Perception of the crypto industry in 2021 isn’t the same as it was ten years ago; things have changed and crypto has gone mainstream. We have reached the point where many families are now considering and now open to some form of investment in crypto-assets, and several have allocated significant resources to crypto-assets. In some cases, this is driven by attracting returns, in other cases by next-generation family members who advocate investment in cryptography.
However, investment horizons in the crypto space have entirely changed since 2017. Investment opportunities now include Security Tokens, Non-Fungible Tokens, and DeFi (Decentralized Finance).
What is DeFi?
DeFi is the mechanism by which investors can enter into financial transactions – usually loans or commercial agreements – without the involvement of a bank or other intermediary. Operationally, DeFi transactions occur on public blockchains (usually, but not always, Ethereum) via decentralized applications (or dApps). dApps are built using blockchain-guaranteed smart contracts, and there is a wide variety of dApps serving different industries. There are dApps for various sectors, such as real estate, art, insurance, but DeFi is the name given to dApps with a financial function.
DeFi has received a lot of attention over the past twelve months, and we are now seeing customers using DeFi. Let’s consider some customer scenarios.
Borrow using DeFi
We’ve seen customers use DeFi to borrow against their crypto assets. Let’s suppose:
- A customer has significant crypto-assets;
- They do not want to sell the assets because the market is strong;
- They are holding a capital gain of 95% of the asset’s value, so they do not wish to generate a capital gain;
- They need to generate an income stream and diversify into conventional assets
One solution is to invest your crypto assets on a DeFi platform and then take out a loan in another cryptocurrency.
This allows to:
- Invest the loan proceeds in the stock market and generate a revenue stream;
- Retain your crypto-assets for the long term; and
- We typically avoid making a taxable disposition
Some customers also appreciate that they don’t need to provide personal guarantees, as they would with bank loans, or provide personal information to a centralized lender. There are numerous downsides to borrowing through DeFi – high fees, interest, and excess collateral – but for some customers, the benefits are more significant.
Lend Using DeFi
Other crypto investors may decide to earn passive income by borrowing their crypto assets through DeFi. For private lenders, DeFi can offer attractive returns.
The practical procedure is as follows: lenders stake their crypto-assets into ‘liquidity pools’ and often in return receive ‘Liquidity Pool Tokens (LPTs), which represent their interests in the pool. Liquidity pools are formed by ‘pairs’ of cryptocurrencies. This creates liquidity and allows borrowers to borrow at interest rates determined by an intelligent contract based on supply and demand.
Due to the transparent nature of blockchains, lenders can inspect liquidity pools to ensure they are sufficiently secured to allow repayment to all creditors. As the borrower’s collateral is held within smart contracts, in the event of default, the legal title of the collateral’s crypto-assets is transferred to the liquidity pool and lenders automatically.
Lenders should always seek tax advice before depositing their funds on DeFi platforms. Suppose they receive LPTs in exchange for the assets they put into the liquidity pool. In that case, they can undoubtedly make a taxable disposition by exchanging one crypto-asset for another, although there is some technical debate on this point. Lenders should also seek tax advice on the nature of the return on their investment, which usually takes the form of taxable interest.
There are a growing number of DeFi platforms, known as DEXs — Decentralized Exchanges, all seeking to attract new customers. To encourage users, platforms like Uniswap or Compound grant new crypto tokens native to their platforms and on which customers can also generate adequate returns. They are known as ‘Governance Tokens.’ This can add value to the investment, but potential investors should ensure they receive tax advice on obtaining and disposing of Governance Tokens.
Risks and Opportunities
DeFi has opened up a new cryptic but fast-moving world. As family offices and wealth holders consider investment opportunities through DeFi and other crypto innovations, they may be drawn to lucrative earnings and potential tax efficiency reports. However, they must be equally wary of the tax, investment, and fraud risks that often go hand in hand with investment in cryptocurrencies.