One of the few ways forward for US-based decentralized crypto exchanges is moving overseas as the IRS looks to use proposed new rules to tighten reporting requirements.
Those rules equate to “a potential death sentence for decentralized exchanges created by US persons,” said Mark DiMichael, Citrin Cooperman partner and digital asset practice leader.
Under the proposed regulations, crypto exchanges would be required to track and report information on their clients’ transactions including their identities—cutting directly against the ethos and selling points of many decentralized exchanges.
Many may simply opt out of starting DeFi exchanges in the face of the new requirements, said Jonathan Jackel, EY financial services organization managing director.
“This will really weigh on the people thinking about doing these projects, and some may choose not to participate because they perceive the risk being too high,” he said. “It is a discouragement of the innovation that we’ve seen in this space.”
For those who persist, the cost could be steep.
While centralized exchanges, such as Coinbase and Kraken, frequently build the infrastructure to tackle these tax reporting requirements and staff up to operate and maintain them, decentralized exchanges, such as Uniswap and dYdX, use smart contracts to execute cryptocurrency transactions with no intermediaries to provide liquidity or verification.
That means no one is employed to check the trades, track their details, or monitor the identities of the users on the platforms.
Having no one in place to control a decentralized exchange raises questions about who in the network will be held responsible to meet requirements and who would be held accountable for failing to do so or for passing along false information. This is called being the person “in a position to know,” defined as anyone who can make changes to the network.
DiMichael said threats of user fraud or error when reporting their identities and other information likely will mean exchanges will need to add infrastructure and staff to get it right—and none of that is very decentralized.
“Users of decentralized exchanges could simply provide false information to the decentralized exchange,” he said. “Is the software developer supposed to forward that erroneous information to the IRS? Or is the software developer supposed to review identification documents? If an exchange is collecting identification documents and filing 1099s, it starts to sound more like a centralized exchange than a decentralized one.”
There may be ways around reporting requirements.
Some say a shift in this direction could force DeFi exchanges to prove which really are decentralized and which are just structured that way while being owned and operated by an individual or a small group through majority token ownership or other mechanism.
Exchanges that are truly decentralized don’t have a person in the position to know, the thinking goes.
“My point of view is if you’re truly decentralized, you don’t have to worry about it,” said Shehan Chandrasekera, head of tax strategy and a CPA at CoinTracker. “Maybe this is a good incentive for us in the industry to look at what we’re doing and truly become decentralized.”
One way to do this could include coders making decentralized exchanges and then locking themselves out of the system, letting it run itself with no one able to change things or control any part of the network and eliminating any possibility of a person in a position to know.
“I’ve never seen a decentralized system where the original coders can’t get in and see the code, but it could happen,” said Anthony Tuths, KPMG LLP digital asset practice leader and principal in alternative investment tax. “And you might incentivize someone to actually do that and have someone lock themselves outside the protocol and actually be decentralized. These regulations almost incentivize someone to do it.”
This approach comes with some clear drawbacks. Software is typically an iterative process in which tweaks, upgrades, and patches are frequently added as the need arises and unseen glitches are found. Locking coders out would mean no ability to do that.
Another option: Exchanges that want to continue operating may be able to move overseas and keep out US-based users.
That option may be going away, however, as more and more countries pass crypto reporting regulations. Jessalyn Dean, Ledgible Crypto Tax & Accounting vice president of tax information reporting, said Europe appears close to passing similar rules, and other countries are looking into it as well.
“You can run, but you can’t hide,” she said.