With a total locked value (“TVL”) of over $235 billion, the decentralized finance (“DeFi”) market has quickly established itself as a natural option for compounding cryptocurrency gains. Mainstream media regards crypto lending as a lawless land, but that hasn’t stopped individuals, retail traders, and even institutional investors from leveraging the benefits of this burgeoning market.
In fact, crypto lending has skyrocketed in popularity among both lenders and borrowers. In turn, the growing popularity of crypto lending has put more pressure on governments across the world to reign in this “wild west” through regulation. Crypto has been a particularly hot topic for the US government, which undoubtedly means legislation is on its way. But, until this point, the government hasn’t offered much clarity for crypto investors.
So, what do we actually know, and what can we expect to emerge from the legislative pipeline?
Cryptocurrency Regulations for Service Providers
While regulation and governmental oversight guiding the crypto industry is still conflicting and unclear, we do have some understanding of how leaders within various governmental agencies view crypto, which is helpful to understanding how they will regulate the emerging technology. For example, in 2018, former Security and Exchange Commission (SEC) Chairman Jay Clayton said,
“To the extent that digital assets like [initial coin offerings, or ICOs] are securities — and I believe every ICO I have seen is a security — we have jurisdiction, and our federal securities laws apply.”
At a basic level, this suggests that the SEC regards cryptocurrencies and digital tokens as securities — which would classify them in the same regulatory framework as traditional securities like stocks or bonds. Should that be the case, crypto lending platforms would also be subject to a long list of requirements if servicing US citizens or transacting with US dollars. The implications become more complicated, however, as crypto lending comes in two primary forms — centralized and decentralized.
Centralized Lending Services
Centralized lending options typically deal with both digital assets and fiat currencies. For example, popular platform BlockFi offers users the ability to use digital assets as collateral to borrow US dollars. While this is an incredibly important bridge between the traditional and digital financial worlds, these providers also face the heaviest regulatory requirements, as they require a physical entity as well as appropriate regulatory licensing to operate.
Having a physical entity makes the process more complicated, as most of these companies fall under the jurisdiction of the Security and Exchange Commission. The SEC has stated that it views crypto loans as unregulated securities. This classification adds numerous regulatory complexities to the process of becoming licensed, which is why services like Coinbase Lend — despite its significant financial and political backing — have seen difficulty getting off of the ground.
Physical entities operating in the crypto space have requirements to adhere to the Bank Secrecy Act, which generally lays out anti-money laundering (AML), sanctions, and know-your-customer (KYC) guidelines for banking and financial institutions. As an exchange, crypto service providers that touch fiat currency must also obtain a Money Service Business (“MSB”) license from US financial regulator FinCEN, which can be an onerous process. All in all, operating as a centralized lending provider brings steep compliance and licensing requirements alongside significant expenses associated with maintaining compliant operations, such as continuous monitoring and reporting to satisfy AML and KYC requirements.
Decentralized Lending Services
By contrast, decentralized lending services lack a physical operating entity, and typically do not offer trading pairs with fiat currencies. Like most decentralized services, crypto lending is quite difficult to regulate, and centralized regulatory bodies face significant hurdles to regulating a borderless, decentralized — and typically faceless — platform.
AAVE, one popular example of a decentralized lender, often stands out as one of the largest DeFi protocols by TVL and volume. Its collateralized lending services allow users to lend and borrow crypto, thereby adding a considerable amount of liquidity to the decentralized world.
Because AAVE operates as an automated protocol on the blockchain, there isn’t a specific entity or individual that would be subject to regulation. AAVE, as such, is neither required to maintain a KYC framework or AML monitoring reporting processes, nor would these requirements be enforceable by the SEC or any other centralized regulatory body.
Crypto Regulations for Individuals
Despite the uncertainty of compliance requirements for crypto lending platforms, the average HODLer is still subject to the taxman. Whether borrower or lender, the IRS will still expect its cut.
Given the SEC regards digital tokens as securities and the IRS views them as “property,” there is a good understanding of how crypto trading activity should be reported. For the average crypto trader, exchanging or selling a token is considered a taxable event. Depending on the length of time that a token has been held, a given transaction will qualify under short-term (if the tokens have been held for under a year) or long-term capital gains taxation.
The caveat here — which lends (excuse the pun!) an exciting opportunity for crypto lending services — is the traditional concept of securities collateral. For decades, investors have been collateralizing stocks and other securities for credit loans. By simply using these securities as loan collateral instead of selling them for cash, investors avoid triggering a taxable event and can therefore obtain the liquidity they need without paying capital gains tax.
Furthermore, since digital tokens are classified as securities by the SEC, the same logic can be applied in the cryptosphere as well. By using a platform like AAVE for tokens or Kyoko.Finance for NFTs, users can apply their digital assets as collateral and borrow against them. This avoids any reportable taxable event but still offers the opportunity to use on-hand illiquid digital assets for near-instant liquidity.
Finally, should a HODLer decide to sell off their digital assets, the process is simple. Repay the loan, withdraw funds, and exchange on a centralized exchange for fiat. Just be aware that, at this point, a taxable event will take place that requires capital gains taxes. The tax will consider the difference between the token’s original purchase price and its final sales price, and any interest earned on the tokens through lending will also be taxable.
Making Sense of Cryptocurrency Legislation
Being on the cutting edge of technology and finance offers both opportunity and threats. While there’s incredible upside to be gained in the cryptosphere, an unclear regulatory environment still remains one of the largest threats to the industry.
It’s clear, however, that the increasing popularity of crypto is pressuring lawmakers to action. One of the upcoming hallmark debates will be on the regulatory definition of digital assets — and specifically, whether they will remain classified as securities or if they will be considered property, commodities, or a host of other options.
New legislation seems to be on the table for 2022. Recent news made the headlines when a Wyoming Senator announced plans to introduce a new bill that would address the uncertainty surrounding crypto. The bill seeks to provide a better definition of cryptocurrencies and digital assets, which would offer additional clarity to regulators, operators, and HODLers across the board. Meanwhile, a House Representative has proposed a bill to prohibit the creation of a digital currency by the Federal Reserve — not unlike those Central Bank Digital Currencies (CBDC) that have been adopted by countries around the globe, such as China, Russia, India and more.
All in all, more laws will undoubtedly come that swing the balance in both directions. Given the challenges that DeFi poses for lawmakers around the globe, it’s only a matter of time before regulation follows. Only time will tell how the industry will respond, but at the end of the day, clarity and structure, no matter through supportive or other legislation, will certainly benefit all within the cryptosphere — particularly around tax season.
About Kyoko
Kyoko.Finance is a DAO-to-DAO and cross-chain GameFi NFT lending market for guilds and players. Kyoko’s DAO-to-DAO lending offers liquidity to promote web3 development, while its guild-to-guild lending, P2P NFT lending, and cross-chain asset lending platforms aim to solve the most pressing issues challenging the GameFi market, including the rising cost of entry and siloed in-game assets across different blockchains. Kyoko’s metaverse will also allow Guilds to display their history, progress, and other accomplishments, while players can connect with others in a world that can be built in, developed, and sold off.
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