I wrote an article for CampdenFB in November 2017, which included the following statement:
“Only a courageous chief investment officer would stand before a family committee meeting to advocate a crypto investment... But perceptions are changing.”
Now, in 2021, perceptions have indeed changed. We have reached the point where many family offices are open to some form of crypto-assets investment, and a number have allocated serious resources to crypto-assets. In some cases, this is driven by the lure of returns, in other cases by next generation family members advocating crypto investment.
However, the horizons of crypto investment have completely changed since 2017. The investment opportunities now include security tokens, Non-Fungible Tokens and DeFi (Decentralised Finance).
What is DeFi?
DeFi is the mechanism by which investors can enter into financial transactions—often lending or trading arrangements—without the involvement of a bank or other intermediary. Operationally, DeFi transactions take place on public blockchains (usually, but not always, Ethereum), through decentralised apps (or ‘DAPPS’).
DAPPS are built using smart contracts secured on the blockchain and there are a wide range 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 much attention in the past twelve months and now we are seeing clients using DeFi. Let us consider some client scenarios.
Scenario 1: Borrower using DeFi
We have seen clients use DeFi to borrow against their crypto assets. Let us assume:
- Our client owns significant crypto-assets;
- They do not wish to sell the assets as the market is strong;
- They are holding a capital gain of 95% of the asset value, so do not wish to trigger a capital gain;
- They need to generate an income stream and diversify into conventional assets
One solution is for them to pledge their crypto-assets into a DeFi platform, and then take a loan in another crypto-currency. This enables them to:
- Invest the loan proceeds into the stock market and generate an income stream;
- Retain their crypto-assets over the long-term; and
- Normally avoid realising a taxable disposal (although we would always review the tax position based on the specific arrangements involved in a particular transaction)
Some clients also appreciate the fact they do not have to offer personal guarantees as they might with bank lending, or provide personal information to a centralised lender. There are numerous disadvantages of borrowing through DeFi—high fees, interest and over-collateralisation—but for some clients the advantages are greater.
Scenario 2: Private Lender using DeFi
Other crypto investors may decide to earn a passive income by lending their crypto-assets through DeFi. For private lenders, DeFi can offer attractive returns.
The practical procedure is as follows: lenders seed their crypto-assets into ‘liquidity pools’, and often in exchange receive ‘Liquidity Pool Tokens (LPTs), which represent their interest in the pool. Liquidity pools are formed of ‘pairs’ of cryptocurrencies. This creates liquidity and enables borrowers to borrow at interest rates which are determined by a smart contract based on supply and demand.
Due to the transparent nature of blockchains, lenders can inspect liquidity pools to ensure they are sufficiently collateralised to enable repayment to all lenders. As borrowers’ collateral is held within smart contracts, in the event of default the legal title to the collateral crypto-assets is transferred to the liquidity pool and to lenders automatically.
Lenders should always take tax advice before depositing their funds into DeFi platforms. If they receive LPTs in exchange for the assets they put into the liquidity pool, they may arguably make a taxable disposal by virtue of exchanging one crypto-asset for another, although there is some technical debate on this point. Lenders should also take tax advice on the nature of their investment return, which usually takes the form of taxable interest.
There are a growing number of DeFi platforms, known as DEXs—Decentralised Exchanges, all of which are seeking to attract new customers. To incentivise users, platforms such as Uniswap or Compound award new crypto tokens which are native to their platforms, and on which clients can also generate effective returns. These are known as ‘Governance Tokens’. This can add value to the investment, but potential investors should ensure they take tax advice on the receipt and disposals of Governance Tokens.
Risks and opportunities
DeFi has opened up an esoteric, but fast-moving, new world. As family offices and wealth-holders consider investment opportunities through DeFi and other crypto innovations, they may be drawn to the reports of lucrative yields and potential tax efficiency. However, they should be equally wary of the tax, investment and fraud risks that often go hand in hand with crypto investment.
In 2017, when I wrote my last crypto article for CampdenFB, bitcoin was still an outsider investment. Bitcoin has since entered the mainstream, and it is now the turn of DeFi and other innovations to receive the scrutiny that bitcoin once did. Time will tell whether DeFi will become as big as Bitcoin, but there will be significant implications if it can deliver just a fraction of its promise.