How UKs shock DeFi tax rules could torpedo Londons crypto and fintech boom: It could just drive trading to Portugal

The UK tax authoritys approach to taxing DeFi transactionsmay drive down trading volumes and make the market less liquid.

Thats according to DLA Piper partner Jason Collins, who told Financial News thatfintechs may need to scale down activity if users step back from crypto investments over fear of a tax hit, which could also be applied retroactively.

DeFi has grown exponentially over the last two years the top 100 DeFi tokens had combined market capitalisation of nearly $100bn as of December, according to Moodys Analytics.

Collins said the potential for a tax hit on any yield could make lending less attractive but there could also be greater market damage long term.

It may just drive trading to other countries with a more favourable tax regime, such as Portugal, Collins said.

Her Majestys Revenue and Customs, the UK tax authority, changed its rules on 2 February after a consultation on taxing cryptoassets and stablecoins. Itcaught the sector by surprise, deviating from the Financial Conduct Authoritys approachthat treated cryptoassets as financial instruments.

The tax authoritys view of crypto strips it of a more favourable treatment that comes with the financial instrument classification, Collins said, adding that the changes would apply retroactively.

Firms are just starting to grapple with how this would hit their business models and customers.

The new rules are out of step with the governments aims to amp up Londons status as a global leader of innovation and a hub for thriving fintech startups post Brexit, says executive director of CryptoUK, Ian Taylor.

He warned undue reporting requirements for the consumer and confusion as crypto investors must report hundreds or even thousands of transactions.

The latest change would particularly hit users using DeFi to grow their cryptoassets via so-called lending and staking with a stake, a user leases cryptoassets to a particular blockchain and earns a fee for doing so, while lending would involve direct loan of a cryptoasset to a borrower. The UK is among the first countries that have produced a clearer approach to taxing digital assets, second to Norway.

Not all are as gloomy on the new rules.

HMRCs update should be seen as encouraging, according to Lavan Thasarathakumar, director of regulatory affairs for Emea at Global Digital Finance, the umbrella body for policymakers and regulators. GDF also counts large institutional investors, banks and fintech firms among its global members.

This sets out how [DeFi] would be dealt with and the acknowledgement that DeFi is here to stay, he said. The GDF speaks regularly to HMRC and will engage with the UK Treasury, which sets the strategic tax policy and policy development on the matter, in the coming weeks.

This will create friction in the process and is another example of how current rules do not quite fit crypto.The broader crypto strategy has to be looked at. We would like to see a bespoke regime for cryptoassets, Thasarathakumar said. This would depart from the current approach of expanding existing legislation and trying to bolt on things to make it work for crypto.

The matter raises questionsabout how much patience firms have over regulatory sluggishness perceived to be harming the market and their business models.

There is a problem in terms of all these big functions of government trying to legislate something they dont really understand, and innovations moving things forward at a pace they cant keep up with, Mark Hipperson, CEO at challenger bank Ziglu and former founder and CTO at Starling Bank, said.

He expects Ziglus investment accounts would be affected, sinceit loans out deposits for a 5% yield to customers, which would be subject to tax.

Hipperson says he isn’t worried about any data-reporting burdens Ziglu has told the FCA that it would provide a tool for users to simply download tax return data, but it wont be ready for use until the next tax year.

They recognise this isnt gambling, it is a proper investment class, and theyre bringing it into the capital tax regime, said Hipperson. Ziglu plans to send its 100,000 or so customers a briefing note about the changes, to remind them to consider their tax position.

Hipperson, who started his career at Barclays where he was deputy CTO and head of technology for the Barclays Group, said HMRCs change would mean complexity for individuals that use multiple exchanges. Firms would likely face the burden, he said.

Jonathan Rowland, CEO of Mode, an app that enables users to grow digital assets, said the latest change had brought confusion to the market. Rowland has had a 25-year career in financial services that include his founding of challenger lender, Redwood Bank, as well as a directorship of Luxembourg-based private lender, Banque Havilland.

He said regulators had gone from very positive, exciting, fast-moving to were back to the usual ways of red tape. Many might simply just give up and go somewhere else, he said.

Rowland said the changes are worrying because everyones set their business up, hired people and spent money on [creating] jobs. So, do we now stop? Do we scale back?.

This move could just introduce so much complexity and confusion that it would actually put a dampener on the progression that you have had so far, and the pace of development, Rowland said.

Customers might say, Until I understand what this means, I wont buy, sell, or be involved in the crypto industry. That is the ultimate worry for us.

Bigger investors outsize smaller retailers on DeFi adoption large institutional transactions above $10m accounted for over 60% of DeFi transactions in the second half of 2021, compared to under 50% for all cryptocurrency transactions, Chainalysis notes.

The technology relies on algorithm-based financial services powered by smart contracts laid over ledger platforms. Stripping out intermediaries in high-street banks in some cases means cheaper borrowing plus the opportunity for individuals to make their crypto or fiat liquidity work for a return.

To contact the author of this story with feedback or news, email Penny Sukhraj