This post was originally published on Forbes by Shehan Chandrasekera on February 21st, 2020
Uniswap is a peer-to-peer, decentralized cryptocurrency exchange which allows you to trade ERC 20 tokens. Uniswap exchange is different from a traditional exchange like Coinbase where your transactions are processed through an intermediary.
The tax code has not addressed how taxes work for Uniswap transactions. However, there is enough guidance in place to infer some of the tax consequences of transacting in this unique DeFi exchange. In this two part series, you will get a high level overview of how Uniswap exchange works and tax implications of various transactions.
What is Uniswap?
Understanding technicalities and underlying economics behind the Uniswap platform is beyond the discussion of this post. If you are curious about how it actually works, I highly recommend reading this guide published on the website. This introduction is sufficient for you to get a basic understanding of the platform so you can apply tax rules to various transactions.
If you are new to crypto, Uniswap will be a somewhat difficult concept to grasp. The easiest way to get a good understanding of Uniswap platform is by looking into three elements (liquidity, trading activity & fees) every crypto exchange needs and how Uniswap is handling them differently.
First, Uniswap relies on users’ funds to create liquidity. This is done by allowing users to participate in liquidity pools. The way these work are somewhat unique. Basically, if you want to participate in a liquidity pool, you have to deposit ether and an equivalent amount of another ERC 20 token at the same time. For example, assuming the price of 1 ETH is $200, if you want to participate in the ETH/cDAI liquidity pool, you would deposit 1 ETH and 200 cDAI, assuming price of 1 cDAI is $1. Your total dollar deposit will be $400. 1 ETH to 200 cDAI is the initial “deposit ratio”. Once the pair is deposited, Uniswap gives you a liquidity token labeled “UNI-V1” representing your deposit ratio.
You might wonder why anybody would provide liquidity. Uniswap platform charges a 0.3% flat fee when users trade (aka swap) ERC 20 tokens. Liquidity providers get a proportional share of these transaction fees based on the amount of liquidity provided. In a centralized exchange like Coinbase, these transaction fees would go to the exchange; it will not be distributed among participants.
Further, after you deposit your initial pair to the liquidity pool, the initial deposit ratio could change depending on trading activity. By going with the example above, regular trading activity by other participants in the ETH/cDAI pool could add more (or less) ETH or cDAI to the pool. This would proportionately affect your initial 1:1 deposit ratio. By going with the example above, if you leave your initial deposit on the platform for a while, you may see 1.2 ETH to 150 cDAI. This ratio will continuously change.
Another unique aspect of Uniswap compared to a traditional exchange is that, the exchange price of tokens in the platform is determined by the ratio of funds deposited in a certain pool. In contrast, traditional exchanges determine USD price of tokens based on supply and demand. Supply and demand is shown in the order book.
Finally, liquidity providers can take back their funds by burning liquidity tokens (UNI-V1). When they retrieve the funds, most likely, their initial deposit ratio has changed due to trading activity on the platform.
As you can see, using Uniswap is more complicated than trading through a centralized exchange (or a decentralized exchange) with a traditional order book in place. Understanding how Uniswap works is essential before analyzing the tax impact. In the next post, we will take a deep dive into tax implications of the above events.
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Disclaimer: this post is informational only and is not intended as tax advice. For tax advice, please consult a tax professional