining their tax treatment accordingly.

Third, we need to consider DeFi in the context of the wider ecosystem. No DeFi application exists in a vacuum, and the degree of interconnection is particularly high in DeFi. Clarity about only some types of DeFi activities in the ecosystem can result in even more confusion and stifle innovation.

Finally, regulators must ensure that new guidelines provide real clarity and certainty for the industry. Regulatory ambiguity has hindered the growth of the industry in a number of jurisdictions: we cannot thrive and innovate without ground rules.

Especially on DeFi taxation, clarity is needed on topics such as yield farming, liquidity provision, staking and other forms of DeFi participation. This will level the playing field for players in this space and, if pursued concurrently with the other ecosystem components, will make the UK a highly competitive environment for the next wave of digital innovations.

As with all regulatory debates, stakeholder involvement and buy-in is key. As Sarah Pritchard, chief executive of markets at the FCA recently said, it is important that communication and collaboration between regulators and the blockchain industry is prioritized.

The DeFi landscape is rapidly evolving, and continuous engagement with the industry enables regulators to better understand new trends, products and technologies. This is why the Cardano Foundation actively engages with decision makers on several fronts.

If DeFi is given the regulatory framework to succeed, it could usher in a new era of financial inclusion and efficiency. This approach should take the form of a forward-looking, adaptable framework that can accommodate DeFi applications, technologies and integrations that have yet to be invented.

The intersection of DeFi and taxation is largely uncharted territory, and the UK now has the opportunity to develop and implement a truly agenda-setting approach.