There has been a headwind of digital change disrupting the financial services sector for some years. However, says Simeon Moss, Director, Islands & Gibraltar Advisory at Deloitte, two of the most significant innovations are now rapidly evolving and converging to present the next wave of disruptive challenge – decentralised finance
Maturing blockchain technology and the proliferation of digital asset classes are combining with rapidly emerging decentralised finance (DeFi) business models to present both a challenge and opportunity for new entrants and traditional operators in the financial services sector.
What is DeFi and why should we be interested?
DeFi has its roots in utilising the decentralised foundations of blockchain technology and is the collection of financial services that utilise this. For example, it can facilitate transactions for digital assets and cryptocurrencies.
The distinction is that transactions are undertaken in an open, permissionless and largely interoperable technology stack, built on smart contract platforms.
Transactions can be executed securely and in a verifiable way with agreements enforced by code existing on a public blockchain.
This, at face value, then provides a highly accessible and immutable financial system offering equal access rights, transparency and reduced need for intermediaries.
While DeFi has many layers to its architecture, the types of use cases at the application layer range from payments, borrowing and lending, asset management and insurance through to derivatives and decentralised exchanges.
These are supported through publicly viewable smart contracts, which execute and govern how transactions take place for the respective DeFi product.
These sit on an asset layer that can either be fungible tokens – for example, ether or stable coins – or non-fungible tokens such as images and video and supported by blockchain distributed ledgers at the settlement layer.
The reason why these are different is that these are decentralised with no central authority, legal system or external enforcement mechanism required, resulting in new levels of transparency.
Coupled with the emerging ‘metaverse’ and the diversification of crypto assets, this offers opportunities for new growth and innovation.
This protocol, delivered through smart contracts, provides a high degree of trust, with changes verifiable independently by any actor along the chain, minimising the risk of any manipulation.
Regulatory focus
At present, there is a low alignment with existing regulatory defined factors across compliance, liquidity and governance, but a strong alignment to concepts of customer accessibility and transparency. Regulators globally are turning their attention to DeFi alongside crypto more broadly.
They will need to balance protection of consumers and investors with market integrity and prevention of financial crime.
But these are early days, with some regulators stressing the riskiness of DeFi platforms, particularly with the absence of any legal protections offered for traditional financial products and services.
We have also seen non-governmental industry bodies such as the Financial Action Task Force (FATF) updating guidance to virtual assets and virtual asset service providers, highlighting DeFi considerations that may fall under FATF requirements and definitions.
Collectively, regulators, watchdogs and international oversight bodies will be considering the following themes:
• The ability to provide timely regulatory responses to rapidly emerging DeFi products and services
• The ability to undertake supervisory and/or examination activities in the absence of centralised governance mechanisms
• Defining the roles that each specific regulator and body will play.
Jersey is already seeing a market for fintech-focused growth and investment, with crypto recognised as a separate asset class and the licensing of the world’s first crypto regulated fund.
The Jersey Financial Services Commission has published guidance on initial coin offerings (ICOs), which draws a distinction between security and utility tokens.
And while there is currently no specific legislation, the introduction of a virtual asset service provider (VASP) regime will provide a framework for the regulation and oversight of VASPs. Any financial services currently being provided are regulated within Jersey’s financial services regime.
Guernsey is also very active in this area having launched its first crypto fund, a Bitcoin exchange-traded fund (ETF) in late 2021, regulated by the Guernsey Financial Services Commission, one of a handful of Bitcoin ETFs globally.
So, while the DeFi ecosystem remains largely unregulated, this is likely to change, and organisations should build this into their strategy and own risk models.
The importance of obtaining independent assurance over the control environment in these organisations cannot be overstated, particularly relating to AML and CFT, which the VASP regimes seek to address.
Regulators locally and globally also continue to stress the inherent risks to retail customers in the investment space.
Tax implications
What are the tax implications for DeFi and crypto? At present there is no specific legislation on the taxation of cryptocurrencies or digital assets.
But in Jersey, there is guidance on the tax treatment of transactions in cryptocurrency from both an income tax and goods and services tax perspective, confirming that they will be taxed in accordance with principles of taxation.
Similarly, in the UK, the view of HMRC is that holding crypto assets should be subject to the same treatment as any other investment, being subject among other things to tax on capital gains.
Furthermore, different crypto assets are treated as separate assets for tax purposes and therefore there may be gains when one crypto asset is traded for another despite no underlying currency value being received.
Normal income tax rules are also applicable to crypto mining where validation of blockchain transactions occurs, typically through the receipt of further digital tokens (how the system is governed and self-regulating).
The historic fluctuation in value of any given token may cause challenges for valuations at a given point. This is also an emerging landscape from a tax perspective.
Where next?
DeFi introduces both opportunities and risks, but what is clear is that organisations will be required to manage cross-organisational challenges and market opportunities with emerging regulatory definitions. As a minimum, organisations should include DeFi for review in their strategic horizon.
As a market leader in digital assets, blockchain technology, business model optimisation, regulatory strategy and operations, Deloitte is uniquely positioned to assist organisations in navigating the complexities of this innovative space.
Further information
Simeon Moss is Director, Islands & Gibraltar Advisory, at Deloitte
Email: stmoss@deloitte.co.uk
• This advertising feature was first published in the June/July issue of Businesslife magazine