Financial rules for the algorithm age

Everything from loans to derivatives to exchanges are being rebuilt as autonomous digital products outside the traditional finance system. These are not niche innovations. Some estimates have upwards of $50 billion locked up in DeFi products right now.

Consider one of the most innovative financial services in the DeFi space: automated market makers. These AMMs allow users to trade one digital asset for another without going through a traditional central orderbook. Investors – “liquidity providers” – put assets into a pool. People who wish to trade one asset for another make exchanges with the pool, which reprices each asset automatically to keep the pool in balance. Investors get fees and bear risk if the external price of the assets change.

AMMs are a brilliant innovation and a regulatory nightmare. Let us start with tax. The Australian Taxation Office treats any token-to-token exchange as a capital gains event, where profits and losses incur a tax liability is incurred, just like a normal exchange of financial assets. This regime makes sense for traditional finance. But it creates huge burdens for DeFi.

Imagine a relatively simple DeFi investment – putting bitcoin in an AMM. First, you have to bring your bitcoin onto a smart contract network like ethereum. Bitcoin can only truly exist on the bitcoin blockchain, so you vouchsafe your coins with a provider who then mints a digital representation of your bitcoin on the ethereum network. You deposit this “wrapped bitcoin” token (and usually another token) into the AMM. You get a receipt – just another token – that represents your share of the pool.

Each of these exchanges are capital gains events. None of them are denominated in Australian dollars. Even the most diligent DeFi user will inevitably make mistakes when trying to account for the capital gains and losses. Few users even realise they are actually performing a token-to-token exchange when they make AMM investments. It is hard to describe the capital gains treatment of DeFi as a functioning part of the tax system at all.

The tax regime may be a compliance nightmare, but at least it is navigable. There are even harder compliance questions in our imagined DeFi investment. For instance, what actually is an AMM, in law? It looks a lot like a managed investment scheme – that is probably what ASIC will think. Like a traditional managed investment scheme, investors pool money in return for profits and don’t have day-to-day control of the investments. But if an AMM is a managed investment scheme … well, it doesn’t have a manager. Algorithms can’t hold financial licences. Nor on a censorship-resistant blockchain can they be shut down.

There are solutions to these problems. Capital gains events should be limited to when cryptocurrency is converted to fiat or used to buy goods or services. My colleagues Darcy Allen, Aaron Lane and I have called for a new exemption to the managed investment scheme framework – what we call “autonomous investment products”. Where a product is entirely algorithmic, has no ongoing responsible party, and is completely open source and auditable by investors, the heavy compliance burdens of a managed investment scheme don’t make sense.

But these solutions will almost certainly require legislative change. Until now, Australia’s cryptocurrency policy has been made via regulatory guidance. That approach has reached its use-by date. Fintech innovation can’t be left to suffocate under regulatory uncertainty and incoherence.

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