What is the need for DeFi KYC
Asking for KYC processes (Know Your Customer) in the world of decentralized finance may seem unnatural, since DeFi is primarily focused on reducing the need for KYC processes in banking and financial institutions. However, the relationship between DeFi and KYC has far-reaching implications for the broader picture. Let us shed some light on the necessity of one for the safe existence of the other.
Equality between rules and financial decisions based on blockchain
Blockchain technology has been successful in achieving significant progress in terms of recognition by the authorities. After the Financial Action Task Force on Money Laundering, or FATF, the global regulatory body, presented updated guidance in June 2019, the authorities ‘ views on the use of blockchain technology changed.
Blockchain was widely used in the creation of decentralized applications that allowed users to sell, buy, store and exchange digital assets, tokens and virtual currency. However, the lack of rules for financial applications based on blockchain has had a very detrimental impact on the implementation of blockchain.
Gradually, blockchain-based solutions for financial services are being formed in the form of traditional financial institutions. How are blockchain-based financial services solutions changing? The scale of decentralized KYC largely depends on this transformation, as decentralized financial services are gradually coming under the laws and regulations on KYC and anti-money laundering (AML).
Many companies using blockchain in this area, such as wallet keepers and digital asset exchanges, will have to comply with the requirements. The rules will be the same for decentralized companies and traditional financial institutions. The FATF rulings on combining virtual asset service providers and traditional financial institutions on the same page in terms of regulations for AML and KYC laid the foundation for regulatory reforms. National regulatory authorities are also joining this trend and setting new criteria in their codes of laws to adapt to changes.
Although the new rules are relevant for platforms and organizations working with cryptocurrency, there is no specific mention of DeFi platforms. The KYC of decentralized finance is unlikely, since it does not fall under the category of sender, exchange or custodian. However, recent updates to the FATF manual indicate the imminent possibilities of regulating the DeFi space.
A brief reflection on DeFi
Before proceeding to further discussion, it is important to understand the meaning of DeFi. Decentralized financing has allowed us to recreate traditional financial instruments with a decentralized architecture. Its distinctive feature is the absence of any interference from the government, financial institutions or companies. The potential and breadth of use of DeFi go beyond centralized financing or CeFi.
Freedom from government and financial intermediaries implies open access to financial services for everyone. However, this aspect turns out to be one of the most serious failures for DeFi. Concerns about data security and compliance with the potential requirements of new regulations to introduce new risks mean a lot to DeFi. It is not about “whether KYC is needed” but rather about “what it can do for centralized finance”. The extent to which a DeFi solution provider wants to enforce compliance has a profound impact on their decisions to implement KYC on a DeFi solution.
Any entrepreneur or a newly established company in this area will obviously want to be on the side of the law. This will help them attract both institutional and corporate clients, referring to compliance with the new rules. However, will the combination of DeFi and KYC destroy the foundations of the decentralization of the sector?
In fact, there are many reasons why this may not be a problem. The new KYC and AML rules do not necessarily mean that DeFi will lose its original value. Here are the reasons that can show how KYC can work in DeFi, while maintaining its capabilities in the form of a decentralized approach to the provision of financial services.
- Attracting customers
The DeFi space is new, and many businesses are really interested in investing in this domain. However, the lack of rules may alienate the interests of such enterprises from DeFi. Thanks to the possibility of a comprehensive KYC process in their AML protocols, DeFi solutions can gain the trust of both private and institutional clients. When a reliable DeFi KYC protocol is demonstrated, it is easy to expand your customer base. Does it seem reasonable to dissuade potential customers without KYC in the DeFi solution?
- Security of personal data
One of the main problems associated with decentralized KYC is related to the vulnerability of personal data. The transparency of decentralized finance can become a serious deterrent for people offering their KYC data. However, in such situations, innovative technology can come to your aid.
It is important to note that the personal ID data does not need to be transmitted or stored in the application, the DeFi portal or VASP. For example, KYC-Chain can conduct end-to-end KYC assessment of potential customers. Interestingly, customer data never gets into the DeFi provider’s own database.
- The myth of centralization
Let’s say you think that decentralized KYC financing will lead to centralization. Due to KYC, the DeFi platform can continue to offer decentralized financial transactions. At the same time, it can also protect access to the platform for users with a confirmed identity. So, this is basically a DeFi within the framework of identity verification, without losing its essence.
Disadvantages of refusing to implement KYC in DeFi
The massive introduction of unregulated DeFi has led to the creation of many traps for the future of the sector. As the platforms seek to expand the scope of their use cases, the FATF continues to take measures to prevent any operations of DeFi platforms and exchanges without KYC. The CipherTrace report, showing some of the notable DeFi hacks in 2020, demonstrates the need for this solution. Various DeFi hacks have included well-known names such as,
- Uniswap
- Balancer
- Finance
- OUSD
- Axion Network
- Harvest Finance
- Value DeFi
- COVER
- Pickle Finance
The report also highlights some notable aspects that effectively answer “Whether KYC is needed for DeFi”. This indicates that massive capital growth and limited regulatory guarantees have led to the emergence of malicious agents in the ecosystem. The lack of rules has been identified as one of the main reasons for most of the annual DeFi hacks.
The sector added almost $129 million to the total amount compromised by the theft of cryptocurrency in 2020. Thus, it is quite obvious that the absence of KYC protocols will not support the ability of DeFi to provide commercial as well as legal stability.
On the other hand, one important issue remains – the introduction of KYC in DeFi. How will the sector, which was mainly designed to protect against the rules, be regulated?
Regulatory Authority for Decentralized KYC
The growing popularity of DeFi platforms and solutions in terms of their use was the subject of FATF attention. Currently, it is not a regulatory body. However, it offers a set of guidelines that define how DeFi solutions work with KYC. The FATF has demonstrated a promising determination to keep the DeFi space under regulatory control.
The perspective of the regulator clearly demonstrates the approaches of national governments to regulation, as well as their impact. FATF emphasizes the importance of combining DeFi and KYC to combat the possibility of using DeFi as a tool for money laundering and other illegal financial activities.
Most recently, the US Commodity and Futures Trading Commission (CFTC) adopted sanctions against the BitMEX crypto exchange. This is a clear indicator of the desire of regulators to ensure compliance with KYC on DeFi platforms and exchanges. The FATF has the impression that the decentralized KYC financing offers regulation, while simultaneously creating effective AML protocols and countering the financing of terrorism. The global body wants to use KYC to regulate DeFi, as in other areas of the financial industry.
Now the main task of implementation is the decentralized aspect. The decentralized features of DeFi have made it attractive to businesses and individuals as a favorable tool for managing and using finance in the first place. In a decentralized structure, no one is in charge, which leads to the question “who do you choose for regulation”.
KYC and Decentralized Compliance
Democratization is one of the fundamental principles of decentralized finance. Many of the first players in the field of DeFi focused on providing unique financial services and opportunities to individuals. They are aimed at creating an ecosystem that is completely independent of the usual financial industry and other centralized intermediaries.
In addition, the concept of DeFi KYC also contradicts another fundamental feature of DeFi, that is, anonymity. DeFi users can place bets, exchange and perform many other functions of financial services without any centralized authority that knows their information.
The regulator, along with the relevant regulatory regimes, considers the anonymity of financial transactions and activities as potentially dangerous. FATF also believes that anonymous financial transactions can also be very vulnerable to use by attackers. Thus, the organization emphasized the need to consider platforms, applications and VASP DeFi in its updated draft guide, which was received in March 2021. It is reasonable to ask what approach FATF will use to solve the problem of decentralized compliance.
The advent of decentralized KYC financing will mean that the FATF will not classify the underlying software or technology as VASP. On the other hand, the FATF will consider the owners or users of the platform, service or exchange as DeFi VASP. In fact, the FATF has updated the definition of VASP in its updated draft guide released recently.
The owners of DeFi platforms and services mainly need a KYC process so that users can allow them into the network to avoid regulatory sanctions. Thus, the owners of DeFi projects and innovators can face a wide range of technical and, possibly, ideological problems. For example, some crypto analysts note that DeFi and KYC can divide the world of DeFi. The first part of the world will be a regulated ecosystem, while the other part of DeFi will remain unregulated and anonymous.
What will happen next?
As you can see, the discussions on this topic revolve around the need to preserve decentralization. However, the real focus should be on the importance of compliance with regulatory requirements. Following the law is a basic social norm, and any DeFi solution provider looking for opportunities in an emerging market would not want to be labeled a “bad boy”. Regulatory sanctions can become a serious deterrent for companies and institutional investors interested in the DeFi space.
In the case of DeFi projects, owners and users must continuously work in jurisdictions with a notable experience of strict compliance with FATF guidelines. The use of KYC processes is a reasonable option, working in an environment compatible with FATF. Ultimately, DeFi projects seeking to participate in the financial ecosystem must provide KYC processes.
Conclusion thoughts
Weak KYC processes can become a serious obstacle for DeFi. Even if the sector opens the doors to financial services for everyone, it can turn into a platform for money laundering. The absence of rules and anonymity gives criminals the opportunity to use the services of DeFi without KYC confirmation. Thus, they can easily evade the rules and regulations on money laundering.
What if they use finance to support illegal activities, such as drug trafficking or terrorism? All the consequences of having DeFi without KYC clearly demonstrate why DeFi KYC will become the next norm in decentralized finance.