It is often said that nothing is new - well, it seems that DeFi has taken a leaf from the history books in following the lead of mutual insurance companies and cooperatives which had pioneered much of the insurance sector we know today. Furthermore, DeFi has embraced the mutualisation based on peer-to-peer transactions. The data held by these DeFi platforms is in a cryptographic manner and decentralised, hence not reliant on one point of failure which so many of our existing centralised services providers currently rely on. Good behaviour is incentivised and poor behaviour is easily identified and penalised. An example of such a DeFi protocol is Feed Every Gorilla (FEG), a community-driven platform which uses smart contracts to help protect investors from ‘rug pulls’ (i.e., when the developers abandon a project and take investors’ money). A market practise constantly monitored by regulators in traditional equity markets is known as ‘front running’, which is when asset managers buy stocks before they buy for a client in the belief that the price will rise once the client’s order is executed. Front running presents a challenge for DeFi exchanges since transactions are broadcast publicly. This means people can see large trades about to happen and therefore try and trade beforehand so as to take advantage of the situation. All they need to do is to work fast and bid high for gas charges so that their deals get processed more quickly. DeFi exchange, Osmosis, is working on a way in which to tackle front running. These previous examples help to give an insight into how DeFi exchanges are learning from the experiences of traditional centralised exchanges and are trying, therefore, to both build systems and use technology so as to ensure that investors can have confidence in how DeFi exchanges operate.

Meanwhile, DeFi has also created new products and services such as Yield farming which transfers cryptocurrencies 24/7/365 between different lending marketplaces, to maximize returns, with no custodians/middlemen, and available to anyone, anywhere provided they have access to the internet. Another service DeFi platforms offer is flash loans used by DeFi traders looking to profit from arbitrage opportunities when two markets price a digital asset at different prices. This means that price differentials are quickly normalised and so, in time, ought to lead to more stable pricing of digital assets. DeFi can enable the way risk is managed in a completely different manner since decentralised exchanges can automatically match buyers and sellers on a peer-to-peer basis ensuring best execution and reducing all human involvement and inherent human error that can so often take place. In effect, this means that anyone with assets is able to turn once passive assets into assets that can be borrowed and generate additional returns, not dissimilar to traditional stock lending which historically has been dominated by only institutional investors.

Whilst DeFi is attempting to reduce and manage risks using technology, there is a possibility that smart contracts could themselves create new types of risks that need insuring. In essence, the power of DeFi is really based on smart contracts, defined by International Insurance.org as : “Smart contracts are irrevocable computer programs deployed on a blockchain that execute a set of pre-DeFined instructions. They are the basis of the DeFi ecosystem as tokens are themselves a smart contract”. Smart contracts rely on data which is ideally sourced from trusted ‘oracles’ i.e. sources that are trusted and independent. This presents a challenge for insurers because if the oracles are defective who is liable in the event of a claim and how can this risk be underwritten. Moreover, who is liable in the event that a smart contact fails? In essence, despite these potential issues, what we are now seeing in the DeFi sector is regulation, legislation and smart contracts overlapping and, until we see greater clarity from regulators, it will be hard for those using DeFi exchanges to truly understand all the risks, let alone insure them.

New risks to address

Source: International Insurance

According to the legal firm Norton Rose, since DeFi is accessible to various jurisdictions a variety of legal and regulatory challenges exist, including:

• the need for analysis to confirm if the structure will fall within the scope of the insurance regulatory perimeter of relevant jurisdictions. 

• risk coverage provided in relation to parametric-type insurance with index-based loss payments also has the potential to push the boundaries of how an insurance contract can operate within existing regulatory frameworks – in particular, the extent to which certain products can arguably be seen to constitute derivative contracts.

• the need for analysis to confirm the status of any tokens issued by the dApp, from a regulatory and securities perspective, in relevant jurisdictions.

Meanwhile, as reported by the Evening Standard: “Increased trading activity amongst retail shareholders through lockdown is set to help deliver a £1.5 billion boost to stamp duty receipts over the next two years”. Surely then, HMRC and tax authorities in other jurisdictions will be lobbying their governments to introduce legislation so that, ideally, all trading carried out by citizens will be liable for stamp duty, or the equivalent. This could prove to be difficult, however, where the exchanges are not regulated and/or not based in the country where the relevant tax authority is located. Exchanges/platforms which are regulated to trade stocks, shares and cryptocurrencies do exist, such as e-Toro, so it would be very easy for these exchanges to levy stamp duty or some form of trading tax. In Germany, Swarm Markets, which claims to be the only regulated DeFi exchange globally  could, in theory, also levy a transaction tax (stamp duty) since having carried out KYC to sign up a client, it could remit the tax collected to the relevant jurisdiction where the client is taxable.

The ten most used Blockchains by institutions

Source: Blockdata

With over 70 million digital wallets now in existence, the volume of digital assets is only set to rise. The table above shows a snapshot of the number of transactions on average per day, for just eleven cryptocurrencies. Furthermore, a report published by data acquisition and analysis company, DappRadar, highlights that:

• NFTs generated $10.67 billion in trading volume during Q3 - an increase of 704% from the previous quarter. Axie Infinity, just one NFT collection has now traded over $2billion historically.

• the DeFi total value of asset locked-in rose 53.45% in the last quarter to reach $178.12 billion.

• the blockchain industry grew 25% quarter-over-quarter and 509% year-over-year in terms of Unique Active Wallets (UAW), reaching 1.54 million daily UAW on average during Q3 2021.

• on-line games attracted UAW increasing by 140% in the last quarter, with reports claiming that 44% of gamers have purchased or traded game-related items on the blockchain in the last year.

With trading volumes and assets such as the above, it acts as a powerful driver for those governments, having run up huge deficits due to COVID-19, to look at new ways in which to raise revenue from taxing digital assets. Interestingly enough, there is no reason why smart contracts could not be employed in order to automatically calculate and deduct a small transaction tax for every digital asset traded. Now, wouldn’t that be ironic for tax authorities globally to be using Blockchain technology to collect tax revenue on assets not regulated by their own jurisdictions? But then again, under the 5th Money Laundering Directive in Europe (and an increasing number of other jurisdictions), regulators are insisting exchanges and platforms must carry out KYC and AML checks on clients even though the assets that are trade and listed on the platforms are not, themselves, regulated - or in some cases, not legally recognised. Whilst it is difficult to gather any exact numbers based solely on the daily turnover of the top 10 cryptocurrencies in a 24-hour period, according to Coingecko, turnover on the 2nd of November was $338billion. Therefore, if you assumed 365 trading days and then levied a transaction/stamp duty tax of 0.5%, this would raise $600+billion! 

Now Mr Taxman, surely this must grab your attention……?