Capital Gains Tax and The Crypto Market

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Cryptocurrencies.Ai may take a buy or sell a position in any cryptocurrency it writes about, at any given time. None of the information contained in this article is financial advice.

Last week, the investment industry was shocked by Joe Biden’s proposal to increase the capital gains tax rate from 20% to 39.6% for anyone with an annual income over $1 million. Although not surprising since Biden has promised to increase taxes ever since he started his presidential campaign, the announcement still led to a crash in the broader capital market.

For the cryptocurrency market, the news about capital gains tax rates hike on April 22nd also caused a negative price action for Bitcoin, and the asset broke a major trendline that can be traced back to the beginning of the current bull cycle.

To recap, capital gains tax is the tax being charged for the profit made. Short-term capital gains are charged when the assets are sold within a hold time of fewer than 12 months and long-term capital gains are charged when the assets are sold within a hold time of over 12 months.

Source: IRS

Biden’s proposal would increase long-term investors’ capital gains tax rates, potentially causing it to double. On the other side, short-term investors may see their new capital gains tax rates increasing by 2.6%. In other words, the tax proposal reduces the incentive for investors to hold their assets for a longer period because the benefits of doing so are marginally diminished.

Tying this proposed policy back to the cryptocurrency market, we argue that any increase to the US capital gains tax rates would not affect the crypto market as much as other assets such as equity.

Crypto is Truly Global

The cryptocurrency market is truly global. A report by Messari that was released in January 2021 stated that Asia accounts for almost half of global crypto trading, equivalent to that in the US and Europe combined. Additionally, the top 20 token projects, which account for approximately more than 40% of the market capitalization, are based in Asia.

It might come to no one’s surprise, but the US capital gains tax rates, and most of the western world in general, is one of the highest in the world, especially if compared to Asian countries. In fact, for the two arguably most active US states when it comes down to their investment activities, California and New York, Biden’s proposal would increase the total rate to 56.7% for Californians 54.3% for New Yorkers. Emerging markets in the Southeast Asian region have significantly lower capital gains tax rates.

Decentralized Lending

One of the most popular methods to mitigate the effect of capital gains tax is by using loans. For instance, Elon Musk borrowed $548 million in personal loans from Morgan Stanley, Goldman Sachs, and Bank of America Corp with his stakes as collateral last year. If he were to sell his shares, he would have incurred a taxable event and reduces his voting power in the company.

The crypto market will not only benefit from its global nature but also decentralization. Decentralized Finance (DeFi) as a sector has helped the crypto industry found a natural product-market fit, enabling crypto users from all over the world to have full control over their capital.

In fact, crypto lending has since grown to one of the biggest subsectors of the industry, with total value locked reaching multi-billion dollars.

Lending protocols such as Compound, Maker, and AAVE have achieved tremendous success. The total value locked in the entire DeFi ecosystem did not even reach $1 billion as of January 2020; but as of May 2021, the total value locked in the top three lending protocols alone is close to $30 billion.

Due to its newer and riskier nature, DeFi platform currently offers a much better borrowing and lending rate for investors on top of other benefits such as the ability to conduct all the transactions online.

The table below shows the crypto lending interest rates for various DeFi and CEXs on lending and borrowing. The rates are a 30-day average taken on April 26, 2020.

Meanwhile, according to the Federal Deposit Insurance Corporation (FDIC), the US average interest rate on savings accounts currently stands at 0.04% APY. While taking a loan from the bank, the personal loan interest rates will be charged by the bank based on credit score and average loan interest rates of 10.3% to 32%.

In the future, as the DeFi ecosystem grows, investors will be more incentivized to keep their money in the ecosystem. All of this is without considering innovative products that have started to emerge such as yield farming.

Besides DeFi, centralized exchanges have also starting to become fully integrated financial service firms, with lending, fixed-income, and consumer-banking products (crypto cards). In short, the entirety of the crypto ecosystem will be able to leverage its online, global, and decentralized nature to incentivize investors to keep their money in the ecosystem, mitigating taxable events as much as possible, while accruing all of the benefits of a traditional financial ecosystem.

In the future, as the DeFi ecosystem grows, investors will be more incentivized to keep their money in the ecosystem. All of this is without considering innovative products that have started to emerge such as yield farming.

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